Falkenstein: I found the transmission mechanism, the amplifier

How did problems in subprime housing translate into a crisis that paralyzed Wall Street and thrust Main Street into the Great Recession?

Many have asked that question since the catastrophic days of September 2008.

Eric Falkenstein, economist, quant, blogger and author of “Finding Alpha,” thinks he’s found the answer.

From his May 18, 2009, blog:

Until today, I was totally befuddled by the transmission mechanism, the amplifier.

I mentioned that last year at this time I was at a National Bureau of Economic Research conference, and Markus Brunnemeier pointed out that the decline in housing prices was insignificant relative to the change in stock market, and this was in May 2008!

Almost everyone in the audience of esteemed financial researchers agreed, and thought the market was in a curious overreaction. That is, we did not know why a loss of $X in housing valuation, caused a $10X change in the stock market–and it was only to get much worse.

You see, greed, hubris, fat tails, copulas, regulatory arbitrage, do not really work. …

Gary Gorton makes the first really compelling explanation I have seen, and he’s an economist. He is drawing on his experience as a consultant at AIG, and his experience modeling bank runs. I think this highlights that those best able to fix things should not have totally clean hands. … Gorton did not anticipate the 2008 events, but his analysis is much richer than those blaming complexity or hubris ….

The Gorton story is as follows. We have not had a true bank run since the Great Depression in the US, so we forgot what they look like. The essence of a bank run is described in those books on Bear Stearns: sparked by plausible speculation and a first mover, if you think a bank is losing other depositors, it pays to take out your deposits, and as no bank is sufficiently liquid to pay off all its depositors immediately, if this idea become popular the bank is doomed as each depositor seeks its own self-interest in getting to be first in line for their money. …

Say the banking system has assets of $100 financed by equity capital of $10, long-term debt of $40, and short term financing in the form of repo of $50. In the panic, repo haircuts rise to 20 percent as banks are wary of previously Gold AAA rated securities, amounting to a withdrawl of $10, so the system has to either shrink, borrow, or get an equity injection to make up for this. As we saw, after some early equity injections during the fall of 2007, this source dried up, as did the possibility of borrowing. That leaves asset sales. So the system as a whole needs to sell $10 of assets. They sell their tradeable securities as their liabilities decrease, and those securities are in a pricing matrix with the AAA rated collateral that is increasing its haircut.

Gorton estimates the banking system needed to replace about $2 trillion of financing when the repo market haircuts rose. This is the amplifier. …

Thus, the problem is that repo replaced retail deposits as the center of the bank run, as AAA rated securities of all types used in these transactions were all downgraded implicitly to non-prime (below A2/P2), and in many cases based on mortgages which historically were the safest asset class in the US. There was a bank run but it was by the ‘shadow bank sector’, and so all we could see were the effects not the usual cause (lines of panicked individual depositors). …

Looked at in this narrative I marvel at how the future can be so like the past, but different enough to escape notice in real time. I suppose every war or financial crisis is like that.


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