Gorton: Crisis was a 21st Century run on the repo market

Professor Gary B. Gorton teaching students at the Yale School of Management. (Yale photo)

Yale Professor Gary B. Gorton told the Financial Crisis Inquiry Commission today that the financial crisis of 2007 and 2008 was first and foremost a bank run on the repurchase market, similar in many ways to the bank crises of 100 years ago.

The main problem, then, is not one of greed or fraud. Instead, depositors lost faith in the repurchase market and fled, just as a century ago depositors lost faith in their neighborhood banks and lined up at the front door to withdraw their deposits. In the 1930s Congress fixed that problem wwith FDIC insurance.

Yes, we have been through this before, tragically many times. U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we are repeating. A basic point of this note is that there is a fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. The problem is not that we have banking; we need banks and banking. And we need this type of bank product. But, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem. The problem then is structural.

Gorton said the run in 2007 and 2008 was invisible to most Americans because it occurred between giant financial institutions that borrow from and lend to each other on the repurchase market.

Experts used to think repo loans were safe because they are collateralized, and thanks to securitization there seemed to be a generous supply of collateral. But in the financial crisis of 2007 and 2008, repo lenders – who are the depositors in the repurchase market – lost faith in the mortgage-backed securities sometimes used as collateral.

Gorton said repo runs will repeat until the collateral is made bulletproof. Just fixing mortgage securities isn’t enough, because the next crisis may involve a different type of collateral. Limiting collateral to U.S. Treasuries will unnecessarily restrict credit, he said.