Slapped by the Invisible Hand: The Panic of 2007 (Financial Management Association Survey and Synthesis) [Hardcover]

Gary B. Gorton (Author)

Book Description

Publication Date: March 8, 2010 | Series: Financial Management Association Survey and Synthesis

Originally written for a conference of the Federal Reserve, Gary Gorton's "The Panic of 2007" garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown. Now, in Slapped by the Invisible Hand, Gorton builds upon this seminal work, explaining how the securitized-banking system, the nexus of financial markets and instruments unknown to most people, stands at the heart of the financial crisis.

Gorton shows that the Panic of 2007 was not so different from the Panics of 1907 or of 1893, except that, in 2007, most people had never heard of the markets that were involved, didn't know how they worked, or what their purposes were. Terms like subprime mortgage, asset-backed commercial paper conduit, structured investment vehicle, credit derivative, securitization, or repo market were meaningless. In this superb volume, Gorton makes all of this crystal clear. He shows that the securitized banking system is, in fact, a real banking system, allowing institutional investors and firms to make enormous, short-term deposits. But as any banking system, it was vulnerable to a panic. Indeed the events starting in August 2007 can best be understood not as a retail panic involving individuals, but as a wholesale panic involving institutions, where large financial firms "ran" on other financial firms, making the system insolvent.

An authority on banking panics, Gorton is the ideal person to explain the financial calamity of 2007. Indeed, as the crisis unfolded, he was working inside an institution that played a central role in the collapse. Thus, this book presents the unparalleled and invaluable perspective of a top scholar who was also a key insider.

Editorial Reviews

Review

"Think you know what caused the collapse of Wall Street? Gary Gorton, the Sherlock Holmes of the financial crisis, has news for you."--Robert Hahn, Founder of the AEI Center for Regulatory and Market Studies

"Slapped by the Invisible Hand is essential to understanding the deep weakness in the banking sector that led to the financial crisis. Like consumer banks before the Great Depression, the 'shadow banking market' is vulnerable to runs and panics and hysteria, and we are all, in turn, vulnerable to it. By looking beyond this financial crisis to the systemic flaws that make us vulnerable to all sorts of crises, Gary Gorton has created a necessary guidebook for what's happened, and what needs to be done."--Ezra Klein, Washington Post

"Gorton has produced the clearest account yet of what has happened...Slapped By the Invisible Hand is not a conventional retrospective. Instead it is a real-time chronicle of what the authorities were told at key points in the drama by a practitioner who was steeped in the history of banking as well...it is a major contribution."--David Warsh, Economic Principals

"Provides a lucid framework for understanding the crisis truly substantive Slapped deserves an audience of more than just crisis connoisseurs."--Barron's

"It's must-reading for anyone who wants to understand the recent economic unpleasantness."--Matthew Yglesias, Think Progress

"Fascinating for anyone interested in the crisis, or in banking and finance more generally, this is absolutely essential reading."--Tyler Cowen, Marginal Revolution, Professor of Economics at George Mason University

"Slapped by the Invisible Hand tells us that there were bank panics--systemic crises--in 1873, 1884, 1890, 1893, 1896, 1907, and 1914. On the other hand, there were no systemic crises from 1934 to 2007. The problem, as Gorton makes clear, is that the Quiet Period reflected a combination of deposit insurance and strong regulation-undermined by the rise of shadow banking. So we have a choice: restore effective regulation or go back to the bad old days."--Paul Krugman, New York Times "Conscience of a Liberal"

"Gary Gorton has written an important book, one that clearly identifies the issues surrounding the recent financial crisis and separates them from the ongoing macroeconomic policy turmoil....quite an accomplishment, given that many of us are still trying to figure out happened in earlier panics and crises.... By narrowly focusing on the events and institutions of the Panic of 2007, how the economy got to where it is today becomes much clearer."--EH.net

"Offers the most coherent and convincing account of the recent financial crisis that I have seen, stressing its essential similarity to historical banking panics. Gorton's analysis leads to operational proposals for a regulatory environment that would be consistent with a safe, closely regulated banking system and with continued innovation in other financial services."--Robert Lucas, University of Chicago, Nobel laureate in economics

"To understand the actual moment and mechanism of crisis, the definitive take is Yale economist Gary Gorton's, in the delightfully titled Slapped by the Invisible Hand. Gorton's is a challenging book for a non-finance type, but there is no better technical explanation of the panic." --Slate.com

"Essential reading for anyone who wants to know what really happened in the world financial meltdown of 2007-08. Gorton writes with a wide grasp of financial history and a detailed understanding of complex areas such as the repo market. This book deserves to be read widely."--Bill Bradley, Former United States Senator

"Think about it. If porcine greed, by itself, is enough to crash the financial sector, why doesn't Wall Street crash every year? For that matter, why should the crash of the subprime market result in a recession so much worse than the one that followed, say, the dotcom bubble? To answer these questions, you should read [this] book. --National Post

"An indispensable and insightful guide to the origins and the mechanics of the financial crisis. If you want to be among those who understand what happened and what should be done you must read Slapped by the Invisible Hand." --Peter R. Fisher, BlackRock and former Under Secretary of the U.S. Treasury for Domestic Finance

"Gary Gorton's Slapped by the Invisible Hand perceptively explains how the financial crisis of 2008 was actually a crisis of 2007 and provides an essential historical context. It needs to be read by all who seek to shape our future policies."--H. Rodgin Cohen, Chairman, Sullivan & Cromwell LLP

"This is the best book on the crisis what makes this book a winner is that [Gorton] lays bare the root cause of the crisis." --David Merkel, CFA - Finacorp Securities, Aleph Blog

"Gorton comes to the table with long experience in the study of financial bubbles: he offers a challenging analysis of the late meltdown as a classic bank panic in modern dress." --John D. Ayer, UC Davis Professor of Law Emeritus

"Scholars like Gorton do not get enough attention as we try to understand what caused the crisis and how to prevent a repeat he is one of the people that will play an important role in shaping reform." --TheStreet.com

"Gorton, an authority on financial panics, argues convincingly that our most recent unpleasantness is not so different from earlier monetary disasters. The big change is that this one didn't involve runs on your neighborhood 'retail' banks, but was a 'wholesale' crisis that came close to destroying the huge, unregulated network of brokerage houses that trade esoteric securities largely with each other. He believes that we must understand what caused the crisis before we can take steps to prevent another, similar crash in the very near future. His book is a guide to learning those lessons." --Internet Review of Books

"The definitive history of the 2007 meltdown." -The Electric Review

About the Author

Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Management and Finance at the Yale School of Management, and Research Associate at the National Bureau of Economic Research. He formerly taught at the Wharton School for twenty-four years and worked in the Federal Reserve System. He is also a former consultant to AIG Financial Products, where he worked on credit derivatives and commodity futures for over ten years.

Product Details

• Hardcover: 240 pages
• Publisher: Oxford University Press, USA; 3rd Printing edition (March 8, 2010)
• Language: English
• ISBN-10: 0199734151
• ISBN-13: 978-0199734153
• Product Dimensions: 6.3 x 0.8 x 9.5 inches
• Shipping Weight: 1.2 pounds (View shipping rates and policies)
• Average Customer Review: 4.2 out of 5 stars  See all reviews (12 customer reviews)
• Amazon Best Sellers Rank: #166,200 in Books (See Top 100 in Books)

More About the Author

Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Management and Finance at the Yale School of Management, and Research Associate at the National Bureau of Economic Research. He formerly taught at the Wharton School for twenty-four years and worked in the Federal Reserve System. He is also a former consultant to AIG Financial Products, where he worked on credit derivatives and commodity futures for over ten years.

Most Helpful Customer Reviews

43 of 48 people found the following review helpful

3.0 out of 5 stars A five star insight wrapped in a 3 star book May 20, 2010

By EWC

Format:Hardcover

Gorton has made an important contribution to the debate on the Financial Crisis (and I was eager to read his book because of it). He argues that government guarantees of retail deposits enacted in the 1930s, and not capital adequacy requirements, (temporarily) ended previously common panicked withdrawals from the entire banking system. As uninsured short-term institutional deposits have grown and become the primary source of funds for money center banking, it was just a matter of time before these runs began anew. But the book just about starts and ends there. At a critical junctures like ours, the country needs clear thinkers like Gorton to provide leadership by addressing the issues comprehensively, speaking out against demagoguery and making recommendations. Otherwise, why step to the microphone with a book instead of the papers he already published? Gordon scarcely draws conclusions and makes no substantial recommendations!

He points out why repurchase agreement failed as an alternative to government guarantees but goes no further. He shows (in many pages of unnecessary detail) that structured finance contributed to the difficulty of knowing how much (sub-prime) risk each bank held but he doesn't analyze whether credit default swaps and flawed credit ratings also contributed to the confusion. Nor does he show that the value of withdrawing funds to reduce risk in fear of others doing likewise wouldn't have occurred no matter the availability of information. He admits that better information likely would not have solved the problem but he offers no alternatives.

He claims, with little support (although surely its true) , that increased capital adequacy requirements will simply contract the boundaries of banking but he doesn't show where, speculate how the resulting unfilled customer needs with be filled and whether these alternatives would be good or bad for the economy in terms of reducing systematic risk. In this context you'd also like to hear his evaluation of convertible bank debt as an alterative solution to the problem but again, nothing. (Increased reserves would likely curtail mortgage lending.) He asserts that the reduced value of monopoly rent conferred by previously restricted bank charters caused banks to take more risk. If his recommendation is to return to something akin to the restrictions of old, it would take a lot more than just pointing out the issue to show how, why and to what effect.

If you put forward a theory, you also have to show why it's better than alternative explanations but he devotes only a couple pages to pooh-poohing the alternative theories that originate-to-distribute and misaligned incentives reduced lending standards (although I agree with his conclusions) . Except for noting that sub-prime finance served as a trigger, he never addresses the role of Freddie and Fannie in spurring on sub-prime mortgage lending and the extent to which the crisis could have been averted were that not the case. (Presumably we can infer Gordon thinks something else just would have come along.) The role of the trade deficit in the build-up of uninsured short-term institutional deposits is never mentioned. If the answer is for the government to guarantee institutional deposits should we also be guaranteeing offshore deposits into US financial institutions?

If you've read Gorton's papers, there is nothing more here. If you haven't, it's a lot to slog through for what could have been summarized in a much shorter piece. Sentences like, "This agent cares about the intertemporal marginal rate of substitution, so the pricing kernel weights the expected returns on the demand deposits in determining the currency-deposit ratio." and many others like it, are not helpful to the public debate. If you've been sucked in by the superficial logic of demagogues... unfortunately I haven't yet seen a better alternative by a serious thinker.

9 of 10 people found the following review helpful

5.0 out of 5 stars An interesting contrarian analysis from an insider January 21, 2012

By Gaetan Lion TOP 1000 REVIEWER

Format:Hardcover

There are many good books on the financial crisis. For an excellent survey on the topic I recommend the paper "Reading About the Financial Crisis: A 21-Book Review by Andrew Lo." These authors typically espouse Irving Fisher's early The Debt-Deflation Theory of Great Depressions. They address moral hazard with distorted economic incentives. Creditors lent too much to seek short-term profits ignoring long term risk. Borrowers borrowed too much leading to an amount of debt they possibly could not repay. And, when borrowers could not refinance their mortgages; the ensuing defaults and foreclosures impaired the balance sheet of their creditors. In turn, creditors did not trust each other ability to repay their liabilities. And, the financial system shut down.

Gorton's book is interesting because it offers a different crisis theory. For Gorton, it was all about information. Gorton is very qualified to expand on his theory. He has been a finance professor at top business schools for over two decades (Yale, Wharton). He worked for the Federal Reserve. And, most relevant he was involved in structuring synthetic credit portfolios for AIG.

Gorton's disinformation theory has several building blocks. They include: 1) subprime mortgages; 2) mortgage backed securities (MBS); 3) collaterized debt obligations (CDOs); and 4) special investment vehicles (SIVs). Those building blocks consist of a time bomb (1), an information shredder (2, 3, 4), and a collapse of trust (4).

Bank of America innovated the first subprime mortgage back in 1998. It offered a lower fixed rate for the first two years that would adjust upward at two years. By design, the (low-income) subprime borrower was not expected to being able to repay the mortgage at the higher rate level. That's when such borrower was to refinance the mortgage at a higher level relying on the rising value of his home. Every time the borrower refinanced he compounded the risk of both creditors and borrowers wiping out their respective capital through foreclosures. Thus, subprime mortgages were a speculative time bomb. And, the trigger was national home prices not rising anymore (they did not even need to decline).

Gorton goes into exhaustive detail regarding the complexity of MBS structure. As he described, they often were entirely made of subprime mortgages. Thus, European banks were loading up on senior MBS tranches rated AAA. Meanwhile, they had no idea that what supported those "AAA" credits were mortgages extended to low-income borrowers who had no capacity to repay the mortgages.

Gorton by analyzing a few MBS deals shows how an MBS structure is dynamic over time. Let's say an MBS starts with 90% senior AAA tranches and 10% junior tranches. If home prices go up, because of different cash flow allocation, the senior AAA tranches are paid down and represent now only 85% of the MBS, and the junior tranches represent 15%. That's good. But, if home prices decline the junior tranches taking the first losses get wiped out and soon the senior AAA tranches amount to 100% of the MBS and are fully exposed to the subprime mortgage time bomb. That's really bad. And, that is what happened. So, here was a major case of misinformation. Investors (European banks in good part) thought they had bought AAA securities. They really did not. The rating agencies (Moody's, S&P) bear a huge responsibility in having misrated those MBS and having misinformed investors. Remember for Gorton it is all about information (or lack of).

If MBS were not already complex enough, CDOs ensured to complete a black hole of such intense gravity that no light could come out of it (no information). CDOs simply invested in other MBS. Sometimes, they even invested in other CDOs. For the ultimate CDO investor it was impossible to evaluate the quality of the underlying mortgage collateral of the original MBS. By that time, the information shredder was almost complete.

One last piece of the information shredder was the asset side of the off balance sheet SIVs sponsored by various commercial or investment banks to lower their capital requirements. Those SIVs were heavily invested in such CDOs and other complex structured finance products.

By now, the information shredder is complete. Pity the investors in SIVs short-term funding, they had no idea of SIV repaying capacity. They relied on the SIVs having back up line of credits with their supposedly strong sponsors (major bank, etc...).

Gorton indicated that for a while the black hole of (lack of) information did not hurt. As long as home prices went up, everyone performed up the credit chain starting with subprime borrowers ability to refinance. When home prices flattened, refinancing stopped. The house of cards collapsed.

Gorton indicated that one new piece of information accelerated the collapse. This was the advent of the tradable ABX indices. All of a sudden, all investors in MBS, CDOs, and SIVs could readily observe the deterioration in value in a basket of 20 large MBS deals supposedly similar to the ones they were ultimately holding.

That's when the lack of trust shut down the financial system. Investors did not roll over the short-term funding of SIVs. The latter went bust. Their sponsors had to claim them back on their balance sheet with disastrous consequences to their capital levels. Sometimes, this scenario played out with a sponsored hedge fund instead of a SIV (the Bear Stearns situation) causing the failure of the sponsoring parent (Bear Stearns). Finally, all the large banks and financial intermediaries did not trust each other's capacity to repay and refused to lend even overnight to each other. The short term money market shut down. This forced Lehman into bankruptcy in September of 2008. It also forced Merrill Lynch into the arms of Bank of America (BofA) a few days later. Ultimately, BofA will need nearly $30 billion in TARP funds to stay afloat.

Gorton ends up at the same place as the consensus. A financial crisis is in the end all about trust (lack of). But, they get there following different paths. The consensus follows a trail of moral hazard and short-term economic incentives. Gorton instead follows his own path focused primarily on information (lack of).

Gorton does a pretty good job at debunking the moral hazard theory. He indicates that contrary to what people think, the system was not plagued by egregious short term incentives. He mentions that the senior executives of Lehman Brothers and other investment banks lost huge fortune in the drop in value of their stock options. The stock options amounted to long term incentive to preserve the solvency of their firm. Similarly, mortgage originators had incentives to generate good quality mortgages for several reasons. They were exposed to their own origination by having to warehouse such deals sometimes for a few months. They also were exposed to recall provision if one of their deals defaulted in the first month. They also were in the repeat business and had no incentives to sell crappy mortgages only to be shut out of that market. The investment banks who structured the MBS and CDOs similarly had strong long term incentives as they often had to retain a piece of the most junior tranche (equity) to market a deal. They also invested in their own MBS. They also often conducted warehouse lending to mortgage originators. All those should have insured sound due diligence for the originators of mortgages and developers of MBS and CDOs.

In summary, for Gorton the system faltered because of opacity. Meanwhile, for others it faltered because of moral hazard. Ultimately, it faltered because of both. Gorton's moral hazard rebuttal is good. But, it does not entail that moral hazard behavior did not take place for two reasons. First, the market players ignored the dangers and factors Gorton mentioned. Second, Gorton ignored other really powerful moral hazard related economic incentives that countered the ones he mentioned. One of those is that mortgage originators got paid a lot more for originating subprime mortgages than prime mortgages. This was because of the former higher cash flows. That's what the mortgage securitization market was craving. And, that's what it got. The rest is history. And, Gorton's information theory is a really important part of it.

5 of 5 people found the following review helpful

4.0 out of 5 stars Educational, Accurate, Insightful, and Difficult May 1, 2011

By R. Spell VINE™ VOICE

Format:Hardcover|Amazon Verified Purchase

I am an investment banker/mortgage trader and have been poring through the many books on the recession. MOST, concern subprime mortgages or reaction to the financial meltdown. This book is the printing of three research papers with wrapped analysis around those papers so calling it a book is somewhat of a stretch. Pretty short book to write since you are just using your previously written material. But what makes this book GREAT is its clinically written analysis of the cause of our banking panic. Instead of describing what happened as so many other books have, this clinical paper puts the recession/disruption in the terms of comparison to other bank runs. Now this wouldn't seem normal as I doubt the majority of working people would define this disruption as a bank run. Yes, Wamu and IndieMac may have had quick drops in deposits. But our real liquidity problems happened outside government guaranteed depository institutions. Rather the exotic security market became severely disrupted and the highly leveraged investment banks, whose debt was basically short commercial paper, could not roll over their paper. This is why the government had to step in, to protect the commercial paper market and our banking industry which supplies the leverage that runs our country.

This book raises the theme of the substantial change in banking, the shadow banking system, and shows that its importance and fragile nature, which had for so long been ignored, was the major cause of the recession and the "new" bank run. It's a well documented book and worthy of reading. But not without flaws. For example, as mentioned earlier, it's really three research papers. No problem, but one of them veers far from the tenet of the book and is actually an analysis of private label securitization structure. While subprime securitization was the catalyst of the crash, do we suddenly three years later need to revisit the basic structure of securitization?

In closing, if you want a serious discussion with flaws about why we had the crash, this is the book for you and I'm strongly recommend this for the serious students of financial history.