Explaining FinReg: Shadow bank runs, or the problem behind the problem
On June 20, 2007, Ben Bernanke said that the subprime crisis “will not affect the economy overall.” That wasn't a one-time slip: He'd also said that "the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained,” and assured investors that "while rising delinquencies and foreclosures will continue to weigh heavily on the housing market this year, it will not cripple the U.S.”
Embarrassing, no? But Yale economist (and former AIG consultant) Gary Gorton is sympathetic to Bernanke's statements: Subprime shouldn't have been big enough to cause this sort of crisis. In 2005 and 2006, the market originated about $1.2 trillion in mortgages -- big, but not a vital organ of the American economy.
Subprime was the trigger for the crisis, but not the cause. What happened, rather, was that the subprime crisis set off an old-fashioned bank run in a newfangled market: the shadow banking market, which was, and is, vulnerable to runs.
Understanding this market, Gorton says, is crucial to understanding the last crisis and stopping the next one. The shadow banking market is where big banks, institutional investors, and other folks who have a lot of money do their banking -- particularly their short-term banking. So let's say I'm Ezra Bank. I've got a $100 million that I'm going to invest next month, but for now, I need to put it somewhere. I head to the "repo market," and I ask Bear Stearns to hold my money and pay me interest. They agree. But how do I know Bear Stearns won't just keep my money?
Individual depositors in the normal banking market never have that fear. The government insures our deposits. But they don't insure massive institutional deposits. So Ezra Bank would ask Bear Stearns for "collateral" -- something that is low-risk and valuable they could hold in order to make sure Bear Stearns returned their money. Something like, say, AAA mortgage-backed securities.
This manner of banking created a massive hunger for collateral. And it was this hunger, Gorton thinks, that drove the wild demand for mortgage-backed securities.
But think about the difference between the shadow banking market and your bank: The FDIC's deposit insurance exists to prevent bank runs (which happen when creditors become scared that their bank is insolvent and rush to get their money back, which in turn makes their bank insolvent). The shadow banking market doesn't have deposit insurance. So how does it deal with the problem of bank runs?
Answer: It doesn't. What we had in 2008, Gorton says, was a bank run. No one knew which banks were exposed to the subprime crisis, so everyone froze. But it didn't need to be the subprime market that experienced the shock. A lot of different types of shocks would've done the trick. The underlying problem is that the collateral is "informationally sensitive": That is to say, information can dramatically and unexpectedly change its worth (i.e.. news that subprime mortgages are defaulting makes securities based on subprime mortgages worthless), and then confidence drains out of the whole system. "It's the e coli problem," Gorton says. "When they recall 10 million pounds of burger, it brings all sales of ground meat to a halt because no one knows how much e coli there is or where it is."
This next graph comes from Gorton's paper “Slapped by the Invisible Hand” (pdf). It's a graph of repo market haircuts, which is to say, how much it cost for major investors to lend to each other.
"The figure," Gorton writes, "is a picture of the panic." That is to say, it is a picture of the bank run in the shadow banking market.
Conversely, our deposits with our banks are not informationally sensitive: Where small pieces of new information can scare the shadow-banking market, major revelations are shrugged off in the commercial banking market. News that Wachovia was going bankrupt, for instance, didn't matter because the federal government insures deposits.
To offer an analogy, consider someone with a weakened immune system who eats a bad piece of fish and gets really sick. Obviously, the first thing you want to do is deal with the illness. But when that's over, the issue you want to deal with isn't so much sushi selection (what made the patient sick this time) as the weakened immune system (what makes the patient vulnerable to dangerous illnesses). Gorton, however, thinks that we're talking about sushi rather than systems. Putting derivatives on exchanges and clearinghouses will do a lot to make sure that the system doesn't get the same illness anytime soon, but it doesn't deal with the system's vulnerability to illnesses -- that is to say, the system's vulnerability to bank runs.
Handling that would require either creating a type of safe, informationally-insensitive collateral for the shadow-banking system to use or examining and insuring the collateral the system does use. But that's a big intervention, and not one that most people seem interested in contemplating right now. Ignoring it, however, leaves the system vulnerable to shocks, even if we've done a fair amount to protect against the specific type of shock that comprised the subprime crisis.
That scares Gorton. Bank runs are not generally an isolated phenomena: As you can see in the graph atop this post, they come in waves, continuing until the country does something that prevents runs -- like deposit insurance -- rather than just preventing whatever caused the most recent run.
(For the rest of the 'Explaining FinReg' series, head here.)
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