Twenty-one months ago, as 2009 began, the financial world was in a shambles. Virtually every market associated with the uninsured, “shadow” banking system had closed down. There were jokes about what specialists in securitization asked in their new jobs. (Would you like fries with that, sir?)
Gary B. Gorton, a Yale finance professor, says losing shadow banks has an economic effect.
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Now, almost every securitization market has reopened. Some are thriving. Even markets that involve lending to borrowers with poor credit, like leveraged loans and junk bonds, have recovered to a significant extent.
The exception is the market whose collapse set off the financial crisis, the residential mortgage securitization market. It is still moribund. And the economy remains subdued. The recession has ended, but the recovery is weak.
Understanding why that market’s failure caused such devastation in seemingly unrelated markets is important. So is understanding why it has not recovered and what that means for the overall economy.
More attention needs to be paid to understanding just how the shadow banking system got out of control, and what needs to be done to regulate it in the future. The Dodd-Frank law did many things, some of them absolutely necessary, but it did not do nearly enough to get a grip on that system.
Gary B. Gorton, a finance professor at Yale, argues that the crisis can be seen as a new version of an old and almost forgotten phenomenon: a bank run.
“The reality is that the so-called shadow banking system is, in fact, banking,” he wrote in his book, “Slapped by the Invisible Hand,” published earlier this year by Oxford University Press.
In the old days, bank runs would start when people grew fearful that a bank was insolvent. If the run was big enough, the bank would become insolvent, since no bank had enough cash on hand to meet all its obligations; the money was lent out, and there was no way the bank could liquefy a lot of loans rapidly.
Deposit insurance ended old-fashioned bank runs, because insured depositors had faith that demand deposits would be paid back even if the bank did go under.
The shadow banking system came to issue money as well, in the form of repos. In that system, those with a lot more money to invest than could be put into an insured banking account would “deposit” it and get back a safe security as collateral. Repos were done using Treasury securities as collateral, and they still are. But ultimately they were also done using other supposedly safe collateral, like AAA-rated securities issued by the shadow banking system, including mortgage-backed securities.
When it turned out those ratings were bogus, the run began. Suddenly, everyone wanted only ultrasafe paper. If some AAA paper that was not guaranteed by the government turned out to be unsafe, perhaps other such paper was also too risky. That, Mr. Gorton argues, is why the panic spread to other types of assets.
If that analysis is correct, then the panic amounted to a sudden shrinking of the money supply. That does not show up in official statistics, because no one knows how many repos are done, and repos are not counted in the current measures. But Mr. Gorton argues that repos are money and that the shrinking of that market had economic effects. If so, that impact continues.
In a new paper, “Regulating the Shadow Banking System,” Mr. Gorton and Andrew Metrick, another Yale finance professor, propose that the Federal Reserve be given the power to regulate that system. They would establish a new category of financial institution, “narrow funding banks,” which would bring securitization under the regulatory umbrella and assure that all repos were backed by high-quality paper. Those narrow funding banks would be the only buyers of securitizations; other investors could buy notes issued by the new banks.
Such regulation could reinvigorate the money supply and provide the Fed with better tools to both measure and control it.
The essential fact behind that analysis is that securitization succeeded in large part because it appeared to create what Mr. Gorton calls “information-insensitive debt” that could be freely exchanged by people who did not need to check into its quality. He wants to recreate that situation, but with new controls. After all, the old system ended in disaster because it turned out that mortgage-backed securities — even the tranches rated AAA — were not really safe.
Without that regulation, the move now is to find other ways to keep the disasters of yesteryear from happening again. And those moves generally involve going in the opposite direction from creating securities that can be trusted at face value. Regulators accept that investors must be vigilant about the quality of securitizations, and seek to both make it easier for them to do so and to force them to do so.
One reason the securitization market succeeded is that regulators agreed to safe harbor rules to prevent bankruptcies of sponsors from affecting them. If a bank failed and was seized by the Federal Deposit Insurance Corporation, the regulator promised to respect the securitization and not try to take the assets supporting it.
This week the agency issued new rules on safe harbors, a move mandated by the fact that the old safe harbor was based in part on accounting rules that have since been changed. The new rules adopt requirements proposed by the Securities and Exchange Commission for much better disclosure of loan-level information.
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.
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