QnA About Financial Crisis

8/8/2019 QnA About Financial Crisis

1/17

Bestifviewedincolor.

QuestionsandAnswersabouttheFinancialCrisis*

PreparedfortheU.S.FinancialCrisisInquiryCommission

GaryGorton

YaleandNBER

February20,2010

Abstract

Allbondpricesplummeted (spreads rose)during the financial crisis,notjust thepricesof subprime

relatedbonds.Thesepricedeclinesweredue toabankingpanic inwhich institutional investorsand

firmsrefusedtorenewsaleandrepurchaseagreements(repo)shortterm,collateralized,agreements

that the Fed rightlyused to count asmoney. Collateral for repowas, to a large extent, securitized

bonds. Firmswere forced to sell assets as a resultof the banking panic, reducing bond prices and

creating losses.There isnothingmysteriousor irrationalabout thepanic. Therewere genuine fears

about the locationsof subprime risk concentrationsamongcounterparties. Thisbanking system (the

shadoworparallelbankingsystem) repobasedonsecuritization isagenuinebankingsystem,as

large as the traditional, regulated and banking system. It is of critical importance to the economy

becauseit

is

the

funding

basis

for

the

traditional

banking

system.

Without

it,

traditional

banks

will

not

lendandcredit,whichisessentialforjobcreation,willnotbecreated.

*ThankstoLoriGorton,StephenPartridgeHicks,AndrewMetrick,andNickSossidisforcommentsand

suggestions.


2/17

1

Unfortunately the subject [of thePanicof1837]hasbeen connectedwith theparty

politicsoftheday. Nothingcanbemoreunfavorabletothedevelopmentoftruth,on

questionsinpoliticaleconomy,thansuchaconnection. Agooddealwhichisfalse,with

someadmixtureoftruth,hasbeenputforwardbypoliticalpartisansoneitherside. As

it isthewishofthewriterthatthesubjectshouldbediscussedon itsownmeritsand

free from such contaminating connection, he has avoided as much as possible all

referencetothepoliticalpartiesoftheday (Appleton(1857),May1841).

Thecurrentexplanations[ofthePanicof1907]canbedividedintotwocategories. Of

these the first includes what might be called the superficial theories. Thus it is

commonlystatedthattheoutbreakofacrisisisduetoalackofconfidence asifthe

lackof confidencewasnot itself thevery thingwhichneeds tobeexplained. Of still

slighter value is the attempt to associate a crisiswith some particular governmental

policy,orwithsomeactionofacountrysexecutive. Suchpuerile interpretationshave

commonlybeenconfinedtocountriesliketheUnitedStateswherethepoliticalpassions

of a democracy had the fullest sway. . . . Opposed to these popular, but wholly

unfounded,interpretations

is

the

second

class

of

explanations,

which

seek

to

burrow

beneaththesurfaceandtodiscoverthemorefundamentalcausesoftheperiodicity

ofcrises(Seligman(1908),p.xi).

Thesubject[ofthePanicof1907]istechnical. Opinionsformedwithoutagraspofthe

fundamentalprinciplesandconditionsarewithoutvalue. Theverdictoftheuninformed

majoritygivesnopromiseofbeingcorrect.Iftosecureproperbankinglegislationnow

it is necessary for a . . . campaign of public education, it is time it were begun

(Vanderlip(1908),p.18).

Don'tbothermewithfacts,son.I'vealreadymadeupmymind." FoghornLeghorn

1. IntroductionYes,wehavebeenthroughthisbefore,tragicallymanytimes.

U.S.financialhistoryisrepletewithbankingcrisesandthepredictablepoliticalresponses. Mostpeople

are unaware of this history,whichwe are repeating. A basic point of this note is that there is a

fundamental, structural, featureofbanking,which ifnotguardedagainst leads to suchcrises. Banks

createmoney,whichallowstheholdertowithdrawcashondemand. Theproblemisnotthatwehave

banking;we

need

banks

and

banking.

And

we

need

this

type

of

bank

product.

But,

as

the

world

grows

andchanges, thismoney featureofbankingreappears indifferent forms. Thecurrentcrisis, far from

beingunique,isanothermanifestationofthisproblem. Theproblemthenisstructural.

Inthisnote, Iposeand trytoanswerwhat I thinkarethemostrelevantquestionsabout thecrisis. I

focusonthesystemiccrisis,nototherattendant issues. Idonothavealltheanswersbyanymeans.

But,Iknowenoughtoseethatthelevelofpublicdiscourseispoliticallymotivatedandbasedonalack


3/17

2

ofunderstanding,asithasbeeninthepast,astheopeningquotationsindicate. Thegoalofthisnoteis

tohelpraisethelevelofdiscourse.

2. QuestionsandAnswersQ.

What

happened?

A.Thisquestion,thoughthemostbasicandfundamentalofall,seemsverydifficultformostpeopleto

answer. They canpoint to the effectsof the crisis,namely the failuresof some large firmsand the

rescuesofothers. Peoplecanpointtotheamountsofmoney investedbythegovernment inkeeping

somefirmsrunning. Buttheycantexplainwhatactuallyhappened,whatcausedthesefirmstogetinto

trouble. Whereandhowwere lossesactuallyrealized? Whatactuallyhappened? Theremainderof

thisshortnotewilladdressthesequestions. Istartwithanoverview.

Therewasabankingpanic,startingAugust9,2007. Inabankingpanic,depositors rushenmasse to

theirbanksanddemandtheirmoneyback.Thebankingsystemcannotpossiblyhonorthesedemands

becausethey

have

lent

the

money

out

or

they

are

holding

long

term

bonds.

To

honor

the

demands

of

depositors,banksmustsellassets. ButonlytheFederalReserveislargeenoughtobeasignificantbuyer

ofassets.

Banking means creating shortterm trading or transaction securities backed by longer term assets.

Checking accounts (demand deposits) are the leading example of such securities. The fundamental

businessofbankingcreatesavulnerabilitytopanicbecausethebankstradingsecuritiesareshortterm

andneednotbe renewed;depositors canwithdraw theirmoney. But,panic canbepreventedwith

intelligent policies.What happened in August 2007 involved a different form of bank liability, one

unfamiliar to regulators.Regulatorsandacademicswerenotawareof the sizeorvulnerabilityof the

newbank

liabilities.

Infact,thebank liabilitiesthatwewillfocusonareactuallyveryold,buthavenotbeenquantitatively

importanthistorically. The liabilitiesofinterestaresaleandrepurchaseagreements,calledtherepo

market. Before the crisis trillionsofdollarswere traded in the repomarket.Themarketwasavery

liquidmarketlikeanotherveryliquidmarket,theonewheregoodsareexchangedforchecks(demand

deposits).Repoandchecksarebothformsofmoney.(Thisisnotacontroversialstatement.)Therehave

alwaysbeendifficulties creatingprivatemoney (likedemanddeposits) and this time aroundwasno

different.

Thepanic in2007wasnotobservedbyanyoneotherthan those tradingorotherwise involved inthe

capitalmarketsbecause the repomarketdoesnot involve regularpeople,but firmsand institutional

investors. So,thepanic in2007wasnot likethepreviouspanics inAmericanhistory(likethePanicof

1907,shownbelow,orthatof1837,1857,1873andsoon) inthat itwasnotamassrunonbanksby

individualdepositors,but insteadwasarunbyfirmsand institutional investorsonfinancialfirms. The

factthattherunwasnotobservedbyregulators,politicians,themedia,orordinaryAmericanshasmade

the events particularly hard to understand. It has opened the door to spurious, superficial, and

politicallyexpedientexplanationsanddemagoguery.


4/17

3

Q.Howcouldtherebeabankingpanicwhenwehavedepositinsurance?A. Asexplained,thePanicof2007wasnotcenteredondemanddeposits,butontherepomarketwhich

isnotinsured.

Astheeconomytransformswithgrowth,bankingalsochanges. But,atadeep levelthebasicformof

thebankliabilityhasthesamestructure,whetheritisprivatebanknotes(issuedbeforetheCivilWar),

demanddeposits,orsaleandrepurchaseagreements. Bankliabilitiesaredesignedtobesafe;theyare

short term, redeemable, and backed by collateral. But, they have always been vulnerable to mass

withdrawals,apanic. Thistimethepanicwasinthesaleandrepurchasemarket(repomarket). But,

beforewecometothatweneedtothinkabouthowbankinghaschanged.

Americansfrequentlyexperiencedbankingpanicsfromcolonialdaysuntildepositinsurancewaspassed

in 1933, effective 1934. Government deposit insurance finally ended the panics that were due to

demanddeposits(checkingaccounts). Ademanddepositallowsyoutokeepmoneysafelyatabankand

getitanytimeyouwantbyaskingforyourcurrencyback. Theideathatyoucanredeemyourdeposits

anytimeyouwantisoneoftheessentialfeaturesofmakingbankdebtsafe. Otherfeaturesarethatthe

bankdebtisbackedbysufficientcollateralintheformofbankassets.


5/17

4

Before the CivilWar the dominant form ofmoney was privately issued bank notes; there was no

governmentcurrencyissued. Individualbanksissuedtheirowncurrencies. DuringtheFreeBankingEra,

18371863, these currencies had to be backed by state bonds deposited with the authorities of

whatever state thebankwas chartered in. Banknoteswerealso redeemableondemandand there

werebankingpanicsbecausesometimesthecollateral(thestatebonds)wasofquestionablevalue. This

problemof

collateral

will

reappear

in

2007.

DuringtheFreeBankingErabankingslowlychanged,first inthecities,andoverthedecadesafterthe

CivilWarnationally. Thechangewasthatdemanddepositscametobeavery importantformofbank

money. During the Civil War the government took over the money business; national bank notes

(greenbacks)werebackedbyU.S.Treasurybondsandtherewerenolongerprivatebanknotes. But,

banking panics continued. They continued because demand deposits were vulnerable to panics.

Economists and regulatorsdidnot figure thisout fordecades. In fact,whenpanicsdue todemand

depositswere ended itwasnotdue to the insightofeconomists,politicians,or regulators. Deposit

insurance was not proposed by President Roosevelt; in fact, he opposed it. Bankers opposed it.

Economistsdecried

the

moral

hazards

that

would

result

from

such

apolicy.

Deposit

insurance

was

a

populistdemand.Peoplewantedthedominantmediumofexchangeprotected.Itisnotanexaggeration

tosaythatthequietperiod inbanking from1934to2007,duetodeposit insurance,wasbasicallyan

accidentofhistory.

Times change.Now,bankinghas changedagain. In the last25 yearsor so, therehasbeenanother

significantchange:achangeintheformandquantityofbankliabilitiesthathasresultedinapanic. This

changeinvolvesthecombinationofsecuritizationwiththerepomarket. Atrootthischangehastodo

withthetraditionalbankingsystembecomingunprofitableinthe1980s. Duringthatdecade,traditional

banks lostmarket share tomoneymarketmutual funds (which replaceddemanddeposits)andjunk

bonds

(which

took

market

share

from

lending),

to

name

the

two

most

important

changes.

Keeping

passivecashflowsonthebalancesheetfromloans,whenthecreditdecisionwasalreadymade,became

unprofitable. Thisledtosecuritization,whichistheprocessbywhichsuchcashflowsaresold. Idiscuss

securitizationbelow.

Q. Whathastobeexplainedtoexplainthecrisis?

A. Itisveryimportanttosetstandardsforthediscussion. Ithinkweshouldinsistonthreecriteria.

First, a coherent answer to the question ofwhat happenedmust explainwhy the spreads on asset

classescompletelyunrelatedtosubprimemortgagesrosedramatically. (Or,tosay itanotherway,the

pricesof

bonds

completely

unrelated

to

subprime

fell

dramatically.)

The

figure

below

shows

the

LIBOR

OIS spread,ameasureof interbank counterparty risk, togetherwith the spreadsonAAA tranchesof

bondsbackedbystudentloans,creditcardreceivables,andautoloans. Theunitsontheyaxisarebasis

points. The three typesofbondsnormally tradenearorbelowLIBOR. Yet, in thecrisis, they spiked

dramaticallyupwardsandtheymovedwiththemeasureofbankcounterpartyrisk.Why?


6/17

5

Source: GortonandMetrick(2009a).

Theoutstandingamountofsubprimebondswasnotlargeenoughtocauseasystemicfinancialcrisisby

itself. Itdoesitexplainthefigureabove. Nopopulartheory(academicorotherwise)explainstheabove

figure. Letmerepeatthatanotherway. Commonexplanationsaretoovagueandgeneraltobeof

anyvalue. Theydonotexplainwhatactuallyhappened. The issue iswhyallbondpricesplummeted.

Whatcausedthat?

Thisdoesnotmeanthattherearenototherissuesthatshouldbeexplored,asamatterofpublicpolicy.

Nordoes itmeanthattheseother issuesarenot important. Itdoes,however,meanthattheseother

issueswhatevertheyareareirrelevanttounderstandingthemaineventofthecrisis.

Second,anexplanationshouldbeabletoshowexactlyhowlossesoccurred. Thisisadifferentquestion

thanthefirstquestion.Pricesmaygodown,buthowdidthatresult intrillionsofdollarsof lossesfor

financialfirms?

Finally,aconvincinganswertothequestionofwhathappenedmustincludesomeevidenceandnotjust

beaseriesofbroad,vague,assertions.

InwhatfollowsIwilltrytoadheretothesecriteria.


7/17

6

Q. Wasntthepanicduetosubprimemortgagesgoingbadduetohousepricesfalling?

A. No.Thiscannotbethewholestory. Outstandingsubprimesecuritizationwasnot largeenoughby

itself to have caused the losses that were experienced. Further, the timing is wrong. Subprime

mortgagesstartedtodeteriorateinJanuary2007,eightmonthsbeforethepanicinAugust. Theredline

belowis

the

BBB

tranche

of

the

ABX

index,

ameasure

of

subprime

fundamentals.

It

is

in

the

form

of

a

spread,sowhenitrisesitmeansthatthefundamentalsaredeteriorating. Thetwoaxesaremeasured

inbasispoints;theaxisontherightsideisfortheABX. Theotherline,theonethatisessentiallyflat,is

theLIBORminusOISspreadameasureofcounterpartyriskinthebankingsystem. Itismeasuredon

thelefthandaxis. Thepointisthis: Subprimestartedsignificantlydeterioratingwellbeforethepanic,

which isnot shownhere. Moreover, subprimewasnever largeenough tobean issue for theglobal

bankingsystem. In2007subprimestoodatabout$1.2trillionoutstanding,ofwhichroughly82percent

wasratedAAAandtodatehasverysmallamountsofrealizedlosses. Yes,$1.2trillionisalargenumber,

butforcomparison,thetotalsizeofthetraditionalandparallelbankingsystemsisabout$20trillion.

Source:GortonandMetrick(2009a). LIBOISistheLIBORminusOvernightIndexSwapspread. ABX

referstothespreadontheBBBtrancheoftheABXindex.

Subprimewill

play

an

important

role

in

the

story

later.

But

by

itself

it

does

not

explain

the

crisis.

Q. Subprimemortgageswere securitized. Isnt securitization bad because it allows banks to sell

loans?

A. Holding loansonthebalancesheetsofbanksisnotprofitable. This isafundamentalpoint. Thisis

whytheparallelorshadowbankingsystemdeveloped. Ifanindustryisnotprofitable,theownersexit


8/17

7

the industrybynot investing; they investelsewhere. Regulatorscanmakebanksdo things, likehold

morecapital,buttheycannotpreventexitifbankingisnotprofitable. Exitmeansthattheregulated

bankingsectorshrinks,asbankequityholdersrefusetoinvestmoreequity. Bankregulationdetermines

thesizeoftheregulatedbankingsector,andthatisall. Oneformofexitisforbankstonotholdloans

but to sell the loans; securitization is the sellingofportfoliosof loans. Selling loanswhilenews to

somepeoplehas

been

going

on

now

for

about

30

years

without

problems.

In securitization, thebank is stillat riskbecause thebankkeeps the residualorequityportionof the

securitizedloansandearnsfeesforservicingtheseloans.Moreover,bankssupporttheirsecuritizations

whenthereareproblems. Noonehasproducedevidenceofanyproblemswithsecuritizationgenerally;

thoughtherearehavebeenmanysuchassertions. Themotivationforbankstosellloansisprofitability.

Inacapitalisteconomy, firms (includingbanks)makedecisions tomaximizeprofits. Over the last25

yearssecuritizationwasonesuchoutcome.Asmentioned,regulatorscannotmakefirmsdounprofitable

thingsbecause investorsdonothaveto invest inbanks. Bankswillsimplyshrink. This isexactlywhat

happened. The traditionalbanking sector shrank,and awholenewbanking sectordeveloped the

outcomeof

millions

of

individual

decisions

over

aquarter

of

acentury.

Q. What isthisnewbankingsystem,theparallelbankingsystemorshadowbankingsystemor

securitizedbankingsystem?

A. Amajorpartof it is securitization. Nevermind thedetails forourpresentpurposes (seeGorton

(2010fordetails);themainpointisthatthismarketisverylarge. Thefigurebelowshowstheissuance

amountsof various levelsof fixedincome instruments in the capitalmarkets. The green line shows

mortgagerelatedinstruments,includingsecuritization. Itisthelargestmarket.

0.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

3,000.0

3,500.0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

$

Billions

Issuancein

US

Capital

Markets

Municipal

Treasury

MortgageRelated

CorporateDebt

FederalSecurities

AssetBacked


9/17

8

Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS,

Bloomberg.

Of greater interest perhaps is the comparison of the nonmortgage securitization (labeled Asset

Backed intheabovefigure) issuanceamountswiththeamountofallofU.S.corporatedebt issuance.

Thisis

portrayed

in

the

figure

below.

Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS,

Bloomberg.

Thefigureshowstwovery importantpoints. First,measuredby issuance,nonmortgagesecuritization

exceededtheissuanceofallU.S.corporatedebtstartingin2004. Secondly,thefigureshowstheeffects

ofthecrisisonissuance:thismarketisessentiallydead.

Q. So, traditional, regulated, banks sell their loans to the other banking system. Is that the

connectionbetweentheparallelorshadowbankingsystemandthetraditionalbankingsystem?

A. Yes. Theparallelor shadowbanking system isessentiallyhow the traditional, regulated,banking

system is funded. The two banking systems are intimately connected. This is very important to

recognize. Itmeansthatwithoutthesecuritizationmarketsthetraditionalbankingsystemisnotgoing

tofunction. Thediagrambelowshowshowthetwobankingsystemsarerelated.

0.0

200.0

400.0

600.0

800.0

1,000.0

1,200.0

1,400.0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

$

Billio

ns

NonMortgageABSIssuancevs.CorporateDebt

CorporateDebt

AssetBacked


10/17

9

Capital

Debt

Capital

CP, MTN &

Capital

CorporateBorrower

TraditionalBanks

MMF

SecuritiesLenders

InvestmentManagers

Under-

exposedBanks

Pension CoInsurance Co

Loan

Loan

$/

CP

MTN

CDCP

ConsumerBorrower

Global: $11T*

Bank Conduits : $1T

SIVs

LPFCs

Securitizations:ABS

RMBSCMBSAuto loans

CLOsCBOs

CDOs

Specialist CreditManagers $500B

Products

Parallel Banking System Investors

BankEquity

< $10T

$500B

$2T

$4T

$2T

$25T

$1T

$40TCapital

Debt

Capital

CP, MTN &

Capital

CorporateBorrower

TraditionalBanks

MMF

SecuritiesLenders

InvestmentManagers

Under-

exposedBanks

Pension CoInsurance Co

Loan

Loan

$/

CP

MTN

CDCP

ConsumerBorrower

Global: $11T*

Bank Conduits : $1T

SIVs

LPFCs

Securitizations:ABS

RMBSCMBSAuto loans

CLOsCBOs

CDOs

Specialist CreditManagers $500B

Products

Parallel Banking System Investors

BankEquity

< $10T

$500B

$2T

$4T

$2T

$25T

$1T

$40T

TraditionalBankingFundingviatheParallelBankingSystem(preCrisisnumbers)

Source:GordianKnot.

The figureshowshow the traditionalbankingsystem funded itsactivitiesjustprior to thecrisis. The

loansmade to consumers and corporations, on the left side of the figure, correspond to the credit

creationthatthetraditionalbanksareinvolvedin.Wheredotheygetthemoneytolendtocorporations

andconsumers? Portfoliosofthe loansaresoldasbonds,tothevarioussecuritizationvehicles inthe

parallel

banking

system

(the

greenish

box

in

the

middle).

These

vehicles

are

securitization,

conduits,

structured investmentvehicles (SIVs), limitedpurpose financecorporations (LPFCs),collateralized loan

obligations (CLOs), collateralizedbondobligations (CBOs), collateralized debtobligations (CDOs), and

specialistcreditmanagers. Like thetraditionalbanks,thesevehiclesare intermediaries. They inturn

arefinancedbytheinvestorsontherightsideofthefigure.


11/17

10

Q. Butwerentthesesecuritizationssupposedtobedistributedtoinvestors? Whydidbankskeepso

muchofthisontheirbalancesheets?

A. Abovewediscussedthereasonsthatsecuritizationarose,thesupplyofsecuritizedproducts. What

about thedemand? There isa story that ispopularcalledoriginatetodistributewhichclaims that

securitizationsshould

not

end

up

on

bank

balance

sheets.

There

is

no

basis

for

this

idea.

In

fact,

there

is

an important reason for why banks did hold some of these bonds: these bonds were needed as

collateralforaformofdepositorybanking. Theotherpartofthenewbankingsectorinvolvesthenew

depositors. Thispartofthestoryisnotshowninthefigureabove.

InstitutionalinvestorsandnonfinancialfirmshavedemandsforcheckingaccountsjustlikeyouandIdo.

But,forthemthereisnosafebankingaccountbecausedepositinsuranceislimited. So,wheredoesan

institutional investor go to deposit money? The Institutional investor wants to earn interest, have

immediate access to themoney, andbe assured that thedeposit is safe. But, there isno checking

accountinsuredbytheFDICifyouwanttodeposit$100million. Wherecanthisdepositorgo?

Theanswer

is

that

the

institutional

investor

goes

to

the

repo

market.

For

concreteness,

lets

use

some

names. Supposethe institutional investor isFidelity,andFidelityhas$500million incashthatwillbe

used tobuysecurities,butnot rightnow. RightnowFidelitywantsasafeplace toearn interest,but

such that themoney isavailable incase theopportunity forbuyingsecuritiesarises. Fidelitygoes to

BearStearnsanddepositsthe$500millionovernightforinterest. Whatmakesthisdepositsafe? The

safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some assetbacked

securities thatareearning LIBORplus6percent. Theyhaveamarket valueof$500millions. These

bondsareprovidedtoFidelityascollateral. Fidelitytakesphysicalpossessionofthesebonds. Sincethe

transaction isovernight,Fidelitycanget itsmoneybackthenextmorning,or itcanagreetorollthe

trade. Fidelityearns,say,3percent.

Just like banking throughout history, Bear has, for example, borrowed at 3 percent and lent at 6

percent. Inorder toconduct thisbankingbusinessBearneedscollateral (thatearns6percent in the

example)justlikeintheFreeBankingErabanksneededstatebondsascollateral. Inthelast25years

orsomoneyundermanagement inpension fundsand institutional investors,andmoney incorporate

treasuries,hasgrownenormously,creatingademandforthiskindofdepositorybanking.

Howbigwastherepomarket? Nooneknows.TheFederalReserveonlymeasuresrepodonebythe19

primarydealerbanksthat it iswillingtotradewith. So,theoverallsizeofthemarket isnotknown. I

roughlyguessthat it isat least$12trillion,thesizeofthetotalassets intheregulatedbankingsector.

The

fact

is,

however,

that

the

repo

market

was

never

properly

measured,

so

we

will

likely

never

know

for sure how big itwas. There is indirect evidence, however, thatwe canwe bring to bear on this

question.

Onethingwecan lookat ishowbigthebrokerdealerbankswerecomparedtothetraditionalbanks.

Brokerdealer banks to a large extent were the new depository institutions. Since repo requires

collateral,theebankswouldneedtogrowtheirbalancesheetstoholdthecollateralneededforrepo.

Brokerdealersareessentiallytheoldinvestmentbanks. Whilethisdivisionisnotstrictlycorrect,itgives


12/17

11

someidea. Thefigurebelowshowstheratioofthetotalassetsofbrokerdealerstototalassetsofthe

regulatedbanks.

Youcansee inthefigurethattheratiooftotalassetsofbrokerdealerbankstotraditionalbankswas

about 6 percent in 1990, and had grown to about 30 percentjust before the crisis onset. In the

meantime,as

we

saw

above,

securitization

was

growing

enormously

over

the

same

period.

Why

would

dealerbanksbe growing theirbalance sheets if therewasnot someprofitable reason for this? My

answeristhatthenewdepositorybusinessusingrepowasalsogrowing.

Source:FlowofFundsdata;GortonandMetrick(2009a).

Now,ofcoursethere isthealterativehypothesis,thatthebrokerdealerbankswerejust irresponsible

risktakers. Theyheldall these longtermassets financing themwith shortterm repojust to takeon

risk. (Ofcoursetherearemucheasierwaystotakeon(muchmore)risk.) Asatheoryofthecrisisthis

theoryishardtounderstand.ItisalazyexplanationintheformofMondaymorningquarterbacking.

Further,thisview,ofcourse,ignoresthefactthatsomeonemustbeontheothersideoftherepo. Who

werethedepositors?Whatwastheirincentivetoengageinthisifitwasjustrecklessbankers?

Q. WhydoesnttherepomarketjustuseTreasurybondsforcollateral?

A. Aproblemwiththenewbankingsystem isthat itdependsoncollateraltoguaranteethesafetyof

thedeposits. But,therearemanydemandsforsuchcollateral. Foreigngovernmentsandinvestorshave

significantdemandsforU.S.Treasurybonds,U.S.agencybonds,andcorporatebonds(about40percent

isheldbyforeigners). Treasuryandagencybondsarealsoneededtocollateralizederivativespositions.

Further,theyareneededtouseascollateralforclearingandsettlementoffinancialtransactions. There

0%

5%

10%

15%

20%

25%

30%

35%

1

99001

1

99101

1

99201

1

99301

1

99401

1

99501

1

99601

1

99701

1

99801

1

99901

2

00001

2

00101

2

00201

2

00301

2

00401

2

00501

2

00601

2

00701

2

00801

RatioofBrokerDealers'TAtoBanks'TA


13/17

12

are fewAAA corporatebonds.Roughly speaking (which is thebest that canbedone,given thedata

available), the total amount of possible collateral inU.S. bondmarkets,minus the amount held by

foreigners is about $16 trillion. The amount used to collateralize derivatives positions (according to

ISDA)isabout$4trillion. Itisnotknownhowmuchisneededforclearingandsettlement. Reponeeds,

say,$12trillion.

Thedemand forcollateralhasbeen largelymetbysecuritization,a30yearold innovationthatallows

forefficientfinancingofloans.Repoistoasignificantdegreebasedonsecuritizedbondsascollateral,a

combination called securitized banking. The shortage of collateral for repo, derivatives, and

clearing/settlement is reminiscentof the shortagesofmoney in earlyAmerica,which iswhat led to

demanddepositbanking.

Q. Ok,letsassumethattherepomarketisverylarge. Yousaytheeventswereapanic,howdowe

knowthisisso? Whatdoesthishavetodowithrepo?

A. Hereswherewecometothequestionofwhathappened.

Theresanotheraspecttorepothat is important:haircuts. Intherepoexample Igaveabove,Fidelity

deposited $500million of cashwith Bear Stearns and received as collateral $500million of bonds,

valuedatmarketvalue. FidelitydoesnotcareifBearStearnsbecomesinsolventbecauseFidelityinthat

eventcanunilaterallyterminatethetransactionandsellthebondstogetthe$500million. Thatis,repo

isnotsubjecttoChapter11bankruptcy;itisexcludedfromthis.

Imagine that Fidelity said to Bear: Iwilldepositonly $400million and Iwant $500million (market

value)ofbondsas collateral. Thiswouldbea20percenthaircut. In this case Fidelity isprotected

againsta$100milliondeclineinthevalueofthebonds,shouldBearbecomeinsolventandFidelitywant

tosell

the

bonds.

Notethatahaircutrequiresthebanktoraisemoney. Intheaboveexample,supposethehaircutwas

zero to startwith,but then itbecomespositive, say that it rises to20percent. This isessentiallya

withdrawalfromthebankof$100million. Bearturnsover$500millionofbondstoFidelity,butonly

receives $400million. This is awithdrawalof $100million from thebank. Howdoes Bear Stearns

financetheother$100million?Wheredoesthemoneycomefrom?Wewillcometothisshortly.

Priortothepanic,haircutsonallassetswerezero!

For now, keep in mind that an increase in the haircuts is a withdrawal from the bank. Massive

withdrawalsare

abanking

panic.

Thats

what

happened.

Like

during

the

pre

Federal

Reserve

panics,

therewasashockthatbyitselfwasnotlarge,housepricesfell. But,thedistributionoftherisks(where

thesubprimebondswere,inwhichfirms,andhowmuch)wasnotknown.Hereiswheresubprimeplays

itsrole. Elsewhere,Ihavelikenedsubprimetoecoli(seeGorton(2009a,2010)).Millionsofpoundsof

beefmightbe recalledbecause the locationofasmallamountofecoli isnotknown forsure. If the

governmentdidnot knowwhich groundbeefpossibly contained the ecoli, therewouldbe apanic:

peoplewouldstopeatinggroundbeef. Ifweallstopeatinghamburgersforamonth,orayear,itwould


14/17

13

beabigproblem forMcDonalds,BurgerKing,Wendysand soon. Theywouldgobankrupt. Thats

whathappened.

Theevidence is in the figurebelow,which shows the increase inhaircuts for securitizedbonds (and

otherstructuredbonds)startinginAugust2007.

Thefigureisapictureofthebankingpanic. Wedontknowhowmuchwaswithdrawnbecausewedont

know the actual sizeof the repomarket. But, to get a senseof themagnitudes, suppose the repo

marketwas$12trillionandthat repohaircutsrose fromzero toanaverageof20percent. Then the

bankingsystemwouldneedtocomeupwith$2trillion,animpossibletask.

Source:GortonandMetrick(2009a).

Q. Wheredidthelossescomefrom?

A. Facedwiththetaskofraisingmoneytomeetthewithdrawals,firmshadtosellassets. Theywereno

investorswilling tomake sufficiently largenew investments,on theorderof$2 trillion. Inorder to

minimizelossesfirmschosetosellbondsthattheythoughtwouldnotdropinpriceagreatdeal,bonds

thatwerenotsecuritizedbonds,andbondsthatwerehighlyrated. Forexample,theysoldAaarated

corporatebonds.

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

Percentage

Average RepoHaircutonStructuredDebt


15/17

14

Thesekindsofforcedsalesarecalledfiresalessalesthatmustbemadetoraisemoney,evenifthe

salecausestopricetofallbecausesomuchisofferedforsale,andthesellerhasnochoicebuttotake

thelowprice. Thelowpricereflectstodistressed,forced,sale,nottheunderlyingfundamentals. There

isevidenceofthis. Here isoneexample. Normally,Aaaratedcorporatebondswouldtradeathigher

prices (lowerspreads) than,say,Aaratedbonds. Inotherwords, thesebondswould fetch themost

moneywhen

sold.

However,

when

all

firms

reason

this

way,

it

doesnt

turn

out

so

nicely.

ThefigurebelowshowsthespreadbetweenAaratedcorporatebondsandAaaratedcorporatebonds,

both with five year maturities. This spread should always be positive, unless so many Aaarated

corporatebondsaresoldthatthespreadmustrisetoattractbuyers. Thatisexactlywhathappened!!

Source:GortonandMetrick(2009a).

The figure isasnapshotof the firesalesofassetsthatoccurreddueto thepanic. Moneywas lost in

thesefiresales. Tobeconcrete,supposethebondwaspurchasedfor$100,andthenwassold,hoping

tofetch$100(itsmarketvaluejustbeforethecrisisonset). Instead,whenallfirmsaresellingtheAaa

rated

bonds

the

price

may

be,

say,

$90

a

loss

of

$10.

This

is

how

actual

losses

can

occur

due

to

fire

salescausedbythepanic.

Q. Howcouldthishavehappened?A. Thedevelopmentoftheparallelbankingsystemdidnothappenovernight. Ithasbeendeveloping

forthreedecades,andespeciallygrewinthe1990s. Butbankregulatorsandacademicswerenotaware

ofthesedevelopments. Regulatorsdidnotmeasureorunderstandthisdevelopment. Aswehaveseen,


16/17

15

thegovernmentdoesnotmeasuretherelevantmarkets. Academicswerenotawareofthesemarkets;

theydidnotstudythesemarkets.Theincentivesofregulatorsandacademicsdidnotleadthemtolook

hardandaskquestions.

3. SummaryTheimportantpointsare:

As traditional banking became unprofitable in the 1980s, due to competition from, mostimportantly,moneymarketmutualfundsandjunkbonds,securitizationdeveloped. Regulation

Qthatlimitedtheinterestrateonbankdepositswaslifted,aswell. Bankfundingbecamemuch

more expensive. Banks could no longer afford to hold passive cash flows on their balance

sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system.

Securitizationbecamesizable.

The amount ofmoney undermanagement by institutional investors has grown enormously.These

investors

and

non

financial

firms

have

aneed

for

ashort

term,

safe,

interest

earning,

transactionaccountlikedemanddeposits:repo. Repoalsogrewenormously,andcametouse

securitizationasanimportantsourceofcollateral.

Repoismoney. ItwascountedinM3bytheFederalReserveSystem,untilM3wasdiscontinuedin2006. But, likeotherprivatelycreatedbankmoney, it isvulnerable toashock,whichmay

causedepositorstorationallywithdrawenmasse,aneventwhichthebankingsystem inthis

case theshadowbankingsystemcannotwithstandalone. Forcedby thewithdrawals tosell

assets,bondpricesplummetedandfirmsfailedorwerebailedoutwithgovernmentmoney.

Inabankpanic,banksareforcedtosellassets,whichcausespricestogodown,reflectingthelarge amounts being dumped on the market. Fire sales cause losses. The fundamentals of

subprimewerenotbadenoughbythemselvestohavecreatedtrillions in lossesglobally. The

mechanismofthepanictriggersthefiresales. Asamatterofpolicy,suchfirmfailuresshould

notbecausedbyfiresales.

Thecrisiswasnotaonetime,unique,event. Theproblemisstructural. Theexplanationforthecrisis lies in the structure of private transaction securities that are created by banks. This

structure,whileveryimportantfortheeconomy,issubjecttoperiodicpanicsifthereareshocks

that

cause

concerns

about

counterparty

default.

There

have

been

banking

panics

throughout

U.S.history,withprivatebanknotes,withdemanddeposits,andnowwithrepo. Theeconomy

needsbanksandbanking. Butbankliabilitieshaveavulnerability.


17/17

16

ReferencesandFurtherReading

Appleton, Nathan (1857), Remarks on Currency and Banking: Having Reference to the Present

Derangement of the CirculatingMedium in theUnited States (J.H. Eastburns Press: Boston;

reprintof1841original).

Gorton,Gary

(2010),

Slapped

by

the

Invisible

Hand:

The

Panic

of

2007

(Oxford

University

Press;

2010).

Gorton,Gary (2009a), Slapped in the Face by the InvisibleHand: Banking and the Panic of 2007,

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882.

Gorton,Gary(2009b),Information,Liquidity,andthe(Ongoing)Panicof2007,AmericanEconomicReview,PapersandProceedings,vol.99,no.2(May2009),567572;http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1324195

Gorton, Gary and Andrew Metrick (2009a), Securitized Banking and the Run on Repo,


Gorton,

Gary

and

Andrew

Metrick

(2009b),

Haircuts,


Seligman, Edwin (1908),The Crisis of 1907 in the Light of History, Introduction to The Currency

Problem and the Present Financial Situation, A Series of Addresses Delivered at Columbia

University19071908(ColumbiaUniversityPress:NewYork;1908);p.viixxvii.

Vanderlip,Frank(1908),TheModernBank,chapterinTheCurrencyProblemandthePresentFinancial

Situation, A Series of Addresses Delivered at Columbia University 19071908 (Columbia

UniversityPress:NewYork;1908);p.118.

Documents

QnA About Financial Crisis