Slapped by the Invisible Hand: The Panic of 2007

Article excerpt

Slapped by the Invisible Hand: The Panic of 2007. Gary B. Gorton. 223 pages, New York: Oxford University Press, 2010.

Slapped by the Invisible Hand is on Federal Reserve Chairman Ben Bernanke's reading list of publications that have helped him understand the financial crisis. Indeed, this book provides a very detailed analysis of how the problems in one relatively small part of the financial sector-the subprime mortgage market-caused a meltdown of a large portion of the financial system. Gorton's thesis is that the shadow banking system, the financial institutions such as investment banks, and others that were not subject to banking regulations, were behaving like banks and suffered a classic "run on the bank." Lenders to these institutions had no deposit insurance, but assumed that their loans were very safe assets. The run on the banks was caused by the particular design of home mortgages and the securities that were based on them. In Gorton's view, the details of this system matter.

The book is in the Survey and Synthesis Series sponsored by the Financial Management Association, and consists largely of essays that were written for presentation at Federal Reserve conferences in 2008 (Jackson Hole) and 2009 (Jekyll Island). As such, the book is written for professionals and not the general public. It includes sentences such as (p. 27): "If securitization debt is information insensitive, it can be input into the repo system, creating a kind of transaction medium, i.e., collateral that can be rehypothecated." Instructors who choose to use the book in class will need to guide the students carefully.

A basic concept in the book is information-insensitive debt. Gorton argues that a fundamental function of the banking system is the creation of debt that does not have to be monitored by the lender. Currency and demand deposits (with deposit insurance) are prime examples. There is nothing to be gained by producing private information to speculate on these assets.

How did the shadow banks attempt to create information-insensitive debt? First of all, the shadow banking system includes investment banks, hedge funds, structured investment vehicles, and conduits. These last two are off-balance-sheet entities created by parent companies that were involved in creating and holding asset-backed securities such as mortgage-backed securities and the collateralized debt obligations that were derived from them. Shadow banks financed their activities through the repo (repurchase agreement) market. In this market, lenders with large amounts of cash entered into short-term repurchase agreements (many of them overnight). They provided cash to the shadow banks and the shadow banks provided collateral in the form of an asset-backed security. In a repo the lender has the right to take the collateral if the shadow bank fails to "repurchase." The difference between the loan and the repurchase price is the return to the lender, and is called the "haircut." This process makes the shadow bank a kind of bank because:

* The repo has a short maturity, and can be withdrawn upon demand (not rolled over);

* The collateral consists of senior tranches of securitized debt; and

* The collateral can be used in other transactions (rehypothecated).

The need of firms and others with large amounts of cash to invest on a very shortterm basis creates the need for collateral. …