A Grand Unified Theory of the Financial Crash

My colleague Megan McArdle wrote a post this afternoon reviewing the common villains of the financial crisis. It seems that for every villain -- from banker pay to securitization (the ability to turn income streams like mortgages into tradable securities) -- there is a smart, even correct, defense of said villain. Most of the explanations for the crisis, Megan observes, falls into two pat categories: (1) Bankers had bad incentives or (2) bankers didn't understand the risks. Those aren't mutually exclusive, of course, but still I lean, with Megan, toward (2). Where I suppose I break from her lead, however, is her last sentence:

But the more time we waste trying to figure out who did us wrong, the less quickly we will arrive at an actual solution.

I, too, would consider it a waste if we knew exactly what happened in 2008, and all that was left was to divvy up blame between the bankers, regulators, government and public. And I thought I had heard every grand unified theory imaginable of the Crash of 2008. But this column by National Journal's Jonathan Rauch makes me think again ... again!

Rauch summarizes Gary Gorton, a Yale finance professor, whose theory of the crash begins with financial innovation and ends with the evaporation of our money supply. The piece is superb. I don't usually say this, because it's an extraordinary request to tell a reader "Stop what you're doing and read this columm" but ... well, stop what you're doing and read this column.

Here's the synopsis: Financial innovation produced a vast network of complicated asset-backed securities traded among what insiders call "shadow banks," or unregulated banks. Shadow banks looking to park cash where it would hold value and earn interest created a short-term securities market -- much like a checking account. But unlike a regular FDIC-insured checking accounts, these deposits would not be guaranteed by the government. So investors borrowing from this shadow depository system had to put up collateral. And they chose ... their asset backed securities.

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Why is that dangerous? Because in the shadow banking industry, these deposits, backed by sub-prime mortgages instead of the FDIC, acted as money. Banks relied on it for transactions. "Subprime morgage debt had entered the money supply." But then the housing bubble burst. Depositors dumped their assets to raise cash and tried to withdraw their money, raiding the shadow depository market, and the money supply crashed. Here's the crux of the narrative, in Rauch's words:

In the so-called Quiet Period, 1934 through 2007, systemic bank runs seemed to become relics of an unmourned past. Why? Because for about four decades, banks' activities were restricted to heavily regulated ventures that were more or less guaranteed a profit -- and, even more important, because federal deposit insurance, which began in 1934, assured depositors that their savings were safe.

Financial innovation, however, could be delayed but not denied. Around the walled garden grew a forest of new competitors and products. Money-market funds and other investment vehicles took deposits without offering federal guarantees. In a process known as securitization, investment banks converted predictable streams of income, everything from mortgage payments to health club dues, into securities that investors bought eagerly. Derivatives -- securities based on other securities--arose to spread risk and hedge against volatility. In time, shadow banking, as the new institutions and instruments were collectively called, rivaled and even eclipsed old-fashioned commercial banks.

The firms and major financial players making all these trades needed to park cash where it would hold its value and earn some interest, yet be accessible on demand. In other words, they needed the equivalent of checking and savings accounts, the "demand deposits" that banks traditionally provide and that form the backbone of the money supply. But no insured depository could begin to cope with the trillions of dollars involved. And so shadow banking developed what amounted to its own depository system, a short-term securities market called the "sale and repurchase," or "repo," market. It is immense. Gorton figures its size at perhaps $12 trillion, but he says no one knows for sure.

"It's important to see that this is a banking system," Gorton says. But it is like a 19th-century banking system, because repo "deposits" are uninsured. Unable to rely on a federal guarantee, depositors who park their holdings there require that the borrower put up something of value as collateral.

Treasury bonds, because they are safe and liquid, are the ideal form of collateral, but there were nowhere near enough of them to meet the demand. So asset-backed securities -- those packages of safe-looking income from mortgages, auto loans, and all the rest -- were pressed into service as collateral. In time, the better grades of subprime mortgage-backed securities were mixed into the blend, and they, too, won acceptance as collateral.

All of these asset-backed securities were sorted and re-sorted, combined and recombined, sold and resold, until, as Gorton writes, "looking through to the underlying mortgages and modeling the different levels of structure was not possible." Users could not independently assess the value of mortgage-backed collateral any more than your grocer can independently assess the solvency of your bank before accepting your check.

You can see, perhaps, where this leads. Repo is a form of money because it acts as a store of value and financial actors rely on it to conduct transactions. But instead of being backed by a federal guarantee, it was backed by, among other things, subprime mortgages. In this way, without anyone paying much notice, subprime mortgage debt entered the money supply. As in the 19th century, the economy had become dependent upon a form of bank-issued money that was not federally guaranteed and that was not as stable as it appeared. Unlike in the 19th century, however, no one understood how vulnerable the system was to a panic.

Calamity then struck, as it had before. First, the unexpected decline in housing prices tanked the subprime market. Repo depositors knew that most collateral was sound, but they had no way to know if their own holdings were safe; so in 2007 they began what amounted to a run on the repo system, effectively withdrawing their money. To raise cash, repo depositories dumped assets, further depressing collateral values and starting a tailspin.

In September of last year, when the failure of Lehman Brothers, the mighty investment bank, convinced investors that no one was safe, the crisis turned into a meltdown. As the repo market "virtually disappeared" (in Gorton's phrase), the money supply crashed and the economy began to suffocate.