qna about financial crisis
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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.
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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
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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.
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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.
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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?
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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.
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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
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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
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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
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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.
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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
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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%
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2
00201
2
00301
2
00401
2
00501
2
00601
2
00701
2
00801
RatioofBrokerDealers'TAtoBanks'TA
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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
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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
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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,
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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.
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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,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1440752.
Gorton,
Gary
and
Andrew
Metrick
(2009b),
Haircuts,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1447438.
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.
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