Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007

Gary GortonYale and NBER

J.S. Gibbons, The Banks of New York, Their Dealers, The Clearing House and the Panic of 1857 (1859), illustration by Herrick.

http://upload.wikimedia.org/wikipedia/commons/1/18/1907_Panic.png

Introduction

• How did problems in one part of the housing market cause a systemic crisis? What is a “systemic” crisis?

• The current crisis is a banking panic, but it occurred in the wholesale bank market, not the retail bank market.

• Shadow banking is genuine banking, combining securitization and repo.

• Haircuts in the repo market increased, a run on the wholesale banks -- a systemic problem.

What Happens During a Panic?

• Depositors run en masse to their banks to withdraw cash in exchange for their deposits. Usually started in large cities, spreads to smaller towns.

• The banking system is insolvent because the banking system cannot honor contractual demands. It is not possible to sell the assets of the banking system.

• Banks suspend convertibility; cut-off info; issue new money.

• Checks can no longer be used. There is a shortage of cash for transactions—a “currency famine.” Cash is hoarded, causing a “currency premium.”

Pre-Fed U.S. PanicsNBER Cycle

Peak-TroughPanicDate

%∆(C/D) %∆ Pig Iron

Loss perDeposit $

% and # Nat’l Bank Failures

Oct. 1873-Mar. 1879 Sep. 1873 14.53 -51.0 0.021 2.8 (56)

Mar. 1882-May 1885 Jun. 1884 8.8 -14.0 0.008 0.9 (10)

Mar. 1887-Apr. 1888 No Panic 3.0 -9.0 0.005 0.4 (12)

Jul. 1890-May 1891 Nov. 1890

9.0 -34.0 0.001 0.4 (14)

Jan. 1893-Jun. 1894 May 1893 16.0 -29.0 0.017 1.9 (74)

Dec. 1895-Jun. 1897 Oct. 1896 14.3 -4.0 0.012 1.6 (60)

Jun. 1899-Dec.1900 No Panic 2.78 -6.7 0.001 0.3 (12)

Sep. 1902-Aug. 1904 No Panic -4.13 -8.7 0.001 0.6 (28)

May 1907-Jun. 1908 Oct. 1907 11.45 -46.5 0.001 0.3 (20)

Jan. 1910-Jan. 1912 No Panic -2.64 -21.7 0.0002 0.1 (10)

Jan. 1913-Dec. 1914 Aug. 1914 10.39 -47.1 0.001 0.4 (28)

Previous Panics

• Panic occurs when there is a shock, leading depositors to question the value of demand deposits and to prefer cash instead.

• Depositors could not identify bank-specific risks, so they responded to aggregate news, and ran on all banks.

• Clearinghouse issues money and stops releasing information.

• Still, there is a collapse of the transactions infrastructure, a “currency famine” and a “currency premium.”

• The current panic will follow this same pattern.

“Banking”• Safe place to store money and have a transaction

medium.• Transaction medium must be informationally-insensitive.• “Info insensitive” means that the variance of its value is

low- does not pay speculators to trade. Just need ratings.

• Historically, demand deposits: made info insensitive by deposit insurance.

• “Banking” activity has moved out of chartered “banks” into the capital markets. Not news.

• ABS and RMBS bonds are informationally-insensitive.• Repo market is intermediation: repo is $12 trillion (?); TA

in banking system is $10 trillion.

Repo

• A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is backed by collateral. Depositor receives the collateral.

• Collateral value may exceed the amount of cash deposited, i.e., there is a haircut. E.g., deposit $98, receive a bond worth $100.

• Later, the borrower/bank has the right to buy back the bond.

• Repo short term, but typically rolled.• Collateral may be rehypothecated.• Repo collateral: securitized products.

Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS, Bloomberg.

Source: Flow of Funds.

Total Mortgage

Originations (Billions)

Subprime Originations

(Billions)

Subprime Share in

Total Originations (% of dollar

value)

Subprime Mortgage

Backed Securities (Billions)

Percent Subprime

Securitized (% of dollar

value)

2001 $2 ,215 $190 8.6% $95 50.4%

2002 $2,885 $231 8.0% $121 52.7%

2003 $3,945 $335 8.5% $202 60.5%

2004 $2,920 $540 18.5% $401 74.3%

2005 $3,120 $625 20.0% $507 81.2%

2006 $2,980 $600 20.1% $483 80.5%

Mortgage Originations and Subprime Securitization

Where did the risk go?

• We don’t know for sure.• Into CDOs, SIVs, institutional investor portfolios, pension

funds, money market mutual funds.• Counterparty fears.

Subprime Fundamentals and the Interbank Market

LIBOIS on left-hand Y-axis, ABX spreads on right-hand y-axis.

LIBOIS and Other AssetsFull Period, 2007-2008

Summary

• Assert classes unrelated to subprime, but important in the repo market, co-move with LIBOIS.

• The collapse of the repo market, and with it the availability of using these assets as alternatives to cash, caused spreads to widen.

Treasury Repo Fails

Treasury Repo Fails

Conclusions

• Shadow banking is real banking.• But, it was vulnerable to a panic.• The panic centered on the repo market, where concerns

about counterparty risk and the liquidity of collateral led to massive repo haircuts.

• In a panic, the banking system is insolvent.