10/27/12

Misunderstanding Financial Crises, a Q&A with Gary Gorton | FT Alphaville

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Misunderstanding Financial Crises, a Q&A with Gary Gorton
Cardiff Garcia Oct 25 17:02 19 comments

Read enough books and economics papers about the recent US financial crisis, and at some point you might notice something odd. Most of them are about the factors that made the crisis and subsequent recession so profound and enduring excess leverage, deregulation, lax lending standards, the rise of securitisation, blindness of the rating agencies, fraudulent bankers but very few of them are about what actually started the crisis. Gary Gortons work is different. His 2009 book, Slapped by the Invisible Hand, argued that although these factors were all present, they were also somewhat beside the point. The financial crisis started the way all systemic financial crises start: as a bank run. The only difference was that this bank run took place in the shadow banking system, and the creditors who started the run werent depositors of retail banks, but the counterparties of investment banks in repo and commercial paper markets. More to the point, he has long argued that market economies are inherently vulnerable to such runs. And to begin thinking of why the recent crisis happened at all and how to prevent another, it is at least as important to address the question of why the US didnt have a crisis between 1934 and 2007. And to answer that, you need to know something about how the countrys banking system evolved in the century leading up to 1934. In his new book, Misunderstanding Financial Crises: Why We Dont See Them Coming, Gorton frames the recent crisis in the context of this longer history. And he also tackles some of the more complicated epistemological problems of modern-day economics (and in particular, macroeconomic models). Along the way, he arrives at some provocative conclusions including a few that would probably make a lot of regulators, economists, and especially the more severe critics of the banks and bankers a little uncomfortable. Gorton agreed to have an email back-and-forth with FT Alphaville about the book, and beneath we reproduce the transcript. [FT Alphaville:] You make the case that systemic financial crises all share a common structural cause: they begin as runs on short-term bank debt. Before the Quiet Period of 1934-2007, this meant depositors asking that their demand deposits be converted to currency or specie. In the recent crisis, it was the repo counterparties of banks raising haircuts and pulling funding in the shadow banking system. But whether in the regulated or shadow banking system, the one element common to all bank runs is that creditors begin to have doubts about the collateral backing their shortterm debt. Explain why and how this happens. [Gary Gorton:] The output of banks is money, in the form of short-term debt which is used to store value or used as a transaction medium. Such money is backed by a
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Misunderstanding Financial Crises, a Q&A with Gary Gorton | FT Alphaville

portfolio of bank loans in the case of demand deposits, or by collateral in the form of a specific bond in the case of repo. The backing is designed to make the bank debt as close to riskless as possiblein fact, so close to riskless than nobody wants to really do any due diligence on the money, just transact with it. But the private sector cannot produce riskless debt and so it can happen that the backing collateral is questioned. This typically happens at the peak of the business cycle. If its value is questioned, it loses its moneyness so no one wants it, and cash is preferred. But as we know, if everyone wants their cash at the same moment, their demands cannot be satisfied. In this sense the financial system is insolvent. The concept of money, and specifically how short-term bank debt acts as money, plays a big role in your book. What does it mean for this money to trade at par, and why does it matter for the stability of the banking system? It is easiest to think of the case where the money does not trade at par. An example of this situation is the American Free Banking Era prior to Civil War. At that time, each bank issued its own money backed by loans or state bonds. When used in transaction at some distance from the issuing bank, the money traded at a discount. My ten dollar bill, issued by a bank in New Haven,Connecticut would only be worth maybe $9.50 in New York City. But, no one knew for sure what the discount really should be and we would have to argue over this. Transacting in this way is difficult. So, creating private money with the feature that a ten dollar billor a check for ten dollarswould always be accepted as worth ten dollars would make money more efficient. This would require backing that was more credible. But, even if society can get to the point where the money is accepted at face value, there is still the danger that people or firms lose confidencethey come to question the backing assets and ask for their cash. Privately-produced money is inherently vulnerable in this way. Okay, and whats the equivalent of how this works in the shadow banking system now? Prior to the recent financial crisis a variety of different types of bonds were used as collateral. Some collateral was government debt but a variety of different privatelyproduced asset classes were also used. The collateral was acceptable because it was above suspicion, but the moneyness varied. In the modern system not all repo of the same maturity trades with the same overnight interest rate, for example. The overnight rate depends on the collateral. In other words, repo money is not all of the same quality but varies by collateral. This is similar to the different discounts in the Free Banking Era. During the crisis, when suspicions arose about asset-backed securities of various types, market participants tried to re-create moneyness by shortening the maturities of repo and CP, and with haircuts. Some types of collateral also become unacceptable. You also write that the collateral backing short-term bank debt must be secretless and information-insensitive. Yes, secretless or information-insensitive refers to money that all parties accept without suspicion; the money is above suspicion. In this case, it is very easy to transact. Hundreds of billions of dollars change hands in the repo market every morning. No one does due diligence on the collateral because the collateral is above suspicion. That is, it does not pay to do the due diligencethe collateral is secretless.

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Misunderstanding Financial Crises, a Q&A with Gary Gorton | FT Alphaville

And you write that only the government can create this kind of safe collateral, that bank runs are a risk whenever privately created collateral (eg the AAA-rated tranches of private-label MBS in the last crisis) is used to back bank debt. Why is that? As I mentioned above, the private sector cannot create riskless collateral. This is because the backing assets are longer-term than the bank money; the backing assets are claims on real output. An inherent feature of a market economy is that private money is useful over shorter time intervals than the backing collateral. This maturity transformation is not a choice, but inherent in the economy. You also write that before the crisis, there was a shortage of collateral and securitisation met this need. (You note in the book that 48% of all assets at Goldman, Morgan Stanley, Merrill, Lehman and Bear were pledged as collateral at the end of 2006.) If only the government can produce safe collateral, how should it best meet this need? It should not be surprising that roughly half of the assets of the investment banks were pledged. These are banks. In old style banking, the bank borrows at 3 percent and lends at 6 percent, earning the spread. When an institutional investor deposits in Lehman, he earns 3 percent and is given a bond as collateral. The collateral earns 6 percentwhich accrues to Lehman, so Lehman earns the spread. If the collateral is an asset-backed security, then bank loans are being financed this way. Shadow banking is real banking! We know from the data that when there is less government debt outstanding, the private sector creates private safe substitutes. If there is more government debt outstanding, the privately-created safe debt shrinks. This is because of the demand in the economy for safe assets. Privately-produced safe debt can be created without being vulnerable to bank runs with the right regulation. It would be better for the government to oversee the creation of privately-produced safe debt than to try to create enough government debt to meet the demand. I wonder about the limits to this idea. After all, the government creating collateral is another way of saying that the government is incurring liabilities. So lets say that the government provides this collateral either by issuing more debt or by guaranteeing the privately created debt that is used as collateral. Beyond a certain point (deficits/liabilities exceed a certain threshold) wont the collateral lose its perceived risklessness? Yes, there are limits to a governments ability to create safe debt. We have seen this recently in Europe where the debt of some governments has become informationsensitive it is no longer viewed as safe. When that happens, the demand for safe assets migrates to other countries. You can see this in global imbalances where some developing countries buy safe debt from the US and Europe. The US and Europe have a unique, very saleable product, namely safe debt. The book focuses a lot on the history of panics and bank runs in the US, but also on the history of the governments reactions to them. A lot of readers might be surprised to learn that the US has a long (proud?) history of giving forbearance and offering debt moratoria to banks experiencing a panic, and to homeowners behind on their mortgages (during a crisis). And usually the legal basis for the policymakers and courts offering these reprieves was dubious at best. In particular you mention two court cases that reverberated throughout American
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Misunderstanding Financial Crises, a Q&A with Gary Gorton | FT Alphaville

history, the Livingston and Blaisdell cases. Why were they so important? In market economies it has long been recognized that a financial crisis is a unique situation in which the entire financial system is at risk of collapse. No economy can do without the financial system, and so through history various devices have been resorted to, to keep the banking system from collapsing. In many cases, when faced with a bank run banks would suspend convertibility, that is they would simple announce that they would not pay out cash to depositors. This was illegal. In the Livingston case the court in New York State ruled that when all banks had suspended convertibility, the inability of a single bank to honor its debt was not a sign of insolvency. With this ruling banks could not be liquidated in a crisis. This ruling was hailed at the time, 1857, because it saved the banking system. The Livingston case legally identified a crisis situation in which bank debt would not have to honored. Later other devices were used. President Roosevelt declared a banking holiday during the Great Depression. The legal basis for this was very shaky but no one objected. The Blaisdell decision was also remarkable. It was a U.S. Supreme Court decision that upheld a Minnesota law passed during the Great Depression which allowed Minnesota mortgage holders to receive forbearance; they didnt have to pay their mortgages! Again, there was the legal recognition that the circumstances were special. This history has been lost because financial crises are misunderstood. Crises are now attributed to government actions rather than to the inherent features of bank money. The government tries to prevent bank runs, but thenwhen the bank run is not observedthe government is blamed for the crisis. The run on repo was not observed by regulators, academics, journalists, or the public. So instead of the Livingston and Blaisdell logic of saving the banking system and providing mortgage relief, there have been proposals to efficiently liquidate banks during crises. Realistically, this would mean liquidating the banking system. You write: The actions of government can prevent bank runs but seems to increase the costs of crisis resolution if there is a crisis. What are some of the other complexities involved in the timing of the governments response to a crisis? Since 1970 there have been about 145 systemic banking crises around the world, and not just in developing economies. In about 65 percent of these cases there were bank runs. The problem is that market participants expect the government or the central bank to act, and so the runif there is oneis delayed. This seems to result in larger crisis costs. This problem of expectations of government actions changing the timing of crises is best solved by designing regulations that avoids a crisis to start with. There are examples of this in historyrecent historywhere economies have not experienced a crisis for a long period of time. That should be the goal of regulation. Explain what you think is the relevance of the concepts of moral hazard and Too Big To Fail. I think these words have really lost any meaning, and instead are bantered about as political slogans. Even before the Federal Reserve System existed banks bailed out other (big) banks during crises. Basically, these ideas attribute crises to the government, seeing government actions as the cause. The underlying problem of bank runs is not seen as the problem. Hence, Dodd-Frank has living wills so that it will be easy to liquidate the banking system. This confusion between the actual problem and the governments response to the problem has largely become a political issue.
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Misunderstanding Financial Crises, a Q&A with Gary Gorton | FT Alphaville

Relatedly, you write: There is almost no evidence that links capital to bank failures. But you dont write that capital requirements are a waste of time, only that they wont prevent crises. Capital requirements were never the sole focus of attention for bank regulation until the 1980s. Again, there is a basic misunderstanding of financial crises. A bank run is a demand that all short-term debt in the banking system be turned into cash. That is simply not possible. It would be best to create a system where such a demand does not arise because the governments oversight has created sufficient confidence. Capital per se cannot do this. As indicated by what you wrote above, you dont have very kind words for Dodd-Frank. Dodd-Frank may have some good features. It depends on how the rules are written. But, it does not address the fundamental problem that there was a bank run. Its logic is that the government is the problem or proprietary trading is the problem. It has no coherent intellectual foundation but is rather a kind of grab bag of various ideas. You describe in the book how the ability to witness a bank run in person can affect the psychology behind the publics (and the governments) reaction to it. How is it different now that bank runs take place electronically and via phone rather than on the streets? In a pre-deposit insurance bank run, people would line up at their banks to withdraw their cash. Everyone would see the lines and understand that this was a crisis. But still it took over a century in the U.S. before this problem was solved with deposit insurance, which by the way was a populist mandate. Everyoneexcept the American peopleopposed deposit insurance because it was supposed to create moral hazard. Things are worse now because the bank run of the recent crisis was not observed by outsiders. Most people did not observe it and have no idea what happened. This compounds the problem because it leads to effects being mistaken for causes. The run resulted in about $1.2 trillion being withdrawn from dealer banks, which then had to sell assets causing bond prices to plummet. Plunging bond prices caused losses for many firms, many of which failed. The failures were observed, but not the cause. So, the popular narratives focused on bad greedy bankers and other superficial explanations. Okay, but you cant be saying that bad greedy bankers played *no* role in the crisis, right? That issues like mortgage fraud, lax underwriting, misrepresentations by mortgage lenders to the GSEs, things like the Magnetar and Abacus cases and other items that were still picking through should be minimised? If greedy bankers cause crises, we would have a crisis every week. The Quiet Period from 1934 (when deposit insurance was adopted in the US) until 2007, during which there were no systemic crises, is not explained as being due to non-greedy bankers. What, then, caused bankers to suddenly become greedy? In every crisis in history, it happens that fraud is uncovered. Partly this is due to the fact that everyone asks for their money, and sometimes it cannot be produced (as with Madoff). Other times it is the heightened scrutiny of the financial system that reveals these problems. I am not saying that these problems are unimportant. But I am saying that an explanation of the recurrence of systemic financial crises throughout the history of market economies cannot be explained by greed or fraud, etc. These are not explanations of crises and they are not the central problem. We are talking about systemic crises: that is crises in which the entire financial system is at risk. In
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Bernankes testimony before the U.S. Financial Crisis Inquiry Commission, he said that 12 of the 13 largest financial firms in the US were about to fail. How exactly does greed cause that, but it did not during the Quiet Period? But you also write, for instance, that historically many bank runs have started after credit-driven land price and real estate booms. It seems like mandating more prudential lending standards would help if not prevent future bank runs, then make them less frequent or less severe. I dont think that will help. It is an inherent feature of private economies that they cannot create riskless debt. What is the proposed lending standard, that banks are only allowed to make riskless loans? The fact is that the economy needs and wants private bank moneyshort-term bank debt. Such debt cannot be completely riskless. That is the problem that needs to be addressed by the government. You add that your own experience witnessing the crisis of 2007 from the AIG FP trading floor gave you a different perspective, but you dont get into much detail. Can you tell us more about it? Witnessing a bank run as an eyewitness gives one a gut feeling for the size and power of the event. One has the feeling that the tidal wave is so big that there is nothing that can be done, and that even if one had known beforehand that the crisis was coming there is nothing that could have been done. Things happen so fast and they are so large that it felt like the economy was coming to end. We have already forgotten this feeling. The subtitle of the book is Why we dont see them coming. Having read it, its clear that by we you mean economists. So tell us: why dont economists see financial crises coming? Financial crises are not predictable, though the buildup of fragility is observable. But I am referring to see in the intellectual sense. Financial crises were not viewed by economists as an inherent problem in market economies. It was not seen as a structural problem. Rather the problem was viewed as solved, although really no one had thought about it very hard. And financial history is an area that is on the fringes of economic history, which itself is a fringe area. Without understanding the history, economists viewed the crisis as a unique event. You also have a long discourse at the end on the problems with macroeconomic models, and especially their inability to capture how peoples expectations change. Give us a synopsis, and what can be done to fix them. The rational expectations revolution in macroeconomics was a revelation; enormous strides were made in macroeconomics. But even so, it has been difficult to measure and really understand how expectations are formed and how they affect reality. In the book I talk about President Franklin Roosevelts speech about the banking crisis in March 1933. It seems to me that he was able to successfully manage expectations since people lined up to put their money back in banks the next day. But the details of this we do not understand. I think that to address this issue we really need new measurement systems for the economy. Remember that during the Great Depression President Roosevelt had no idea whether the economy was growing or shrinking because national income accounting had not yet been invented. He sent people out to count the number of freight cars on trains. The financial crisis revealed that in a world of derivatives and off-balance sheet vehicles our situation is now pretty much the same. We need a measurement system
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appropriate to the new world. Markus Brunnermeier of Princeton and Arvind Krishnamurthy of Northwestern and I have proposed that risk be measured. Modern macroeconomics was built on national income accounting. Progress will be made if we measure risk. Finally, you offer a two-part solution for regulators: the creation of narrow funding banks, and regulating repo. How would these ideas help? My colleague Andrew Metrick and I proposed that securitization and repo be regulated. We proposed that a new kind of bank be allowed to operate. These new banks would essentially create private safe assets and short-term bank debt subject to regulatory oversight. Essentially, these banks would hold asset-backed securities and finance their portfolios with short-term debt, repo. We want to avoid another run so we want to address the problem head-on. Furthermore, we recognize that this new banking systemshadow banking is real banking. The economy needs this banking system. Prior to the crisis the issuance of non-mortgage asset-backed securities was larger than the issuance of U.S. corporate bonds. So, this banking system was very large and very important. It is difficult to see how the economy can recover when this banking system is in shambles. No positive, constructive, steps have been taken to recreate confidence in this system. Our proposal is a step in this direction.

This entry was posted by Cardiff Garcia on Thursday October 25th, 2012 17:02. Tagged with Banks, Gary Gorton, Repo, Shadow Banking.

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