Customer Reviews

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

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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.

Gorton's explanations of the financial meltdown are the most plausible out there. Gorton has studied banking and banking panics for decades. Unlike other economists he has detailed knowledge of how the banking system has evolved and what exactly happened in the summer of 2007.

In a few words, the little guys bank at regulated commercial banks with deposit insurance. So the little guys don't panic when there are problems in the economy or in the banking system. The big guys put their cash in a shadow banking system where their "deposits" called repos are collateralized by asset backed securities. The system works well until the value of the collateral comes into question. This is what happened in the summer of 2007. The shadow banks had to dump asset backed securities en masse into the financial markets and there was on one to buy them. The price of asset backed securities as a whole began to fall and the shadow banking system froze up. Gorton points out that this is nothing other than a 19th century-style banking panic that occurred behind closed doors and was misinterpreted by economists and regulators who simply had no experience with this sort of event.

As another reviewer points out, the book is a hastily compiled collection of Gorton's papers. One might do better to find the papers on the internet.

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.

I've read a lot of books about the financial meltdown, and so far this is the best.
If you want to read a very intelligent and well written book about this subject
then go out and buy this book. Aside from his wonderful analysis of the background
of the meltdown, he also offers very reasonable suggestions on how to prevent
the next one. My only criticism of this wonderful book is that he should have included
a glossary.

There have been a number of stories about the economic crisis of 2007-2008. Many have been more clearly and stylishly told, but this one is unique and extremely important because it is virtually alone in constructing a consistent operational picture of how precisely the sudden deflation of the U.S. housing bubble led, step by step, to a collapse of the world financial system. As some of the reviews here make clear, this is not a story to satisfy you if you come at this from an ideological perspective, whatever it may be. Gorton is writing not as a Keynesian or a neoclassicist or an Austrian, but as a technical financial economist. It is neither a morality tale nor a work of grand theory but an analysis of what Keynes referred to as "magneto trouble."

It is somewhat disconnected and not altogether clear in some places. In part this is because this is a report from the front lines, written during or shortly after the battle. It will take a long time, as Gorton repeatedly emphasizes, to develop real clarity about what happened and why. Many of the details he goes into truly are mind-numbing, this is a feature rather than a bug, because in Gorton's view the details truly made a big difference, and if we don't understand that then we have much less chance of modifying the system so as to avoid repetition.

By precisely identifying a mechanism for the crisis Gorton puts himself in a position to offer precise proposals for action. In the process, he casts a great deal of doubt on the efficacy of much of what has been put forward and in part adopted so far.

He notes with regret that he has not been able to able to test his theses about the causes and mechanisms of the crash, but as he observes, it is scarcely possible to do so for a truly singular event such as this. We are left with no alternative but a case-study approach, and this is a very important start.

Most of the book simply is a compilation of three previously-published papers, which may be read separately, if one prefers. I have been glad to have them in book form, however, and found that the introductory chapter added significantly to their value.

In one sense, but not in every sense, this is the best book on the crisis. I give Yves Smith credit for diving deep on economics and finance, and laying bare the intellectual bankruptcy there. Simon Johnson and James Kwak did an excellent survey of regulatory difficulties in banking and more. Barry Ritholtz probably wrote the best book, because he has a knack of combining informative and entertaining.

But what makes this book a winner is that he lays bare the root cause of the crisis: we need safe short-term liabilities in order to transact. Banks provide the short term medium of commerce, so that no one has to consider whether their dollars are changing in value month after month.

But when there are alternatives to banks that seem cheaper in the short run in creating stable securities, the banking system gets hollowed out. That can be as simple as money market funds, or as complex as AAA structured securities that finance complex obligations.

At such a point, being a bank is not so valuable, and banks mimic the innovations in order to compete.

Though not an innovation, repo funding was a star of this crisis. Repo funding is a short-term means of gaining liquidity through borrowing while offering high quality liquid assets as collateral. It is very stable most of the time, but when liquidity gets scarce, the system as a whole can unwind.

The book focuses on "safe" liabilities: bank deposits, both before and after deposit insurance, repo funding, and AAA short securities from securitizations. People want to keep their purchasing power safe. But when the safety of any safe security comes under question, the system falls apart.

That is the nature of a systemic crisis. What is previously regarded as safe is not safe.

I have one main policy recommendation as a result of this book -- regulate the repo markets. They were a main factor for contagion in this crisis.

I liked this book a lot, and recommend it. I also like the title a lot, because the invisible hand does deliver negative consequences to those who act foolishly. Punishment is needed for a capitalist system to survive.

Quibbles

Though it is a book, it is really five essays that have been sewn together with some extra copy in order to make it into a book. Also, you don't have to be bright to benefit from the book, but you can't be dumb.

Who would benefit from this book

Anyone looking to understand the fundamental reasons behind the crisis will benefit.

Gorton's book (really a collection of three papers he authored and presented to the Fed contemporaneously with the 2007 financial crisis) will surely be an essential source in any future literature review of the global economic crisis of 2007. As many other reviewers pointed out, Gorton's work is a slog to get through (because he wrote it as a research paper and because he is quite redundant, between and within his papers). Nonetheless, this is must read material for anyone who truly wants to understand: the mechanics of the subprime mortgage meltdown; the importance of recognizing the shadow banking system as real banking (with similar vulnerabilities and fully deserving of well-crafted policy and regulation just like traditional banking); how securitization works; how the ability to fully understand how risk is spread can be lost through derivatives; the impact of information insensitive securities becoming information sensitive; the importance of collateral and repo markets in contemporary global finance. I pretty much drained a highlighter in this book. Gorton's book is well worth the slog if you're serious about enhancing your understanding of what happened, and absolutely essential if you need to be informed enough to engage in intelligent debate on appropriate policy and regulation reform.

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.

I've been following Gorton's insights on the crisis for a while now. Having been in a position to witness the meltdown from a far-too-close-for-comfort situation myself, I find his reading of the event(s), unlike so many other narratives making the rounds, rings true. What we witnessed was a "new-fashioned" banking panic. How did it happen? Why did it happen? Can it happen again? Yep, you should probably read the book....

The book is an excellent study of the financial crisis but it's written more as an academic paper than as a book for general consumption. The equations on some pages would make the average person faint. If you have the background, it's a must read. If not, either give it a pass or be prepared for a slog.