Gorton: Financial crisis is a bank panic

A complex chain of securities, derivatives, and special-purpose vehicles created a stew of hard-to-analyze mortgage securities that lenders have fled since home prices started to fall, Yale Professor Gary Gorton told some of the world’s leading economists and financial market experts at a conference in Jackson Hole, Wyoming, August 21-23.

Unable to determine where the troubled subprime securities are, lenders have stopped making repurchase loans or buying asset-backed commercial paper, two critical sources of credit in recent years.

“The entire financial system was engulfed when the ability to engage in repurchase agreements essentially disappeared,” Gorton said in a paper he presented at the symposium. 

This reaction is like the banking panics of a century ago, and it explains the current turmoil in the financial markets, Gorton told the economists who are trying to understand the forces buffeting the credit markets.

The topic for the economic symposium, which is conducted each year in Jackson Hole by the Federal Reserve Bank of Kansas City, is “Maintaining Stability in a Changing Financial System.”

Many seem to put much of the blame for the turmoil on the originate-to-distribute model of securitization that has become popular with mortgage bankers, Gorton said, but he does not agree with that explanation.

The dominant explanation for the Panic is the ―originate-to-distribute‖ view, which is the idea that banking has changed in such a way that the incentives have been fundamentally altered as a general matter. It is argued that originators and underwriters of loans no long have an incentive to pay attention to the risks of loans they originate, since they are not residual claimants on these loans. In this view, investors apparently do not understand this and have been fooled (fingers point to the rating agencies). …

The originate-to-distribute view argues that the risks of loans were passed along to investors, leaving the originators with no risk. But, this can be immediately rejected. Significant losses have been suffered by many up and down the subprime chain. Originators, securitization structurers and underwriters – firms and individuals – have suffered.

“House price declines and foreclosures do not explain the panic,” Gorton said. Instead, the Panic of 2007 is a bank panic similar to the Panic of 1907, except that it is happening on the shadow banking system instead of on the FDIC-insured system, he said.

Gorton presented a technical paper at the conference that details how securitization works, with its tranches, residential mortgage-backed securities, pools and collateralized debt obligations. (In 2010 the paper became chapters 3 and 4 in Gorton’s book, “Slapped by the Invisible Hand, The Panic of 2007.”)

In his paper, he also discloses that for 12 years he has been “intimately involved in modeling, structuring, and transacting very significant synthetic credit portfolios, as a consultant to AIG Financial Products Corp.” (For more on Gorton at AIG, see the Financial Crisis Inquiry Commission and the Wall Street Journal.)

From Gorton’s summary of his Jackson Hole paper:

How did problems with subprime mortgages result in a systemic crisis, a panic?

The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages.

Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation.

Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives.

When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks.

The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting.  ….

I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.