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Interview with Gary Gorton: New Theory of Debt, Collateral, Repo, Crisis and Regulation

Reading an interview with Gary Gorton of the Minneapolis Fed. (Hat tip to Naked Capitalism). He makes some interesting points regarding the securitization industry, its relationship with the repo market, how when collateral was deemed untrustworthy it led to hair-cutting and then full panic. Side comments on the need for new measurements to size the securitization industry, efforts to build the trust of collateral.

The inability of old economists to think the new paradigm and the need for new measurements:

I mean, one thing I’ve noticed is that most people who are about my age in the profession, basically, their response to the crisis was to say, “All the stuff I’ve been doing for the last 25 years is relevant, and here’s why. I can explain the crisis.” Which is wrong, and we know it’s wrong. Whereas students are coming to it with a fresh eye…

the problem is that we don’t have any new paradigm, and the way I view it is that that has to be built brick by brick, and a large part of it, I think, is getting data. I think we really have to understand what happened. And that poses the challenge.

After the fact, things always look clearer, don’t they? Monday morning. People make statements like, “Obviously, there was too much leverage.” That’s like saying the patient died because his heart stopped beating or inflation is caused by prices going up. Obviously, there was leverage. That’s why I said before that you need a theory of debt; you need to explain why there’s this debt and what is the purpose of having this debt. Does that security, which is optimal, have consequences that are socially suboptimal or not? What’s the problem? To make progress, we need to say more rather than just repeating these things.

I read that and thought that it was profound to realize: We need to generate a theory of debt. The crisis in liquidity when repo markets seized after the fall of Lehman’s  was caused be people all doubting the collateral.

The repo market and collateral.

What happened, I think, is that the depositors in the repo market got nervous to the extent that the only way to protect themselves against agents producing private information was to ask for a buffer. Let’s go back to the repo market. In the repo market, I give you $100 million; you give me $100 million worth of bonds. Let’s say those bonds are AAA, credit-card-linked bonds, an asset-backed security. The only way I can lose as a depositor is if you fail. I am then allowed to unilaterally terminate the agreement, and I go to sell my bonds and I fetch less than $100 million.

Now, if the shock causes me to worry that when I sell my bonds somebody will have produced private information (because now, unlike before, it’s profitable to do that), then I can protect myself by saying, “I’m not going to give you $100 million. I’m only going to give you $80 million, and you give me $100 million of bonds as collateral.”

Let’s do just a back-of-the-envelope calculation: If haircuts go from 0 percent to 30 percent, on average, that’s $3 trillion the shadow banking system has to raise. The run is that depositors want $3 trillion. There’s no place to get $3 trillion. And we know what happened over the course of the crisis. The Fed ends up buying $2 trillion, and commercial banks end up buying $1 trillion. But the process of transferring these assets is very painful.

The collateral for the repo market need to be trustworthy, and the only way to make it trustworthy is to bring it under regulation.

we want to bring securitization under the regulatory umbrella because it’s used as collateral. If the government doesn’t oversee it, then we won’t have high-quality collateral that’s created that people will have confidence in, in the sense that it’s information-insensitive.

This article and the associated paper are going to be worth coming back to.

First published at Spirit in Business.

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