So What Exactly Caused the Financial Crisis?

By David Wessel

Gary Gorton, a finance professor at the Yale School of Management, takes a stab at explaining one key aspect of the recent crisis — the rise of the shadow banking system and the role that securitization plays — in testimony he’ll deliver later this week to the Financial Crisis Inquiry Commission.

The story isn’t as simple as the black hats vs. white hats version that politicians, the press and the public favor. In question-and-answer format, he offers a step-by-step explanation.

It’s wrong to blame this crisis on subprime mortgage lending, he says. Rather, this crisis is best seen as the latest of a series of banking crises throughout history. Banks borrow (or take deposits) short-term, promising to give money to their customers if they want it. They invest that money long-term, lending to businesses and consumers. This “intermediation” process is vital to the smooth functioning of the economy. But if depositors or others from whom banks have borrowed short-term demand their money back — a demand often sparked by panic — banks can’t instantly respond, and bad things ensue. In the old days, these runs were prompted by anxious depositors. Deposit insurance helped solve that problem. In our time, banks were reliant on short-term borrowing known as repurchase agreements — and the folks who held those panicked.

Gorton writes: “Repo is money… But, like other privately created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system — in this case the shadow banking system — cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money. In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime [mortgages] were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.”

“The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.”

Gorton also argues that securitization — the business of making loans and then selling them off as securities — was prompted by a simple fact of banking business life. “Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed,” he says. “As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system.”

In addition to being a scholarly analyst of finance, Gorton had a ringside seat during this crisis. He helped craft models that AIG used to assess the risk of its credit default swaps.