Yale's Gorton analyzes financial crisis at Beattie Lecture
September 14, 2021
(l-r) Western Pres. Amit Chakma, Dean Iain Scott, Gary Gorton, Prof. Christopher Nicholls and Geoff Beattie '84
The recent financial crisis was nothing more than a twenty-first century run on the bank, said influential economist Gary Gorton.
Gorton, an expert in the global financial crisis from the Yale School of Management, delivered the 5th annual Beattie Family Lecture in Business Law at Western’s Faculty of Law on Wednesday November 13. He spoke on The Financial Crisis: What Happened? (view video of lecture below)
In the Great Depression, Gorton said, bank runs in the United States were experienced by traditional bricks-and-mortar, deposit-taking institutions, like the fictional Bailey Bros. Building and Loan portrayed in the Frank Capra holiday film, It’s a Wonderful Life. A run occurs when a large number of customers, believing a bank is becoming insolvent, withdraw their deposits simultaneously. Faced with more sudden demands for cash than they have on hand, even solvent banks can be ruined by runs.
Runs by retail bank depositors in the United States ended with the introduction of government deposit insurance in the 1930s.
In the recent turmoil, however, a new type of ‘run’ occurred in the unregulated shadow-banking sector.
“In the lead up, securities used as collateral in the repurchase (repo) market went from being safe, liquid and tradable to risky,” said Gorton (pictured below)
A repo is similar to a secured loan. The buyer (essentially a lender, in this transaction) “deposits” money and receives securities as collateral to protect it against default by the seller.
Gorton explained that prior to the financial crisis, the rapid expansion of the repo market, as well as the market for financial derivatives, led to an increased demand for collateral in the form of risk-free (or information-insensitive) securities, such as high-grade corporate debt, government bonds (mainly U.S. Treasuries) and AAA-rated asset-backed securities.
The demand for such securities far outstripped the supply of Treasuries. Therefore, private-sector substitutes filled the gap.
These private-sector securities were largely generated through securitization transactions. Loans of various kinds — including subprime mortgage loans — were bundled together and sold to special purpose vehicles, typically trusts. These trusts financed their purchase of these assets by issuing tranches of debt securities.
The most senior tranches were structured to merit a AAA rating from the major credit rating agencies. These AAA ‘mortgage-backed securities’ could then be used as collateral in the repo market, although everyone understood they were imperfect substitutes for truly risk-free government-issued securities.
Trouble hit when the U.S. housing market softened. Many subprime mortgage loans depended on continually rising house prices – enabling borrowers to regularly refinance and keep their loans in good standing.
When that was no longer possible, mortgage borrowers were in trouble, as were the securities whose value depended on the cash flow from those mortgages.
Suddenly, the value of those AAA-rated subprime mortgage-backed securities became uncertain. Worse, the complex securitization structure made it impossible to determine exactly who was exposed to the ‘bad’ mortgages and who wasn’t.
As repo party ‘depositors’ became anxious about the extent of their exposure, they panicked and reacted like the frightened depositors who stormed the doors of the Bailey Bros Building and Loan. They withdrew funds by requiring larger discounts (‘haircuts’) on the securities they held as collateral for their repo loans.
Those withdrawals forced the borrowing firms (firms like Lehman Brothers, and many others) to hastily sell additional assets at fire-sale prices to cover the shortfall.
The highest-quality financial assets were the easiest to liquidate quickly. As many borrowing firms experienced the same kind of pressure, the value of these high-quality financial assets fell. So, although the run was initially prompted by weakness in the relatively small subprime mortgage market, prices for high-quality financial assets unrelated to the subprime mortgage market also began to collapse. A subprime mortgage problem thus morphed into a full-scale financial crisis.
Gorton’s lucid analysis was a sobering reminder of the importance of thoughtful and informed regulation in the financial sector, and of the danger of accepting hasty or populist explanations of complex financial issues.
Geoff Beattie, LLB’84, chairman of Relay Ventures and former CEO of The Woodbridge Company Limited, established the Beattie Family Lecture Series in Business Law in 2008. Past speakers in the series include Nobel Prize-winning economists Robert Shiller and George Akerlof, Chancellor Leo E. Strine Jr. of the Delaware Court of Chancery and Lawrence Summers, former U.S. Treasury Secretary and president emeritus of Harvard University.