Arnold Kling  

Gary Gorton's forthcoming book

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It is called Misunderstanding Financial Crises, a title that may be unintentionally ironic. As you probably know, Gorton is famous for treating the crisis as a "run on the shadow banking system" that had very little real basis.


The deterioration of house prices and defaults in the subprime mortgage market were not enough to cause a systemic crisis by themselves.

Could have fooled me. Gorton's is probably the only treatment of the crisis that you will read in which the housing boom/bust and underwater mortgages are not a central issue. For Gorton, the financial losses were caused almost entirely by mindless panic, not by bad loans.

Gorton comes across as a fan of bailouts.


No society with a market economy has ever chosen (intentionally) to liquidate its banking system

He says, in effect, that the government always bails out banks, and it is better off doing it sooner rather than later.

He writes,


[In January of 2008] I advocated that Freddie Mac and Fannie Mae refinance all subprime mortgages at their initial teaser rate. This was eight months before Lehman failed. I am convinced that had this been done the crisis could have been largely avoided.

Should others share Gorton's conviction? I do not. Freddie Mac and Fannie Mae were not in a position to bail out borrowers. Moreover, the problem for borrowers was not the interest rate. The problem was that borrowers were dependent on ever-rising house prices, and prices had stopped rising.

While it would be best to design a system of bank regulation that avoids crises, this also runs the risk of financial repression. There may be large costs to avoiding crises altogether.

This passage concludes one chapter that seemed to me to stand apart from others. Elsewhere in the book, Gorton praises the period between the mid-1930's and 2007 as a "Quiet Period," during which deposit insurance and restrictions on bank competition reduced financial crises. Was the "quiet" purchased at the expense of financial repression and foregone growth? He never connects this chapter with other chapters.

The government did not know of the existence of the shadow banking system. Further, in light of the testimony of dealer bank CEOs before the Financial Crisis Inquiry Commission, it is doubtful if even the dealer banks understood the changes to the financial system

It would be interesting to read the fourth edition of Marcia Stigum's Money Market. I read an earlier edition back when I worked at the Fed in the early 1980s, and it explained the repo market quite well. While I am sympathetic to the view that there were cognitive shortcomings among market participants and regulators, I am not sure that it is fair to say that there was no awareness of the way that the system functioned.

John Taylor will not agree with this:


there cannot be inflexible rules that the central bank must follow in crises. During noncrisis times most economists think that the central bank should focus on fighting inflation based on rules rather than discretion. But in crisis times it is the opposite. Central banks must have discretion, sometimes to take unprecedented actions.

And I will not agree with this:

The overarching goals of the proposal [by Gorton and his colleague Andrew Metrick] are to bring securitization under the regulator umbrella and to provide a system of collateral production that can back repo without being vulnerable to runs...Re-creating confidence in the shadow banking system is essential for economic growth.

As you know, I think that mortgage securitization could disappear without being missed.

In Not What They Had in Mind, I said that the crisis included four components: bad bets (mortgage loans that should not have been made); excessive leverage; domino effects; and 21st-century bank runs.

Gorton insists that the bad bets and excessive leverage were not important. He refuses to see the period leading up to 2007 as one of financial excesses. His policy prescriptions offer no mechanism for limiting the financial sector's role in the economy, even as they call for unrestricted discretionary bailouts.

There is much that one can learn from reading this book. However, his analysis is so impaired, and his air of smugness is so strong that it is more likely to put off than to convince his fellow economists.



COMMENTS (14 to date)
Eric Falkenstein writes:

Wow. He had a good insight on the nature of shadow banking and bank runs. I saw some of his earlier attempts to apply this and thought it was promising. If he thinks the answer is bailing out banks and refinancing all the underwater mortgages, it was all for naught.

I mean, if we implemented that, how could we stop? If we couldn't stop, what would be the results? I think we couldn't stop, and the results would be massive corporate cronyism and political patronage as everyone has government subsidize mortgages.

Charles R. Williams writes:

I learned a lot from Gorton about shadow banking and how the crisis played out but the mechanics are not the whole story and his proposals are nonsense.

Joe Cushing writes:

Actually, I always had a hard time understanding the math behind the crisis. I don't remember the numbers anymore but lets say 10% of the loans went into default in the worst year. I think that might have been a realistic number. Lets say the homes sell out of foreclosure for half of what the people owed on the homes. You're talking about a 5% loss of principal owed. Plus, keep in mind that the other 90% of loans were paying not only principal but also interest. The entire banking sector was ready to fall because it can't handle a single digit loss on an investment? Of course the problem was that the banks had no equity of their own. They were in a position where they had no money to lose.

Douglas Tengdin writes:

"Mortgage securitization could disappear without being missed."

Really? How will pension funds, mutual funds, sovereign wealth funds, cities and municipalities, and the trillions of non-depository capital looking for an investment home get deployed into residential-based loans without securitization? Turning home-loans into tradeable securities facilitates capital flows from places of low marginal utility to those of high marginal utility, which also facilitates global trade. And it increases liquidity, which decreases the cost of capital.

Do you really think no one would notice lower capital flows, lower global trade, and higher capital costs? On what planet?

Greg G writes:

Gorton was probably the first person to deeply understand and lucidly explain the role liquidity issues played in the financial crisis.

Sadly, it seems he will be the last to understand the role bad loans and leverage played as Arnold does a good job of pointing out in this post.

I don't think it's right to say that mortgage securitization is not being missed. We don't yet have anything workable to take its place and that is a big problem.

It would be nice if Gorton focused more of his very impressive intelligence on discussing some of the mistakes he made in helping to build that house of cards at AIG financial products.

Dave writes:

Joe Cushing: Short answer: credit default swaps and synthetic CDOs caused the financial instruments tied to the housing market to expand into the trillions. Another issues is that even if the default number was low at any given time, the number of underwater borrowers was higher, and this reduced the value of their loans (since the asset backing the loan was now worth less).

Douglas Tengdin: just because people used these securities in the past does not make them valuable in the future. We just learned that chopped up mortgages aren't quite the commodity that oranges are. The devil is in the details, and almost no one (except for the few smart enough to short) could figure out the details.

(Not That) Bill O'Reilly writes:
Gorton's is probably the only treatment of the crisis that you will read in which the housing boom/bust and underwater mortgages are not a central issue. For Gorton, the financial losses were caused almost entirely by mindless panic, not by bad loans.

I seem to recall Edward Conard's "Unintended Consequences" making a similar argument - that banks had sufficient reserves to eat the losses on loans going bad, but were driven over the edge by panicked withdrawals and such.

He does acknowledge that skewed government incentives spurred the bubble, but seems to believe that there didn't need to be a "crisis."

Greg G writes:

Not That Bill,

You are correct. Conard makes the same argument. Both claim that if only investors hadn't panicked and failed to understand how sound the system really was, then everything would have been fine. And both recommend more government guarantees to fix that. They insist they could get it right next time. Reminds me of the guys at Enron insisting they were just the victims of "a run on the bank."

Despite these obvious defects, both guys really are worth reading if you read them critically.

MingoV writes:
For Gorton, the financial losses were caused almost entirely by mindless panic, not by bad loans.
I've read and agreed with similar findings. There is no way that a small percentage of bad mortgages (alone or bundled into mortgage-based securities) can account for the magnitude of the financial losses and the depth and length of the recession. Geithner and Bernanke in 2008 invented a crisis, spurred a panic, and greatly magnified the financial downturn. Reckless and counterproductive government actions such as bailouts and interfering in foreclosures and bankruptcies longed and steepened the slide into a full-blow recession. Those actions plus wasteful government "stimulus" spending, suppressed interest rates, and "regime uncertainty" have stymied a full recovery.
Greg G writes:

The housing bubble, and many of the financial investments built on it, were based on the assumption that there could not be a significant nationwide decline in housing prices.

When it was discovered that assumption was off by 30% it was not "mindless" for a lot of people to realize they were in trouble.

Greg G writes:

@ Joe Cushing & MingoV

I think you guys might be failing to appreciate the dramatic effects of leverage in magnifying small losses. If you are leveraged at 33 to 1, as some investment banks and hedge funds were, then a 3% loss can wipe you out.

And when that happens, your inability to pay your counterparties causes more losses to ripple trough the system. Then as everybody sells assets to try and rebuilt capital levels that further depresses the market value of their remaining assets.

Les Cargill writes:

The problem is that there was a thing that actually happened - Bear went to the overnight repo market and was told "no". This in a general climate of abject insanity with mortgage backed securities, Countrywide and all.

As a dilletante, I have not seen anybody explain how one led to the other. However, a general liquidity shock explains it all handsomely.

If it was leverege, then ... how did *EVERYBODY* except Micheal Burry miss it? So the models were wrong, and ...

I am biased by having gone through the S&L thing in Texas and Oklahoma. SFAIK, that was a pure liquidity problem.

If someone could explain all this to Micheal Lewis and Micheal Lewis could explain it to us, I would think it a good thing.

MingoV writes:

@Greg G: I understand the effects of leveraging, but that is not what happened in 2008. If leveraging of mortgages and mortgage securities* was the problem, then the stocks of banks, mortgage companies, and investment firms with lots of mortgage securities should have been hit earlier and much harder than other stock investments. However, because of the panic, all sectors of the stock market crashed simultaneously. There was a near-perfect correlation between Geithner's panic-inducing ravings and falling stock prices.

*Even the worst of the mortage-backed securities had less than 10% bad mortgages, and a bad mortgage typically results in a 30-50% loss. The worst of the mortgage-backed securities were facing only a 5% loss. So why did Geithner state that such securities could not be valued? That drove their worth to less than 70% of original value and contributed to the panic.

Greg G writes:

MingoV,

Yes, the liquidity crunch was the most immediate trigger for the panic. And yes, IF there was never a shortage of liquidity, and IF there was a never ending inflow of new money, the leverage could have gone on a lot longer.

The thing I think you are missing is that the high degree of leverage was a huge part of the reason that repo lenders were so jumpy. The other reason they were so jumpy is that they began to realize that the whole structure was built on inflated valuations. The whole system was based on the assumption that real estate values only go up on average. When it became clear that was not true, the fragility of the whole structure was exposed.

Geithner was right that these securities could not be valued. The reason is that they are opaque and the cost of investigating them thoroughly would swamp any likely investment return. Geithner was stating the obvious. If they could have been valued the market would have done so.

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