The author refutes the consensus explanation of the cause of the financial crisis of 2007 and provides an alternative view, drawing on his studies of the U.S. banking crises of the late 1800s.
“Greedy people did bad things.” That, in summary, describes the consensus view of the cause of the financial crisis of 2007. Subprime borrowers submitted fraudulent loan applications, bankers violated lending standards, and investment banks corrupted the rating agencies to the point where the agencies gave AAA rankings to dangerously risky securities. In Slapped by the Invisible Hand: The Panic of 2007, Gary Gorton sets out to refute the consensus explanation and present a better model of the crisis, drawing on his studies of the U.S. banking crises of the late 1800s.
The consensus explanation is anecdotally true. Who has not heard of seemingly unreasonable mortgages being granted or investment bankers acting in their own selfish interest? Even so, the standard account should be deeply unsatisfying to both professional investors and economists. First, it does not explain enough: Why were subprime mortgages the root of the problem and not credit card financing or used car loans? How did a problem in one relatively small area of the financial markets create such a pervasive crisis? Second, taken seriously, the conventional interpretation undermines the logic of capitalism: If a small group pursuing its own self-interest can destabilize the entire financial system, then Adam Smith’s invisible hand cannot be trusted and must be shackled.
Gorton’s book is based on three papers he wrote over the past 15 years. He begins by tracing how subprime mortgages created a run in the repurchase market. Next, he shows why subprime mortgage-backed securities were uniquely prone to creating uncertainty and panic. The book concludes with the earliest of the three papers (originally written in 1994), which is an overview of the potential effects of financial market disintermediation.
Arguing that “the details matter,” Gorton shows how the structure of subprime securitization and the terms of the underlying mortgages made the instruments uniquely susceptible to declines in home prices. Mortgages granted to subprime borrowers were structured to become more expensive after a few years, forcing marginal borrowers to refinance, sell, or default. If home prices rose, early repayment would result from either successful refinancing or a full recovery in the event of default. Residential mortgage-backed securities (RMBS) often used these early repayments to help fund the subordination protection that supported the top tranches’ AAA ratings. Conversely, a decline in home prices would prevent borrowers from refinancing and reduce recoveries on default. These effects are magnified in recent-vintage mortgage-backed securities that have not had time to allow early repayments to strengthen their overcollateralization.
Gorton describes how the uncertainty surrounding exposure to recent-vintage subprime mortgage-backed securities created a “run” on the investment banks and other firms that rely on the repurchase markets for their day-to-day financing. The “repo” market requires collateral of unimpeachable value—historically, U.S. Treasury bills, but increasingly, AAA rated securities. Problems arose from the fact that the risk in recent-vintage subprime mortgages had been repackaged into RMBS, then into collateralized debt obligations (CDOs), and even further into CDOs-squared and other complex instruments. Ordinarily, spreading risk reduces its impact, but in the repurchase market, the opposite occurred. Every mortgage-backed security became suspect, and lenders began to require overcollateralization or “haircuts” in repurchase agreements, which quickly drained liquidity from the system and created a funding crisis.
A key insight of this book is the importance of “information-insensitive” securities and the disruptive effects they have on financial markets when they unexpectedly become information sensitive. Recent events have demonstrated the portfolio vulnerability that can arise from buying bonds on rating alone or on the strength of third-party guarantees and from assuming that money market funds are riskless cash substitutes. Investment managers will want to determine what other information-insensitive securities are in their portfolios or the portfolios of their counterparties and how to address the implicit risks associated with them.
Gorton’s thesis is not a complete explanation of the crisis, but it is a useful and important counterargument to the consensus view. The book provides a discerning account of how the crisis spread through the repurchase market and is especially insightful in describing the unique nature of the subprime RMBS that lit the match. The section of the book on disintermediation is the least relevant to the recent crisis and is at best deep background on how the financial markets have evolved over the past 30 years.
In each step of his argument, Gorton provides careful analysis, detailed explanations, and in-depth research. Even financial professionals will learn a great deal about the structure of subprime RMBS and the operations and importance of the repurchase market. The text is well supported by tables, charts, and the occasional historical illustration. Although the book’s style and structure betray its origin as three academic papers, it is accessible to a practitioner audience.
—P.M.