the private-money view of financial...

The Private-Money View of Financial Crises

Gary Gorton, Yale and NBER

Financial Crises

• Doug Diamond: “Financial crises are everywhere and always due to problems of short-term debt (and to the reasons why short-term debt is needed).”

• Need short-term debt but vulnerable to runs.

• Challenge for theory: Explain the optimality of debt, even though it is vulnerable to runs.

Themes

• The evolution of money forms and how the information environment evolved.

• The price system is not supposed to work for bank money.

• When the price system works financial crisis.

• A crisis is an information event.

Crises are Systemic--1837

• At the present moment [during the Panic of 1837], all the Banks in the United States are bankrupt; and, not only they, but all the Insurance Companies, all the Railroad Companies, all the Canal Companies, all the City Governments, all the Country Governments, all the State Governments, the General Government, and a great number of people. This is literally true. The only legal tender is gold and silver. Whoever cannot pay, on demand, in the authorized coin of the country, a debt actually due, is, in point of fact, bankrupt: although he may be at the very moment in possession of immense wealth, and although, on the winding up of his affairs, he may be shown to be worth millions. Gouge (1837; italics in original)

What is a financial crisis?

• A “financial crisis” is not just a bad event.• Stock market crashes are not systemic events.

• A “financial crisis” is an event in which households or firms no longer believe that bank debt (money) is worth par – instead the want cash: A run on the banks.

• Sudden but not irrational.

• But, banks do not have the cash, so insolvent.

• The banking system is insolvent.

• Geithner: “Of the twenty-five largest financial institutions at the start of 2008, thirteen failed (Lehman, WaMu), received government help to avoid failure (Fannie, Freddie, AIG, Citi, BofA), merged to avoid failure (Countryside, Bear, Merrill, Wachovia), or transformed their business structure to avoid failure (Morgan Stanley, Goldman)”.

• Bernanke’s FCIC testimony--During September and October 2008 “. . . of the 13 the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two”.

Financial Crises are not Rare

• Financial Crises: • Have occurred in all market economies throughout history;

• Occur in advanced economies;

• Occur in emerging markets;

• Occur in economies with or without central banks;

• Occur with different forms of bank debt.

Financial Crises not Rare

• Since 1970 there have been 147 systemic events around the world.• Occur in all market economies.

• Not just events from an earlier era.

• And not just in emerging markets.

• Of the 147 events, about 65% involved bank runs.

Crises are Common in Developed Countries

Country Financial Crisis (first year)

Australia 1893, 1989

Canada 1873, 1906, 1923, 1983

Denmark 1877, 1885, 1902, 1907, 1921, 1931, 1987

France 1882, 1889, 1904, 1930, 2008

Germany 1880, 1891, 1901, 1931, 2008

Italy 1887, 1891, 1901, 1930, 1931, 1935, 1990, 2008

Japan 1882, 1907, 1927, 1992

Netherlands 1897, 1921, 1931, 1988

Norway 1899, 1921, 1931, 1988

Spain 1920, 1924, 1931, 1978, 2008

Sweden 1876, 1897, 1907, 1922, 1931, 1991, 2008

Switzerland 1870, 1910, 1931, 2008,

United Kingdom 1890, 1974, 1984, 1991, 2007

United States 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1929, 2007

0

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Per

cen

tage

Dis

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fro

m P

ar

Planters Bank of Tennessee Note Discount in Philadelphia

Source: Gorton and Weber.

• “In the use of money, everyone is a trader; those whose habits and pursuits are little suited to explore the mechanism of trade are obliged to make use of money, and are no way qualified to ascertain the solidity of different banks whose paper is in circulation; accordingly we find that men living on limited incomes, women, laborers, and mechanics of all descriptions, are often severe sufferers by the failure of country banks . . . “ Ricardo (1876, p. 409)

Low Value Final Value of the Collateral Backing High Value

Face Valueof Debt

Payoff on DebtAt Maturity

Bankruptcy point

Contractual Payoff on Debt

Intuition for Dang, Gorton, Holmström (2011)


Distribution of DifferentCollateral Values

Most likelycollateral value

Likelihood ofDifferent FinalCollateralValues

Face Value

of Debt $10


Distribution of DifferentCollateral Values

Most likelycollateral value

Final Valueof Collateral

Likelihood ofDifferent CollateralValues

$10

Debt is the optimal contract

Face Value

of Debt $10


Distributions of DifferentCollateral Values

Final Valueof Collateral

Likelihood ofDifferent CollateralValues

$10

Financial Crisis

Face Valueof Debt

Payoff on DebtAt Maturity


Bankruptcy point

Contractual Payoff on Equity

Debt and Info

• Cut cash flows by seniority—

• cuts information!

• That’s the point of debt.

Frequency of Loss

Size of LossF-X

0

Loss Distribution for Debt

Frequency of Loss

Size of LossF-X

0

Loss Distribution for Debt

Face Value of Debt

Almost riskless

Maximal Info-Insensitivity: Debt-on-Debt

Debt (cont.)

• Debt is information-insensitive.• Does not mean “riskless.”

• Means that it is not profitable to produce private information.

• Avoids adverse selection.

• Price does not change much/at all. Price system not work.

Compare to Equity

• The value of equity always depends on the value of the backing assets or collateral.

• Producing information about equity is always valuable (if you are the only one producing it).

• Equity is information-sensitive.

Debt-on-Debt

• Debt backed by debt maximizes information-insensitivity.

• Free bank notes: backed by state bonds.

• Demand deposits: backed by loans—to consumers and small businesses.

• Money market instruments: backed by debt.• Repo: specific bond

• ABCP: asset-backed securities

Debt and Info

• Cut cash flows by seniority—

• cuts information!!

• That’s the point of debt.

Debt Equity

Purpose “Money-like” Risk Sharing

InformationInfo-insensitive

Retain value; NO Price DiscoveryInfo-sensitive

Price Discovery

Market StructureTrades over-the-counter

BilateralFew Traders

Central Stock Exchange(NASDAQ; NYSE)

Many Traders

Backing Collateral Debt Real Assets

Adverse Selection No No

Liquidity Safe liquidity Risky liquidity

Analysts None really Many

Ratings Yes No

Academics Don’t Study Study

Implications

Implications for Trade

• Bonds do not trade. And when they do, it is bilateral (OTC).

0.0%

1.0%

2.0%

3.0%

4.0%

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20

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20

11

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20

13

20

14

Percentage of Total U.S. Bonds that Trade Daily

Implications for Bond Prices

• Since bonds essentially are not traded after they have been sold, how are off-the-run bonds valued?

• The answer is that the value of a bond is estimated/guessed—”matrix pricing.”

NASDAQ

• “Most bonds are priced relative to a benchmark. This is where bond market pricing gets a little tricky. Different bond classifications, as we have defined them above, use different pricing benchmarks.”

Bond Mutual Funds

• Look at how bonds held by different funds are “marked-to-market.”

• There is significant price dispersion across the exact same bonds (on average).

• The price dispersion is decreasing in bond credit quality: lower dispersion for higher rated bonds.

• Dispersion is higher for high yield bonds than for investment-grade bonds.

But, short-term debt is “money”

• Pre-crisis repo market ~ $10 trillion

- Every morning more than $1 trillion rollover of tri-party repo in early 2008

- - Daily trading volume of bilateral repo $5.81 trillion in 2007 (SIFMA (2008))

- Non-rollover of repos caused bankruptcy of Bear Stearns and Lehman Bankruptcy Examiner’s report (2010, p.3):

- “Lehman funded itself through the short‐term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.“

Back to the Evolution of Bank Money - - -

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

Year 1835 1837 1839 1841 1843 1845 1847 1849 1851 1853 1855 1857 1859 1861 1863

$ T

ho

usa

nd

s

Bank Notes in Circulation

Deposits

Source: Gorton

Growth of Demand Deposits

0

20

40

60

80

100

120

140

18

65

18

67

18

69

18

71

18

73

18

75

18

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18

79

18

81

18

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18

85

18

87

18

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18

91

18

93

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99

19

01

19

03

19

05

19

07

19

09

Nu

mb

er

Sto

cks

New York Stock Market, Active Stocks 1863-1909

Total Number of Stocks in Index

Total Number of Bank Stocks inIndex

Source: Goetzmann, Ibbotson and Peng (2001).

Ratio of Notes to Deposits and Treasury Debt to GDPCorrelation = 0.96

U.S. National Banking Era PanicsNBER Cycle

Peak-TroughPanicDate

%∆(C/D) %∆ Pig Iron

Loss perDeposit $

% and # Nat’l Bank Failures

Oct. 1873-Mar. 1879 Sep. 1873 14.53 -51.0 0.021 2.8 (56)

Mar. 1882-May 1885 Jun. 1884 8.8 -14.0 0.008 0.9 (10)

Mar. 1887-Apr. 1888 No Panic 3.0 -9.0 0.005 0.4 (12)

Jul. 1890-May 1891 Nov. 1890 9.0 -34.0 0.001 0.4 (14)

Jan. 1893-Jun. 1894 May 1893 16.0 -29.0 0.017 1.9 (74)

Dec. 1895-Jun. 1897 Oct. 1896 14.3 -4.0 0.012 1.6 (60)

Jun. 1899-Dec.1900 No Panic 2.78 -6.7 0.001 0.3 (12)

Sep. 1902-Aug. 1904 No Panic -4.13 -8.7 0.001 0.6 (28)

May 1907-Jun. 1908 Oct. 1907 11.45 -46.5 0.001 0.3 (20)

Jan. 1910-Jan. 1912 No Panic -2.64 -21.7 0.0002 0.1 (10)

Jan. 1913-Dec. 1914 Aug. 1914 10.39 -47.1 0.001 0.4 (28)

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ug

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ug

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ug

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2-S

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Pre

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f C

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cy o

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Ce

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cks

(%)

1-Aug

2-Aug

3-Aug

4-Aug

5-Aug

7-Aug

8-Aug

9-Aug

10-Aug

11-Aug

12-Aug

14-Aug

15-Aug

16-Aug

17-Aug

18-Aug

19-Aug

21-Aug

22-Aug

23-Aug

24-Aug

25-Aug

26-Aug

28-Aug

29-Aug

30-Aug

31-Aug

1-Sep

2-Sep

Low 2 2 2 3.5 4 3 2 1.5 1 1.5 2 2.5 2.5 2 1.5 1 1.25 1 0.5

High 1 3 3 3 4.5 5 3.5 3 2.5 3 3 3 3 3.5 3 2.5 2 1.5 1.5 1.25 1 0.75 0.75 0.75 0.5

Currency Premium for the Panic of 1893

Source: Gorton and Tallman.

The Quiet Period, 1934-2007

• A book called “The End of History” became a runaway best seller.

• Economists declared “The Great Moderation.”

• Bob Lucas announced that “macroeconomics . . . has succeeded”.

• Why no crisis? “Moral hazard”?

The Demand for Safe Assets

• There has always been a demand for safe assets.

• Historically, gold coins.

• Short-term safe debt—money-like

• Long-term safe debt--- certainty of final payoff.

• Safe assets are debt that is near-riskless.

• Private sector cannot produce riskless debt. But, can produce substitutes: AAA/Aaa Abs.

The Transformation of the Financial System

• Over the last 30 years prior to the crisis, the architecture of the financial system changed.

• Immobile collateral bank loans became mobile collateral in the form of MBS and ABS—can be traded, posted in derivative positions, collateral for repo and ABCP, rehypothecated.

0%

10%

20%

30%

40%

50%

60%

70%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Ratio of Total Private Securitization to Total Bank Loans

Source: Flow of Funds.

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100

200

300

400

500

600

700

800

900

19

54

19

57

19

60

19

63

19

66

19

69

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72

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19

78

19

81

19

84

19

87

19

90

19

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19

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19

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20

02

20

05

20

08

Growth of Assets in Four Financial Sectors (March 1954=1)

Broker-Dealer Assets

Commercial Bank Assets

Household Assets

Non-financial Corporate Assets

Source: Flow of Funds.

(0.100)

-

0.100

0.200

0.300

0.400

0.500

0.600

0.700

Holders of Treasury Securities as a Fraction of Total Outstanding

US Depository Institutions Rest of the World Insurance Companies

Mutual Funds Securities Broker-Dealers

Securitization

Pooling of Assets

Master TrustPool of Loans

Traditional Bank:Creates Loans

Sells Cash FlowsFrom Loans AAA

85%

A

BBBLast (equity) Tranche

Not Sold

Securitization Investors

Proceeds of Saleof Assets

Tranching of Assets

AA

The Safe-Asset Share

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5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

1952 1955 1958 1961 1965 1968 1971 1974 1978 1981 1984 1987 1991 1994 1997 2000 2004 2007 2010

Government Liabilities Financial Liabilities

Source: Gorton, Lewellen, Metrick (2012)

Components of Privately-produced Safe Financial Debt

0%

10%

20%

30%

40%

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100%

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52

19

54

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10

Deposits Money-like debt MBS/ABS Debt Corporate Bonds and Loans Other Liabilities

Source: Gorton, Lewellen, Metrick (2012)

Shadow Banking

TraditionalBanking

Broker-Dealer Pledged Assets ($ millions)

May 31,

2008

May 31,

2008

May 31,

2008

June 27,

2008

Feb. 29,

2008

2nd

Quarter

Total

Morgan

Stanley

Goldman

Sachs

Lehman Merrill

Lynch

Bear

Stearns Total

Financial Instruments

Owned

390,393 411,194 269,409 288,925 141,104 1,501,025

--of which pledged

(and can be

repledged)

140,000 37,383 43,031 27,512 22,903 270,829

--of which pledged

(and cannot be

repledged)

54,492 120,980 80,000 53,025 54,000 362,497

--of which not

pledged at all

195,901 252,831 146,378 208,388 64,201 867,699

% own financial

instruments pledged 50% 39% 46% 28% 55% 42%

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

$ M

illio

ns

Primary Dealer Treasury Fails

Total Treasury Receive

Total Treasury Deliver

The Scarcity of Safe Debt

Source: Gorton and Muir.

Total

Mortgage

Originations

(Billions)

Subprime

Originations

(Billions)

Subprime

Share in

Total

Originations

(% of dollar

value)

Subprime

Mortgage

Backed

Securities

(Billions)

Percent

Subprime

Securitized

(% of dollar

value)

2001 $2 ,215 $190 8.6% $95 50.4%

2002 $2,885 $231 8.0% $121 52.7%

2003 $3,945 $335 8.5% $202 60.5%

2004 $2,920 $540 18.5% $401 74.3%

2005 $3,120 $625 20.0% $507 81.2%

2006 $2,980 $600 20.1% $483 80.5%

Mortgage Originations and Subprime Securitization

Where did the sub-prime risk go?

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50.0%

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09

Pe

rce

nta

ge

Average Repo Haircut on Structured Debt

Source: Gorton and Metrick

0

500

1,000

1,500

2,000

2,500

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BD+Banks—NET Funding Received from Repo ($ bil; FoF)

-200

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1,000

1,200

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Q2

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Q4

Net Repo Lending ($ bils; FoF)

MMFs

Discrepancy

ROW

Fire Sales: AAA Spreads Above AA Spreads

Aug 2007 Lehman Sept 2008

Crises and Macroeconomic Activity

• Crises preceded by credit boom.

• Credit boom caused by positive shock to TFP and LP.

• If technological change is not persistent, the boom ends in a crisis.

“Those who ignore history are entitled to repeat it.”

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