What Does Ben Bernanke Believe About the Financial Crisis?
Ben Bernanke recommends that we read Yale University professor -- and former AIG consultant -- Gary Gorton's papers for insight into the financial crisis. It's not a bad recommendation. Gorton's latest paper, "Slapped in the Face by the Invisible Hand," is very good. Brilliant, even. But it contains a lot of sentences like "If securitization debt is informationally-insensitive, it can be an input into the repo system of creating a kind of transaction medium, i.e., collateral that can be rehypothecated." So let's try to clean this up a bit.
I should warn you that this post is, by blog standards, a bit long. But I can also promise that it's much, much shorter than Gorton's paper.
Gorton's basic argument is actually pretty elegant. "The period from 1934, when deposit insurance was enacted, until the current crisis is somewhat special in that there were no systemic banking crises in the U.S," he writes. "It is the 'Quiet Period.'" The Great Recession has been a high-decibel disruption of our happy quiescence. The question is: What changed?
What didn't change, Gorton says, is the commercial banking sector. We did not have a 1929-style bank run. Deposit insurance -- the system wherein the government insures deposits of individuals up to $250,000 -- worked. Individuals did not line up around the block.
Rather, the entirety of the crisis was in the "shadow banking sector." This is where major institutions lend to one another. It is a new, and largely unregulated, market. But, in certain important ways, it is very similar to the old banking sector. And not the banking sector we've had since 1934. The banking sector we had before 1934. Fixing the shadow banking sector will, for that reason, require the application of principles that fixed the commercial banking sector in the 1930s. In other words: We've done this before.
The important parallel between the two markets is that both individual depositors plugging $1,000 into their bank and institutional investors looking to park $12 million want the same thing. They want, according to Gorton, "informationally-insensitive debt." This is a key concept, so let's spend a moment on it.
Imagine you give Apple $1,000 for shares in its company. The next day, a rumor starts. Apple CEO Steve Jobs, it seems, has had his head amputated. He might not be back at work for three to five months. Your iPhone cries a salty, electronic tear. So does your portfolio. Apple's stock plummets. Your $1,000 is now worth $812. The stocks you bought from Apple were informationally-sensitive. They were vulnerable to information. You could not count on your $1,000 to exist come hell or high water.
Imagine, now, that you deposited that $1,000 in the bank instead. A week later, the bank becomes insolvent. Half its employees immediately commit suicide. The other half flee the country. This is literally the worst information possible for your deposit. But it doesn't matter. The government -- through the Federal Deposit Insurance Corporation -- insures your money. Your $1,000 is perfectly safe. It was, as it turns out, information-insensitive.
Large investors, Gorton argues, also want informationally-insensitive debt. They want to give a bank $10 million dollars, have the bank owe them $10 million in return and be assured that the $10 million is safe. But the FDIC doesn't ensure deposits that large.
Hence, the shadow banking market. I'm going to glide by the details a bit, as they're complex. His paper has a fuller explanation. But the shadow banking market, according to Gorton, works like this: A mega investor -- the "depositor" -- has $500 million he wants to deposit. Another institution -- the "bank," though it doesn't have to be a bank as traditionally composed -- is willing to give the depositor collateral in return. The collateral is, in most cases, a senior tranche of securitized loans (if you want a good explanation of that concept, see this paper). Those tranches were generally considered informationally-insensitive. They were safe. They were the depositor's insurance.
But there is a difference between being informationally-insensitive and being actually riskless. An individual's $500 deposit is safe unless the government itself defaults. That's pretty unlikely. The senior tranche of a pack of subprime mortgages is safe as long as housing prices keep increasing. That, as it turns out, wasn't very unlikely at all. Which brings us to another key point: "a 'banking panic' occurs when 'informationally-insensitive' debt becomes 'informationally-sensitive' due to a shock, in this case the shock to subprime mortgage values due to house prices falling." In other words, a banking panic occurs when deposits stop looking safe.
That, Gorton argues, is how it happened in the days before deposit insurance, too. Deposits seemed secure. Then, for some reason, they didn't seem safe because the banks seemed like they might go bust. Depositors would panic and run to get their money back before the bank folded in on itself. That would create a bank run, which would, in turn, create insolvent banks.
We ended bank runs in two ways: First, deposit insurance and associated regulations made bank deposits essentially riskless. Second, we made bank charters valuable by promoting local monopolies, underpricing deposit insurance and other means. Put another way, the 75-year "quiet period" was a product of making deposits in commercial banks riskless for individuals and making commercial banks profitable for banks.
Gorton argues that a similar approach is needed for the shadow banking sector. Toward the end of the paper, he offers a "very broad" sketch of what it would look like:
1. Senior tranches of securitizations of approved asset classes should be insured by the government.
2. The government must supervise and examine “banks,” i.e., securitizations, rather than rely on ratings agencies. That is, the choices of asset class, portfolio and tranching must be overseen [by] examiners.
3. Entry into securitization should be limited, and any firm that enters is deemed a 'bank' and subject to supervision.
It is, in other words, very much like what we did after 1934. Examining and insuring "senior tranches of approve assets classes" -- insuring collateral, in other words -- is rather a lot like what the FDIC does with deposits. Limiting access of firms into the shadow market -- which would probably be referred to as the "institutional market" or something similarly less-sinister sounding -- is rather like what we do with commercial bank charters.
This has been a bit of a long post, so I want to remind folks of the lede: I'm not summarizing this paper because I think it's interesting. I'm summarizing it because Ben Bernanke is talking it up. Yesterday, Felix Salmon wrote a post asking "what use economic history?" I don't know if it's of any use, but the appeal of Gorton's analysis to Bernanke might speak to its impact. Gorton is essentially making an argument based on economic history. Bernanke, of course, was an economic historian for most of his career. And according to Bernanke, this is a pretty good summation of how he's understanding the banking crisis.
(Photo credit: Brendan Smialowski -- Bloomberg News Photo)
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