Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007 Gary Gorton Yale and NBER.
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Transcript of Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007 Gary Gorton Yale and NBER.
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Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007
Gary GortonYale and NBER
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J.S. Gibbons, The Banks of New York, Their Dealers, The Clearing House and the Panic of 1857 (1859), illustration by Herrick.
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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.
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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.”
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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)
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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.
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“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.
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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.
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Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS, Bloomberg.
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Source: Flow of Funds.
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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
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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.
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Subprime Fundamentals and the Interbank Market
LIBOIS on left-hand Y-axis, ABX spreads on right-hand y-axis.
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LIBOIS and Other AssetsFull Period, 2007-2008
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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.
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Treasury Repo Fails
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Treasury Repo Fails
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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.