REPO MARKET AND SHADOW BANKING: PROFESSOR GARY GORTON BOOK “SLAPPED BY THE INVISIBLE HAND”January 18, 2011 at 3:49 am | Posted in Economics, Financial, Globalization, History, Research, USA | Leave a comment
Slapped by the Invisible Hand:
The Panic of 2007
Gary B. Gorton (Author)
“In a few words, the little guys bank at regulated commercial banks with deposit insurance. So the little guys don’t panic when there are problems in the economy or in the banking system. The big guys put their cash in a shadow banking system where their “deposits” called repos are collateralized by asset backed securities. The system works well until the value of the collateral comes into question. This is what happened in the summer of 2007. The shadow banks had to dump asset backed securities en masse into the financial markets and there was on one to buy them. The price of asset backed securities as a whole began to fall and the shadow banking system froze up. Gorton points out that this is nothing other than a 19th century-style banking panic that occurred behind closed doors and was misinterpreted by economists and regulators who simply had no experience with this sort of event.”
“Think you know what caused the collapse of Wall Street? Gary Gorton, the Sherlock Holmes of the financial crisis, has news for you.”–Robert Hahn, Founder of the AEI Center for Regulatory and Market Studies
“Slapped by the Invisible Hand is essential to understanding the deep weakness in the banking sector that led to the financial crisis. Like consumer banks before the Great Depression, the ‘shadow banking market’ is vulnerable to runs and panics and hysteria, and we are all, in turn, vulnerable to it. By looking beyond this financial crisis to the systemic flaws that make us vulnerable to all sorts of crises, Gary Gorton has created a necessary guidebook for what’s happened, and what needs to be done.”–Ezra Klein, Washington Post
“Gorton has produced the clearest account yet of what has happened…Slapped By the Invisible Hand is not a conventional retrospective. Instead it is a real-time chronicle of what the authorities were told at key points in the drama by a practitioner who was steeped in the history of banking as well…it is a major contribution.”–David Warsh, Economic Principals
“Provides a lucid framework for understanding the crisis truly substantive Slapped deserves an audience of more than just crisis connoisseurs.”–Barron’s
“It’s must-reading for anyone who wants to understand the recent economic unpleasantness.”–Matthew Yglesias, Think Progress
“Fascinating For anyone interested in the crisis, or in banking and finance more generally, this is absolutely essential reading.”–Tyler Cowen, Marginal Revolution, Professor of Economics at George Mason University
“Slapped by the Invisible Hand tells us that there were bank panics–systemic crises–in 1873, 1884, 1890, 1893, 1896, 1907, and 1914. On the other hand, there were no systemic crises from 1934 to 2007. The problem, as Gorton makes clear, is that the Quiet Period reflected a combination of deposit insurance and strong regulation-undermined by the rise of shadow banking. So we have a choice: restore effective regulation or go back to the bad old days.”–Paul Krugman, New York Times “Conscience of a Liberal”
“Gary Gorton has written an important book, one that clearly identifies the issues surrounding the recent financial crisis and separates them from the ongoing macroeconomic policy turmoil….quite an accomplishment, given that many of us are still trying to figure out happened in earlier panics and crises…. By narrowly focusing on the events and institutions of the Panic of 2007, how the economy got to where it is today becomes much clearer.”–EH.net
“Offers the most coherent and convincing account of the recent financial crisis that I have seen, stressing its essential similarity to historical banking panics. Gorton’s analysis leads to operational proposals for a regulatory environment that would be consistent with a safe, closely regulated banking system and with continued innovation in other financial services.”–Robert Lucas, University of Chicago, Nobel laureate in economics
“To understand the actual moment and mechanism of crisis, the definitive take is Yale economist Gary Gorton’s, in the delightfully titled Slapped by the Invisible Hand. Gorton’s is a challenging book for a non-finance type, but there is no better technical explanation of the panic.” –Slate.com
“Essential reading for anyone who wants to know what really happened in the world financial meltdown of 2007-08. Gorton writes with a wide grasp of financial history and a detailed understanding of complex areas such as the repo market. This book deserves to be read widely.”–Bill Bradley, Former United States Senator
“Think about it. If porcine greed, by itself, is enough to crash the financial sector, why doesn’t Wall Street crash every year? For that matter, why should the crash of the subprime market result in a recession so much worse than the one that followed, say, the dotcom bubble? To answer these questions, you should read [this] book. –National Post
“An indispensable and insightful guide to the origins and the mechanics of the financial crisis. If you want to be among those who understand what happened and what should be done you must read Slapped by the Invisible Hand.” –Peter R. Fisher, BlackRock and former Under Secretary of the U.S. Treasury for Domestic Finance
“Gary Gorton’s Slapped by the Invisible Hand perceptively explains how the financial crisis of 2008 was actually a crisis of 2007 and provides an essential historical context. It needs to be read by all who seek to shape our future policies.”–H. Rodgin Cohen, Chairman, Sullivan & Cromwell LLP
“This is the best book on the crisis what makes this book a winner is that [Gorton] lays bare the root cause of the crisis.” –David Merkel, CFA – Finacorp Securities, Aleph Blog
“Gorton comes to the table with long experience in the study of financial bubbles: he offers a challenging analysis of the late meltdown as a classic bank panic in modern dress.” –John D. Ayer, UC Davis Professor of Law Emeritus
“Scholars like Gorton do not get enough attention as we try to understand what caused the crisis and how to prevent a repeat he is one of the people that will play an important role in shaping reform.” –TheStreet.com
“Gorton, an authority on financial panics, argues convincingly that our most recent unpleasantness is not so different from earlier monetary disasters. The big change is that this one didn’t involve runs on your neighborhood ‘retail’ banks, but was a ‘wholesale’ crisis that came close to destroying the huge, unregulated network of brokerage houses that trade esoteric securities largely with each other. He believes that we must understand what caused the crisis before we can take steps to prevent another, similar crash in the very near future. His book is a guide to learning those lessons.” –Internet Review of Books
“The definitive history of the 2007 meltdown.” -The Electric Review
Originally written for a conference of the Federal Reserve, Gary Gorton’s “The Panic of 2007” garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown. Now, in Slapped by the Invisible Hand, Gorton builds upon this seminal work, explaining how the securitized banking system, the nexus of financial markets and instruments unknown to most people, stands at the heart of the financial crisis. The securitized banking system is, in fact, a real banking system, allowing institutional investors and firms to make large, short-term deposits. But, as any banking system, it was vulnerable to a panic. Indeed the events starting in August 2007 can best be understood as a panic–a wholesale panic, rather than a retail panic–involving financial firms “running” on other financial firms, resulting in the system becoming insolvent. As the financial crisis unfolded, Gorton was working inside an institution that played a central role in the collapse; thus this book presents the unparalleled perspective of a top scholar who was also a central insider.
· Print Length: 240 pages
· Publisher: Oxford University Press, USA
· March 1, 2010
· Language: English
Gorton has made an important contribution to the debate on the Financial Crisis (and I was eager to read his book because of it). He argues that government guarantees of retail deposits enacted in the 1930s, and not capital adequacy requirements, (temporarily) ended previously common panicked withdrawals from the entire banking system. As uninsured short-term institutional deposits have grown and become the primary source of funds for money center banking, it was just a matter of time before these runs began anew. But the book just about starts and ends there. At a critical junctures like ours, the country needs clear thinkers like Gorton to provide leadership by addressing the issues comprehensively, speaking out against demagoguery and making recommendations. Otherwise, why step to the microphone with a book instead of the papers he already published? Gordon scarcely draws conclusions and makes no substantial recommendations!
He points out why repurchase agreement failed as an alternative to government guarantees but goes no further. He shows (in many pages of unnecessary detail) that structured finance contributed to the difficulty of knowing how much (sub-prime) risk each bank held but he doesn’t analyze whether credit default swaps and flawed credit ratings also contributed to the confusion. Nor does he show that the value of withdrawing funds to reduce risk in fear of others doing likewise wouldn’t have occurred no matter the availability of information. He admits that better information likely would not have solved the problem but he offers no alternatives.
He claims, with little support (although surely its true) , that increased capital adequacy requirements will simply contract the boundaries of banking but he doesn’t show where, speculate how the resulting unfilled customer needs with be filled and whether these alternatives would be good or bad for the economy in terms of reducing systematic risk. In this context you’d also like to hear his evaluation of convertible bank debt as an alterative solution to the problem but again, nothing. (Increased reserves would likely curtail mortgage lending.) He asserts that the reduced value of monopoly rent conferred by previously restricted bank charters caused banks to take more risk. If his recommendation is to return to something akin to the restrictions of old, it would take a lot more than just pointing out the issue to show how, why and to what effect.
If you put forward a theory, you also have to show why it’s better than alternative explanations but he devotes only a couple pages to pooh-poohing the alternative theories that originate-to-distribute and misaligned incentives reduced lending standards (although I agree with his conclusions) . Except for noting that sub-prime finance served as a trigger, he never addresses the role of Freddie and Fannie in spurring on sub-prime mortgage lending and the extent to which the crisis could have been averted were that not the case. (Presumably we can infer Gorton thinks something else just would have come along.) The role of the trade deficit in the build-up of uninsured short-term institutional deposits is never mentioned. If the answer is for the government to guarantee institutional deposits should we also be guaranteeing offshore deposits into US financial institutions?
If you’ve read Gorton’s papers, there is nothing more here. If you haven’t, it’s a lot to slog through for what could have been summarized in a much shorter piece. Sentences like, “This agent cares about the intertemporal marginal rate of substitution, so the pricing kernel weights the expected returns on the demand deposits in determining the currency-deposit ratio” appear.
Gorton’s explanations of the financial meltdown are the most plausible out there. Gorton has studied banking and banking panics for decades. Unlike other economists he has detailed knowledge of how the banking system has evolved and what exactly happened in the summer of 2007.
”In a few words, the little guys bank at regulated commercial banks with deposit insurance. So the little guys don’t panic when there are problems in the economy or in the banking system. The big guys put their cash in a shadow banking system where their “deposits” called repos are collateralized by asset backed securities. The system works well until the value of the collateral comes into question. This is what happened in the summer of 2007. The shadow banks had to dump asset backed securities en masse into the financial markets and there was on one to buy them. The price of asset backed securities as a whole began to fall and the shadow banking system froze up. Gorton points out that this is nothing other than a 19th century-style banking panic that occurred behind closed doors and was misinterpreted by economists and regulators who simply had no experience with this sort of event.”
Slapped by the Invisible Hand: The Panic of 2007
Gary B. Gorton (Author)