Institute for Financial Transparency

Shining a light on the opaque corners of finance


Gary Gorton and the Panic of 2007

As I was reading Professor Gorton’s article for the 2008 Jackson Hole conference, I realized it confirms everything I have said about the Economics profession not understanding transparency and the role it plays in the global financial system.

Professor Gorton observes:

Still, I would say that the current credit crisis is essentially a banking panic. Like the classic panics of the 19th and early 20th centuries in the U.S., holders of short-term liabilities (mostly commercial paper, but also repo) refused to fund “banks” due to rational fears of loss—in the current case, due to expected losses on subprime and subprime-related securities and subprime-linked derivatives.

In the current case, the run started on off-balance sheet vehicles and led to a general sudden drying up of liquidity in the repo market, and a scramble for cash, as counterparties called collateral and refused to lend. As with the earlier panics, the problem at root is a lack of information.

His description of the classic bank panic is exactly what you get when dealing with opaque securities.  When doubts arise about the story on which the value of the opaque securities is based, there is no logical stopping point in the downward valuation of these securities other than zero.  Hence, investors have an incentive to “run” and try to get their money out of these securities as soon as doubts arise about the valuation story.

What is the information problem? The answer is in the details….

I develop the thesis that the interlinked or nested unique security designs that were necessary to make the subprime market function resulted in a loss of information to investors as the chain of structures—securities and special-purpose vehicles (SPVs)—stretched longer and longer. [emphasis added]

Professor Gorton identifies the existence of an information problem, but clearly misses the loss of information to investors was intentional.

Please recall from the Information Matrix “bank run” like behavior only occurs when dealing with opaque securities in the Blind Betting quadrant.

Information Matrix

                                      Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying? Yes No
Yes Perfect Information Antique Dealer Problem
No Lemon Problem Blind Betting

Each opaque subprime security was custom designed by Wall Street to be in the Blind Betting quadrant.  It was value based on the story told by Wall Street.  You can take Professor Gorton’s word for it.  His description of the subprime market perfectly fits the Goldman Sachs Theory of the Perfect Financial Market where the market is comprised of investors blindly betting on opaque securities based solely on stories told by Wall Street.

This nesting or interlinking of securities, structures, and derivatives resulted in a loss of information and ultimately in a loss of confidence since, as a practical matter, looking through to the underlying mortgages and modeling the different levels of structure was not possible. And while this interlinking enabled the risk to be spread among many capital market participants, it resulted in a loss of transparency as to where these risks ultimately ended up. [emphasis added]

While it was impossible for investors to look through to the underlying mortgages, it wasn’t impossible for Wall Street.  Wall Street had investments in the subprime mortgage originators and servicers (the people who collect the mortgage payments).  Wall Street used this information on underwriting and collection to inform its trading of subprime mortgage-backed securities.

No place was this better exemplified than Goldman’s Abacus deal.  Goldman was asked by its client to create a security comprised of subprime mortgage-backed deals Goldman expected to fail.  More than 90% of the selected deals failed and its client made over $1 billion on the trade.

While Professor Gorton correctly identified the information problem was a lack of transparency, his analysis stopped well short of giving the correct explanation of what was going on and why.  Thereby confirming the Economics profession doesn’t understand transparency and its role in the global financial system.