Slapped by the Invisible Hand
2007-08 read as a classic run on repo, not on retail deposits.
Summary
Gary Gorton assembled this from papers he wrote during and immediately after the 2007 and 2008 crisis, including the widely circulated account he prepared for the Federal Reserve's Jackson Hole conference in 2008. It sets out his interpretation of the crisis as a banking panic in a banking system that regulators had not recognised as one.
His argument is that securitised banking, meaning the combination of loan origination, securitisation and repurchase agreement funding, performed the same economic function as traditional deposit banking: it created short-term debt that could be used as money because holders did not need to investigate its value. Repurchase agreements collateralised by securitised bonds were the deposits of this system, and institutional investors were its depositors. When subprime losses made the value of the collateral uncertain, holders raised haircuts, which is the equivalent of a withdrawal, and the resulting contraction forced asset sales that lowered prices further.
Gorton documents the growth of the repo market, the mechanics of haircuts, and the specific timing of the run in 2007. He argues that the crisis was not caused by subprime losses as such, which were too small to explain what happened, but by the loss of information insensitivity in the debt backed by them. The policy implication is that any system generating uninsured short-term debt will produce runs, and that regulation must address the debt's information properties rather than the underlying assets. The papers overlap with his later Misunderstanding Financial Crises, which states the argument more accessibly.
Key takeaways 7
- Repurchase agreements collateralised by securitised bonds functioned as deposits for institutional investors and had no equivalent insurance.
- Raising haircuts on repo collateral is the mechanical equivalent of depositors withdrawing, and it forces the same asset sales.
- Subprime losses were too small to explain the crisis, and what mattered was that they made the value of a much larger class of debt uncertain.
- Debt works as money only while holders have no reason to investigate it, and a run begins when that property is lost.
- Securitised banking performed the same economic function as deposit banking outside the regulatory perimeter built for the latter.
- Gorton argues that the failure to see the crisis coming followed from measuring the banking system by the institutions rather than by the debt it created.
- Regulation must address the information properties of short-term debt rather than the credit quality of the underlying assets.
Who should read it
Investors and policymakers who want the primary papers behind the securitised banking run interpretation of the 2008 crisis.
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