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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.

More: Felix Salmon isn't impressed. Nor is Kevin Drum.

(Photo credit: Brendan Smialowski -- Bloomberg News Photo)

By Ezra Klein  |  May 29, 2009; 6:45 AM ET
Categories:  Federal Reserve , Financial Crisis  
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Really great post Ezra. The paper is interesting and your summary is a real service. I'm so glad to see you expanding your expertise into the economy in such a disciplined way. Keep up the good work.

Posted by: Castorp1 | May 29, 2009 7:38 AM | Report abuse

Except that makes no sense. If they wanted a riskless asset they would have bought US bonds. No they wanted a riskless asset that had the returns greater than a riskless asset. No matter you opinion of full information in markets that large of an arbitrage opportunity just isn't there. Convincing yourself that there was no risk is the problem. It happened to be real estate this time, but securitization could occur on anything.

Posted by: endaround | May 29, 2009 7:43 AM | Report abuse

I agree with Eandaround. That is the current problem, companies want their cake and eat it too. That has happened already too many times. Have we not yet realized that true captilisim is a great sin? (Not in religious terms but in moral and ethical terms)

Posted by: 4thFloor | May 29, 2009 9:28 AM | Report abuse

I actually asked Gorton about this: He says that he thinks there simply aren't enough Treasury Bonds to fill this whole market. If you look at his table on page 25, you'll see that mortgage-related debt and corporate debt have both been bigger than Treasury bonds in recent years. So we'd be talking about doubling or tripling the Treasury bonds in the field.

Posted by: Ezra Klein | May 29, 2009 9:52 AM | Report abuse

I am not sure that #1 will work - asset values fluctuate as a result of ungovernable market forces - safe cash investments such as the ones used as an example get much lower returns for that safety. I agree that investors turned to the shadow banking market because of higher returns, and, I would hazard to guess, they fell hook, line and sinker to the argument that risk, because of the quants, was a quaint "old" notion. Hubris, in other words. So, not different than the stock market, really. Anyone who did not know they were investing into a bubble was blind, and anyone who held on just 1 more day after the bad news started trickling out a long time before the "crisis" was greedy. I am not sure why investors in the shadow banking market be insulated from their bad decision making. Depositing your cash into a bank is something that most citizens MUST do in the current world in order to do anything else (cable, utilities, credit, mortgage, etc.). Investing in securitizations, hedge funds, etc. is something that the wealthy and institutional investors CHOOSE to do but not necessary in order to do anything else. Big difference.

Posted by: trichw | May 29, 2009 9:56 AM | Report abuse

Not to sound like an antiquated codger which I am, an economic entity with $500 million to depositor has the wherewithal to determine investment risk and the adjusted interest rate to compensate for any particular investment risk. Mr. Gorton's seductive analysis is nothing more than "high school" economics with the government becoming the insurer of last resort regardless of the actual risk.

As for Mr. Gorton and Mr. Klein, may I humbly suggest that they revisit their Econ 101 text paying close attention to the critical importance of risk adjusted interest rates as the only realistic method to insure the MOST EFFECTIVE ALLOCATION OF CAPITAL!

Posted by: dgward44 | May 29, 2009 9:56 AM | Report abuse

I don't know about capitalism being "a great sin," but I think endaround and 4thFloor are right: the Gordon paper (at least, judging by Klein's summary) seems to miss that the institutional investors wanted low-risk high returns, not just low-risk returns. If they only wanted the latter, then the individual investors who fund the institutional investors would have desposited in FDIC-insured banks or bought government bonds, as endaround suggests. My reading of economic history suggests that part of the reason deposit insurance "worked" is that the shadow banking system was able to take up the slack, directing money toward riskier lending in a way that the FDIC-insured banking sector no longer could. I worry that if we try to make shadow banking "safe," we risk unraveling both banking systems because it will be harder for riskier investments, which are critically important to the economy, to receive credit. A failing in that area of finance could ripple through the rest of the banking system -- unless a shadow shadow banking system emerges to take up the slack.

Posted by: tfirey | May 29, 2009 10:04 AM | Report abuse

This seems totally fraught with moral hazard. FDIC insurance accomplishes two things that are broadly good for society: 1) it encourages people to save money while providing capital for investment and 2) it prevents bank runs. I'm not so sure that securitization is something that's worth providing tacit encouragement. Besides -- it's hard to see how this would have changed things too much. The asset bubble STILL would have burst, and you'd have the government on the line for trillions in bad bets (just like they are now). Sure the banks and investors would be fine in the short term, but the burden would be just placed more directly on the taxpayer (though I suppose there's something more honest about this).

Posted by: dgsexyface | May 29, 2009 12:16 PM | Report abuse

One can only speculate as to why Bernanke finds this paper interesting. My guess is that he is interested in formally extending the reach of government licensing (and its counterpart: regulation) into securitzation, which he is well aware comprises about 50% of the credit delivery system in the US today. He has already taken the Fed there in a big way. In my view there are reasons to want to shrink our reliance on securitization and bring it back within the boundaries of regulated banking. As compared to old-fashioned banking, which required one-off credit judgments all along the life of a long from inception to repayment, securitization relies on statistical methods to automate lending and servicing. In securitization, credit judgments are also skewed toward lending against payment streams (cash flow) rather than lending against asset values, whereas old-fashioned banking tended to rely more on asset coverage as a defense against loss. Bernanke has not been asking questions about what kind of credit delivery system works best as much as he has been trying to keep the system that has evolved intact and functioning. There seems to be no one in Washington thinking hard about this issue, but perhaps I am ill informed. My personal policy recommendations would be to make the regulated deposit-taking banks the originators of all loans that are ultimately securitized, so as to have the benefit of old-fashioned underwriting, and to require that loans be seasons on the books of the banks for some initial period before they are sold into the secondary market, and then only rated AAA if the originating bank retains a 20% equity stake. As things stand, in mortgage lending for instance, the program definitions coming from the secondary market prescribe what kinds of loans are available and banks are doing no more than fitting applicants into boxes. The information content is being massaged out of the loans. Also, it seems to me that deposit insurance has removed information from the market place that would cause banks to be more prudent. Without removing deposit insurance, there could be a rating system that would allow consumers to chose to put their money in safer banks rather than riskier ones, and for safer banks perhaps to pay less for deposits.

Posted by: rfreudthroneofdebtcom | May 29, 2009 12:28 PM | Report abuse

This is an excellent explanation, Ezra.

Posted by: davestickler | May 29, 2009 1:48 PM | Report abuse

"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."

I have a crazy idea: why don't we call it the "capital markets." You know, like everyone in the world did for over a century before August 2007, when the press adopted the sexier-sounding "shadow banking sector" name (at least partly to justify their inexplicable failure to cover the enormously-important capital markets).

Posted by: MarkJ2 | May 29, 2009 6:36 PM | Report abuse

No doubt the financial developments of the 1930's did have some impact on the long quiet period. But I suspect that the reality left by the end of World War II had more to do with it. That period seems to be at an end now. There may be good reason to question whether financial manipulations on their own can produce a new quiet one. The adjustments to the excesses of that boom period are one problem. There is also the problem of adjusting to the end of the 500 year period of European world dominance. Then there is the problem of adjusting to one time events in human history like the depletion of energy, global warming, the impact of human generated waste on the planet, and exponential advancements of technology that probably will eventually allow major modifications in the natural curve of a person's life. The exact timing of the unfolding of these trends is of course very uncertain and it is not impossible that there will still be some extended periods of relative stability. But it is also not impossible that these trends will all merge together in an extended period of much greater instability than those of us born after World War II are used to.

Posted by: dnjake | May 29, 2009 9:13 PM | Report abuse

Great post, clear summary. The line of reasoning is interesting. However, I have a lot of trouble gicing much credence to anything Gary Gorton Says given he spent years working for AIG FP consulting and building models for the credit business. His online CV now omits this information, although given it was over a period of 9 or 10 years, I doubt it simply slipped his mind. Perhaps Gorton could give us some insight on what went wrong at FP?

Posted by: TellTheTruth7 | June 1, 2009 4:47 AM | Report abuse

I usually agree with your analysis, Ezra, but this was way off.

Your readers need to know that Gortonis helped develop the formula for underwriting CDOs and CDOs squared when he was a paid advisor to the now infamous London AIG office.

Gorton is largely responsible for the notion of risk-free investment in CDOs (thanks to the AIG insurance institutional investors purchased) which is precisely what caused the current bubble and crash. If the institutions couldn't buy insurance at least the majority, if not the great majority, would have been a lot more cautious.

Instead of learning from his mistake, he is trying to peddle the same crap to governments.

There is no hope for finance if anyone still takes Gorton seriously.

Posted by: emily16 | June 1, 2009 7:16 AM | Report abuse

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