Q: When we last talked the financial crisis was unfolding. How do things look two years later?
Gary Gorton: It’s surprising to me the extent to which people still have no idea what actually happened, which I think is one of the reasons that my paper in the European Financial Management won awards—people are curious and want to understand. Many bank regulators and other experts can make a list of events, but they can’t explain how those things turned into a systemic financial crisis. And that’s what I have been working on trying to explain. I don’t think I have all the answers, but I think the core of what I was saying has held up.
One way to think about the crisis is as follows: Why did the prices of non-subprime-related bonds fall? We can all understand why the prices of subprime-related securities went down. That part is not a mystery. The question is how and why did it spread? That’s what you have to explain. You can take two points of view on this. One point of view is to think that the crisis is a unique event—nothing like this has ever happened before because it involved all sorts of new things that combined to cause the problem. I take the second point of view. I think it was a problem inherent with bank money creation, and that’s a banking panic.
Banking panics are very familiar in U.S. history. They’ve plagued this country for over 200 years. And in this particular case, the panic happened in a market that most people aren’t familiar with: the sale and repurchase agreement market, or repo market. Omitting the details, the repo market is a kind of checking account for big companies—pension funds and nonfinancial firms like Microsoft. Those companies ran on their banks, much like in the movie It’s a Wonderful Life, and that caused the banks, mostly the old investment banks, to have to sell assets. The assets they ended up selling were non-subprime-related bonds. That’s the mechanism that caused concerns about subprime to be translated to the rest of the asset classes. As soon as everybody has to sell, all asset prices go down and there are going to be problems. In a way, it’s a very old story, but it’s in a new guise.
Will Goetzmann: Gary has set the terms of the current debate about the financial crisis. To view it as a form of a banking crisis means that you start understanding new institutions that have been created over the last 10 or 15 years as proxies for classic banking functions. So there has been considerable excitement among researchers over his hypothesis.
Frank Fabozzi: I agree. He provided the macro framework. Now the issue is to figure out how to respond at the micro level. You can see from the recent financial reform legislation, as well as congressional hearings, that now the focus will be on to what extent we get more involved in regulating banks, or to what extent we start regulating mortgage bankers, regulating ratings agencies, and so on.
Click Here To Read: Yale’s QN: On Where Does Securitization Stand
