National Journal: Was the crisis a bank panic?

The enduring mystery about the financial crisis of 2007 and 2008 is this:  How did defaults in a niche segment of the mortgage market become one of the great financial crises of all time?

Writer Jonathan Rauch thinks Yale University economist Gary Gorton, who has spent his career studying bank panics, has the answer.

In a September 12, 2009, issue of the National Journal, Rauch quotes his friend Gorton:

I never thought we were going to see an event this big. I’m going to spend basically the rest of my career trying to sort this out.

In the National Journal article, Rauch explains why it didn’t make sense to him that subprime could have done so much damage:

Malcolm Gladwell, a New Yorker science writer, recently had this to say about the financial markets’ meltdown last fall: “The roots of Wall Street’s crisis were not structural or cognitive so much as they were psychological.” Too many people, apparently, got too cocky. And — kaboom! — the whole financial system collapsed!

Sorry. That won’t do. No doubt, too many people did get too cocky, but there is nothing new about cockiness (“animal spirits”) on Wall Street. No doubt, too, inadequate and misguided regulation played a part. No doubt, also, expansive monetary policy and affordable-housing mandates were factors. Indeed, many, many factors were factors.

But the core of the problem remains mysterious, even when you add up the standard explanations. The story most people think they know is that the Titanic (the financial system) steamed too fast (financiers got reckless) and hit an iceberg (bad subprime lending), so the ship sank. The problem with that story is that subprime mortgage lending was a big number, big enough to cause grief for investors in subprime paper. But it should not have been nearly big enough to bring the whole financial system to the brink of collapse.

Moreover, asset-backed securities that had nothing to do with subprime lending — paper backed by student loans, auto loans, corporate debt, credit card debt, regular mortgages, and so on — also seized up. On the merits, the crisis should have been sectoral, not systemic. It was as if the Titanic had missed the iceberg, or was only dented, and then sank anyway. Why?

The Rauch article discusses Gorton’s theory that the crisis was a banking panic. It concludes:

Whether Gorton has the story right is not something I am qualified to judge. The meltdown was a seminal event, one that no one, including Gorton, foresaw and one that will take years to understand. …

Assuming he is right, however, higher capital requirements for big banks, consumer-protection laws, and other commonly mooted reforms largely miss the point. The main question, Gorton says, is not how to strengthen conventional banking but how to stabilize shadow banking, which means, first and foremost, recognizing that shadow banking is banking and then asking whether it needs federal insurance, government-backed collateral, reserve requirements, regular audits, and other regulatory stabilizers.

“These are the real issues,” Gorton says. “It doesn’t seem to me that we’re having that kind of discussion.”