Slapped by the Invisible Hand
Rizzi, Joseph, Journal of Applied Finance
SLAPPED BY THE INVISIBLE HAND By Gary Gorton, Oxford University Press: 2010, 215 pages
There is no shortage of books on the financial crisis. Most incorrectly blame subprime mortgages as the cause of the meltdown. Gorton distilled a series of conference papers into "Slapped by the Invisible Hand" which provides an alternative explanation. He provides a valuable service by identifying the cause of the crisis as a traditional banking run in the shadow banking system. The run was triggered, not caused, by subprime losses. He highlights the amount of subprime mortgages losses, although significant at several hundred billion, was too small relative to the multitrillion dollar financial system to have caused such widespread damages.
The crisis reflected the well known adverse selection structural problem in banking. Asymmetric information about the value of financial claims creates a lemons problem. This makes banking fragile, volatile, and subject to collapse. A shock or new information concerning bank valuation can cause a precautionary deposit withdrawal triggering a liquidity crisis. Banks are then forced to sell assets into an illiquid market to meet the withdrawal. This triggers asset losses and transforms a liquidity event into a solvency crisis.
Depression era deposit insurance was designed to address this problem by making bank deposits information insensitive. In exchange, banks became heavily regulated. Unfortunately, the shadow banking system, which performs the same role as regulated banks and suffers from the same fragility, lacks deposit insurance protection. Thus, it is vulnerable to a run, which started in 2007 when questions concerning subprime collateral values became too large to ignore. Unlike more traditional runs, it occurred in the largely invisible shadow banking system. It involved unregulated financial institutions such as Bear Stearns and investors like Fidelity instead of depositors and regulated banks. Comprehension of the shadow banking system is key to understanding the crisis and developing possible remedies.
The shadow banking system includes unregulated nonbank intermediaries that borrow short term and lend long term. The first shadow banks were the government sponsored entities Fannie Mae and Freddie Mac. They created information insensitive claims like bank demand deposits by backing their claims with high quality collateral. The system grew rapidly since the 1980s to rival traditional banking in size. The growth reflected, in part, the desire to escape regulatory capital requirements. It relied upon a secured form of lending known as a repo. Borrowers would "sell" a pool of securities at a discount (haircut), which supposedly reflected the transaction risk level and the collateral quality. Lenders would hold the collateral until repurchased at par by the borrower. A key feature of the repo is the assets are excluded from the borrower's bankruptcy estate. Securitization vehicles like asset backed commercial paper conduits used bankruptcy remote structures to achieve similar investor protection from issuer bankruptcy. The lender can liquidate the securities if the borrower fails to repurchase them at par. The collateral used shifted from low risk Treasuries to higher risk AAA rated structured products over time. The supposedly information insensitive AAA rating served as a substitute for demand deposit related Federal Depository Insurance Corporation (FDIC) insurance. …