Securitized Banking and the Run on Repog p

Gary GortonYale and NBER

Andrew MetrickYale and NBER

The CrisisThe Crisis

• Explaining the crisis requires explaining whyExplaining the crisis requires explaining why the spreads of non‐subprime‐related assets rose significantlyrose significantly.

Subprime Fundamentals and the Interbank Marketp

LIB‐OIS on left‐hand Y‐axis, ABX spreads on right‐hand y‐axis.

First Half of 2007—Before Panic

LIBOIS on left‐hand Y‐axis, ABX spreads on right‐hand y‐axis.

LIB‐OIS and Non‐Subprime AAA Assets, 2007‐2008

The CrisisThe Crisis

• Explaining the crisis requires explaining whyExplaining the crisis requires explaining why the spreads of non‐subprime‐related assets rose significantlyrose significantly.

• Either:C i i i i t– Crisis is a unique event, or –

– Crisis is structural, related to deeper issues to do with debt trading and liquidity provisionwith debt, trading, and liquidity provision generally.

• Very different policy recommendations• Very different policy recommendations.

J.S. Gibbons, The Banks of New York, Their Dealers, The Clearing House and the Panic of 1857 (1859), illustration by Herrick.

Debt and CrisesDebt and Crises

• Banks create debt that is information‐insensitive liquid. Gorton and Pennacchi (1990); Dang, 

Gorton, Holmström (2010a,b).

• To try to create riskless debt important to have a portfolio of collateral, so link to loans.

• Society needs debt/leverage to implement trade.  But, a shock can cause a crisis where information‐insensitive debt becomes information sensitiveinsensitive debt becomes information sensitive.

Repo: New Demand for BankingRepo: New Demand for Banking• A sale and repurchase agreement (“repo”) is a deposit of cash 

at a “bank” which is short‐term receives interest and isat a  bank  which is short term, receives interest, and is backed by collateral.  Depositor takes physical possession of the collateral.

• Repo short term, but typically rolled.

• Trading is fast, minimal due diligence.

• Carved out of Bankruptcy Code; unilateral termination by• Carved out of Bankruptcy Code; unilateral termination by non‐defaulting party.

• Collateral may be rehypothecated.y yp

• Collateral value may exceed the amount of cash deposited, i.e., there is a haircut.  E.g., deposit $98, receive a bond worth $100 a 2% haircut$100—a 2% haircut.

Corporate Borrower MMF

L

CP

CD CP

Global: $11T*

Bank Conduits : $1T

Parallel Banking System Investors

$4TCorporate Borrower MMF

L

CP

CD CP

Global: $11T*

Bank Conduits : $1T

Parallel Banking System Investors

$4T

Traditional Banks

Securities Lenders

Loan$/€

MTN

SIVsLPFCs

Securitizations:

$500B

$2TTraditional Banks

Securities Lenders

Loan$/€

MTN

SIVsLPFCs

Securitizations:

$500B

$2T

CP, MTN &

Capital

Investment Managers

LoanConsumer Borrower

ABSRMBSCMBSAuto loans

Products< $10T

$25TCP, MTN &

Capital

Investment Managers

LoanConsumer Borrower

ABSRMBSCMBSAuto loans

Products< $10T

$25T

Capital

p

Under-exposed Banks

CLOsCBOsCDOs

Bank Equity

$2T$1TCapital

p

Under-exposed Banks

CLOsCBOsCDOs

Bank Equity

$2T$1T

Capital

Debt

Pension Co Insurance Co

Specialist Credit Managers $500B

$40TCapital

Debt

Pension Co Insurance Co

Specialist Credit Managers $500B

$40T

Where did the sub‐prime risk go?Where did the sub prime risk go?

HaircutsHaircuts• Dang, Gorton, and Holmström (2009): A haircut is a tranching 

f h ll l i f i i i iof the collateral to recreate an information‐insensitive security so that it is liquid. 

• The risk that is relevant here is different than the risks weThe risk that is relevant here is different than the risks we usually think about, which are related to the payoff on the security.

h dd h k h f h h ld f h b d• A haircut addresses the risk that if the holder of the bond in repo, the depositor, has to sell a bond in the market to get the cash bank, he may face a better informed trader resulting in a y gloss (relative to the true value of the security). 

• This risk is endogenous to the trading process. 

The PanicThe Panic

• Haircuts were zero on all asset classes prior toHaircuts were zero on all asset classes prior to August 2007.

• A change to a positive haircut is a withdrawal• A change to a positive haircut is a withdrawal from the securitized banking system.

E b k fi i b d h $100• E.g., bank was financing a bond worth $100 with repo (zero haircut).  With a 20% haircut, h b k l i $80 f h b d B kthe bank only receives $80 for the bond.  Bank must come up with the extra $20 – the 

i hdamount withdrawn.

50.0%

Average  Repo Haircut on Structured Debt

40.0%

45.0%

30.0%

35.0%

ge

20.0%

25.0%

Percen

tag

10.0%

15.0%

0.0%

5.0%

2007

2007

2007

2007

2007

2007

2007

2007

2007

2007

2007

2007

2008

2008

2008

2008

2008

2008

2008

2008

2008

2008

2008

2008

2009

2009

1/2/2

2/2/2

3/2/2

4/2/2

5/2/2

6/2/2

7/2/2

8/2/2

9/2/2

10/2/2

11/2/2

12/2/2

1/2/2

2/2/2

3/2/2

4/2/2

5/2/2

6/2/2

7/2/2

8/2/2

9/2/2

10/2/2

11/2/2

12/2/2

1/2/2

2/2/2

Fire Sales: AAA Spreads Above AA Spreads

Aug 2007 Lehman Sept 2008