Gary Gorton is one of the most influential and renowned experts on the financial crisis. Even Fed-Chairman Ben Bernanke referred to his work. Gorton, who teaches finance at Yale and is advisor to the New York Fed, explains the subprime disaster and the subsequent financial crisis as an unobserved bank-run – on repo and asset-backed securities. He speaks about superficial narratives of the crisis, bad regulation, the importance of „information insensitive debt“, shadow banking and the future of the banking industry.
By Alexander Armbruster
F ive years ago, in August 2007, news about problems of three BNP Paribas funds spread. Today this is regarded as the „official“ beginning of the financial crisis. In the following months the whole subprime disaster became clear. Where do we stand now – in respect of recovery and cleaning up?
Historically, the losses from a financial crisis have been large and persistent. In the average case, a decade after the crisis GDP growth is still lower and unemployment higher than the decade before the crisis. In the U.S. we are now mired in this limbo-like state, not a recovery but not a recession, some good economic indications, some not so good. This outcome is not inevitable. While Bernanke and the Fed were successful in avoiding a terrible outcome, policies have not been adopted to avoid the prolonged period of weakness. This is a human tragedy.
Following the crisis, the G20-countries discussed lots of regulations for the financial sector; in the US for example the Dodd-Frank Act/Volcker Rule emerged. For many observers it seems hard to predict whether it covers all the issues. What is your guess on that?
Evaluating Dodd-Frank depends on one’s explanation of the crisis. There are many narratives of the crisis, most superficial or off-point. If your view is that financial crises are special, one-off events -unfortunate coincidences of many factors – then the policy response would be to make a list of these many bad factors and try to solve each one. But, finanical crises happen in all market economies, over and over again. About 140 have occurred around the world since 1970. So, the idea that each is special seems silly.
In fact, there is a common factor which makes financial systems in market economies fragile. Bank debt is vulnerable to runs, sudden exits in which no one wants to lend anymore in the form of short-term debt. Such a run was at the core of the U.S. crisis. The run was on repo and asset-backed commercial paper. Investment banks were very substantially financed by short-term debt in the form of repo. Lenders became suspicious of the backing collateral and withdrew. The banks then had to sell assets, which caused the prices of all bonds to fall, since they were selling all types of bonds. The resulting free fall of bond prices caused many firms to get into trouble.
Unfortunately, the run was not observable to outsiders (academics, regulators, the media, or the public). They only saw the effects of the run – firms get into trouble. They mistook the effects for the causes. This confused view informed Dodd-Frank. Dodd-Frank has nothing to do with the problem of the vulnerability of bank debt, runs. The legislation may have some good features-we will see when the rules are written – but it does not solve the problem of the fragility of the financial system.
During the evolution of the subprime crisis, lots of research and analysis has been done and there are still several reasons mentioned for what happened: Silly lending by banks and the construction of (afterwards) risky assets like CMBS, RMBS, CDOs etc.; low interest rates for too long set by the Fed; homeowner policy done by Washington setting wrong incentives. Could you give us an introduction of the „state of the art“ of this discussion and your view on how and why the crisis happened?
I would say that the discussion is at a very low level. It is basically uninformed and anti-intellectual. I think the discussion ought to be about bank runs. As I said above, the crisis was a bank run, but unfortunately one that was not clearly observed. The laundry list of „causes“ misses the essential point that the private sector cannot create riskless assets to back bank money. So, there is always the chance that holders of bank money will become suspicious of the backing collateral. This occurred in 2007.
A good question is why the level of the public discussion is not more informed. I think there are two reasons for this. First, the experts – economists – were uninformed about crises and did not think a crisis would ever happen again in the developed world. When the crisis happened, they were as uninformed as the non-experts of the metamorphosis of the financial system as everyone else. So, there was no expert advice. Secondly, there is a political problem. In the history of market economies there have been repeated financial crises, each time threatening the solvency of the banking system. As Bernanke said in his testimony to the U.S. Financial Crisis Inquiry Commission, of the thirteen largest financial firms in the U.S., twelve were about to go bust. That is a systemic problem!
In the face of these systemic crises, no country in history has allowed the banking system to go bankrupt and be liquidated. One way or another governments and central banks have acted to keep that from happening. That makes sense, we need the banking system. But, saving the banking system means saving the bankers. And the public resentment and backlash from this causes the focus to shift from the structural features of the economic system to revenge against bankers. It is easy to understand this feeling. It is hard to accept that capitalism is a system where there is no one to blame, to put in jail. But, the system is vulnerable to crises. The system evolved over thirty years, creating the shadow banking system.
Do we know today, who assigned most of the subprime loans and during which time period of the 2000s? Was it the GSEs like Fannie and Freddie or was it mainly small private lenders? Do you have numbers about that?
No, there are no hard numbers on the GSEs. But, this is not key to the crisis. Crises are typically preceded by credit booms, and these often involve mortgages. The credit boom in the U.S. involved a lot of debt of different types.
In your book „Slapped by the invisible hand“, you write about „information-insensitive debt“ and its importance for the whole financial system. Please explain what that means and could you put it into context of the problems in the US and the Euro-Crisis as well?
Short-term bank debt is created to be useful as money. To serve that purpose it must be the case that it is above suspicion. Here’s what I mean. Repo is a short-term, usually overnight, deposit of money for interest. To make it safe the bank gives the depositor bonds as collateral. In this way, depositors (institutional investors, mostly) can get access to their cash each morning if the need it. But, often they don’t need it and they deposit again for another night. So, each morning billions and billions of dollars of repo are rolled, that is, it is agreed to keep the money on deposit overnight again.
The key to this is that depositors must not question the value of the collateral. They must basically accept it as good collateral without doing any research, due diligence, on the collateral. If the collateral is a U.S. government bond, then that seems straightforward. But, what if it is an asset-backed security or other privately-produced bonds? Then those bonds have to be high enough quality to be accepted without question.
„Information-insensitive“ means that the debt has the property that it is above suspicion. It is viewed as good collateral without doing a lot of research. It is like pfandbrief in Germany. Or checks before they were insured by the government. Such debt is not completely riskless and it can happen that suddenly it is not about suspicion, and then no one wants it. Instead they want cash, everyone wants cash. But, when everyone wants cash the banking system cannot possibly honor those demands.
Many observers have questioned this, arguing that depositors are silly or stupid to not check on the collateral. But, note that it was the same problem with checking accounts before they were insured by the government. No household depositor had the time to do credit analysis on the bank of someone paying in their store with a check. Money requires that there is confidence. The money must not be sensitive to information; it must keep its value. The whole point of money is that no one is supposed to have to do due diligence.
Think of it this way. If there is a blackout in the city, a failure of the electrical grid, it is a crisis. One response to this crisis would be to call for more transparency. To criticize people who just assumed that the electrical system would always work – what idiots! Reformers might recommend that the blue prints for the electrical grid be posted on the web for all to see, along with the names of all the electrical utility officials. We might all want to get some training as electrical engineers. The other response would be the opposite. We don’t want any information. We want the government to ensure that the electrical system works. We can’t all become electricians. Money is like electricity in this sense.
Should Europe go on with the strategy of undertaking structural reforms and austerity and an ECB acting in times of overwhelming pressure?
Structural reforms are essential, and this is essentially a political problem usually involving intergenerational transfers. For example, older unionized workers do not want to give up hard-won benefits that entrench them, while the unemployed young want lax rules so that employers will hire more people. Austerity has its limits. You cannot get blood from a stone.
Do you think a kind of a banking union and European deposit guarantee scheme would be of help?
The bank run in Europe has essentially already happened. It was quiet and slow and unobserved by most. Now the ECB provides most of the short-term financing to banks. Deposit guarantees and a banking union may be good ideas, but they are coming somewhat late in the crisis.
Concerning the banking industry, shrinking and consolidation are topics in particular within the investment banking branches: Looking some ten years into the future, what do you think will the banking system look like when you compare it to the years before the crisis?
It is worthwhile thinking about what kinds of financial systems have displayed long periods of stability. Essentially, those have historically been systems where there is an advantage to being a bank, a benefit. If banks are to some extent monopolies, because entry is limited either formally or informally, then there is a benefit to being a bank. Such a benefit causes banks to internalize risk-management. They don’t want to lose this benefit and in exchange they will follow the rules.
Regulators cannot force banks to do anything in a market economy. Bank capital is private property. If there are no benefits, then private bank capital can exit the regulated banking sector and migrate to a more profitable place. That is the logic of capitalism. For example, suppose bank regulators were to impose higher capital requirements on banks. Most economists think this would not be very expensive for banks; say it would cost 10 basis points extra. But, for a profit-maximizing industry 10 basis points times $10 trillion (the size of the shadow banking system) is a reason for some banks to migrate out of the banking sector. That’s a problem because it means that over the next few decades part of the banking system will move somewhere else, and take a different form. Who can predict now where it will be and what it will look like? I can’t.