An interview with Yale professor Gary B. Gorton

Yale University finance economist Gary Gorton discussed his theory of the financial crisis and the run on the repurchase market in a lengthy interview published in December by the Federal Reserve Bank of Minneapolis.

In the interview, Gorton made the point that shadow banking and traditional banking are not separate.  Traditional banks pool loans and create securities that they can use as collateral for a repo loan from the shadow banking system. Then traditional banks use that money from the shadow system to do more lending on the traditional banking system.

From Gorton:

So those bonds, if they’re securitization bonds, asset-backed securities, are linked to portfolios of bank loans. Because of this link, traditional banking and shadow banking are integrated. They’re part of the same system. …

This is a crucial, crucial point. Because if you think about the current unemployment rate and wonder, “Well, banks aren’t lending. What could we do?” A very practical, constructive step would be to help the securitization market, which would at the same time help traditional banks.

The fact is that this market is broken. And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.

Gorton said many of the threads of the crisis, while important, are not the reason for the global financial panic.

I would point out that the overriding issue here, I think we should understand, is the vulnerability of bank money to panic. That’s the issue. It’s not that other things are unimportant. But we haven’t had trouble with the other things in the sense of a global financial crisis.

If you had brokers cheating people, predatory lending, declines in underwriting standards, or you don’t like credit derivatives or something, whatever it is, those things per se are not a global financial crisis. And it’s the global financial crisis that is the first-order effect to be dealt with. And I think we know, we should know by now, what the problem is and what to do. My concern is that we’ll go another 77 years before we figure it out. ….

Looking back at history, think about how long it took to devise a solution to the first banking panic related mostly to demand deposits. That was in 1857. It wasn’t until 1934 that deposit insurance was enacted. That’s 77 years where we’re trying to understand demand deposits and figure out what to do.

The situation that we’re in now, seriously, is one where we are back in about 1860: We’ve just had a big crisis, and we’re trying to figure out what to do. We can only hope that it doesn’t take 77 years to figure it out this time.

Douglas Clement, who conducted the interview, introduced it this way:

Shadow banking—the intricate web of financial arrangements and techniques that developed symbiotically with the traditional, regulated banking system over the past 30 or so years—is territory Gorton has studied for decades, but it (and he) have been largely on the periphery of mainstream economics and policy.

That all changed in mid-2007, when panic broke out in the subprime mortgage market and financial institutions that support it. Expressions like “collateralized debt obligation” and “repo haircut” escaped the confines of Wall Street and business schools, and began to fill the airwaves. We’re still struggling to come to terms—and few are in a better position to help than Gorton.

Gorton might have stayed on the margins had Fed Chair Ben Bernanke not highlighted his research. In a September 2010 speech, for instance, Bernanke cites a Gorton paper as an example of contemporary research that has “significantly enhanced our understanding of the crisis and [is] informing our regulatory response.” By no coincidence, the Fed invited Gorton to major policy conferences in 2008 and 2009 to give papers on shadow banking, versions of which appear in his 2010 book Slapped by the Invisible Hand.

Gorton begins that book with a bit of self-disclosure that reveals his grasp of the issues as more than academic. “I was in a unique position to observe the events” of August 2007, he writes. Not only had his research career focused on banking, financial crises and banking panics, but “starting in 1996, I also consulted for AIG Financial Products, where I worked on structured credit, credit derivatives, and commodity futures.”

Thus, Gorton’s appreciation of modern banking and its vulnerabilities is informed by practice as well as theory. Sharing that understanding requires considerable effort; we’ve provided a glossary to help with the terminology and, fortunately, Gorton is a lucid narrator of a complex tale. And as Wright suggests, the rewards to studying this material are profound.


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