I thought I understood the basics of the 2009 financial crisis, but I did not understand how bad subprime mortgages could bring the entire US financial system to its knees. Well, browsing Greg Mankiw’s site today, he linked to an interesting paper by Yale economist Gary Gorton answering these very questions. I highly recommend everyone read, but here I will summarize the basic ideas.
First Gorton explains that basically all banking crises work the same way: too many investors want to withdraw their deposits from the banks which cannot cover all of the withdrawals. This type of crises is probably as old as banks themselves. Banks lend out a certain percentage of deposits, so if there is a panic, not everyone can get their money back. This financial crises is similar, but less tangible, because it involves an unregulated banking system used by institutional investors and not average individuals.
The Repo market has been growing steadily for the past 30 years. It is basically an unregulated market where institutions can deposit and borrow money outside of the normal banking system. Because there is no FDIC for this market, deposits are backed by collateral, which is how most US banks worked pre-1930. This collateral is longer term, secure investments such as bonds and other securities.
Why is there demand for such a market? As Gorton explains it, imagine you are an institutional investor and you need a secure short-term (overnight) interest-gaining deposit for $100 million. You cannot deposit this at the local bank, FDIC will only cover $100k, so you must go to another banking system. Now imagine you are a bank with mortgages trickling in cash. You can package these mortgages and sell them to add immediate cash to your bottom line. These securities can then be used by as collateral for a Repo deposit. Both parties have benefited from the Repo market and it has been growing accordingly, but because it is so unregulated, no one really knows how large it became! Estimates are at around $12T, which means there should be at least that much in collateral for it to function properly. To give you an example of how large that is, the entire US GDP for 2009 was $14.2T.
This is where the subprime mortgages come in. While subprimes are a small percentage of the total mortgage-security market ($1.2T out of $20T total), no one knew which securities were contaminated by them. Gorton compares this to an E. coli scare where all ground beef is shunned even though only a small percentage is actually contaminated. The Repo market became the target of a panic because the collateral used for deposits became suspect. There was a run on Repo banks which could not possibly honor all of the withdrawals (he estimates a deficit of $2T). The US Government was forced to step-in and bail out some of the crippled banks while many others simply failed.
So while this crisis may seem extraordinary at first, when compared with the history of banking it can bee seen as the same old story repeating itself. There is much more detail and references in the paper, including some nice graphs, so check it out.
Update 9/7/2010: Ben Bernake references Gorton’s research into the financial crisis in his testimony before before the Financial Crisis Inquiry Commission.