There are many good books on the financial crisis. For an excellent survey on the topic I recommend the paper "Reading About the Financial Crisis: A 21-Book Review by Andrew Lo." These authors typically espouse Irving Fisher's early The Debt-Deflation Theory of Great Depressions. They address moral hazard with distorted economic incentives. Creditors lent too much to seek short-term profits ignoring long term risk. Borrowers borrowed too much leading to an amount of debt they possibly could not repay. And, when borrowers could not refinance their mortgages; the ensuing defaults and foreclosures impaired the balance sheet of their creditors. In turn, creditors did not trust each other ability to repay their liabilities. And, the financial system shut down.
Gorton's book is interesting because it offers a different crisis theory. For Gorton, it was all about information. Gorton is very qualified to expand on his theory. He has been a finance professor at top business schools for over two decades (Yale, Wharton). He worked for the Federal Reserve. And, most relevant he was involved in structuring synthetic credit portfolios for AIG.
Gorton's disinformation theory has several building blocks. They include: 1) subprime mortgages; 2) mortgage backed securities (MBS); 3) collaterized debt obligations (CDOs); and 4) special investment vehicles (SIVs). Those building blocks consist of a time bomb (1), an information shredder (2, 3, 4), and a collapse of trust (4).
Bank of America innovated the first subprime mortgage back in 1998. It offered a lower fixed rate for the first two years that would adjust upward at two years. By design, the (low-income) subprime borrower was not expected to being able to repay the mortgage at the higher rate level. That's when such borrower was to refinance the mortgage at a higher level relying on the rising value of his home. Every time the borrower refinanced he compounded the risk of both creditors and borrowers wiping out their respective capital through foreclosures. Thus, subprime mortgages were a speculative time bomb. And, the trigger was national home prices not rising anymore (they did not even need to decline).
Gorton goes into exhaustive detail regarding the complexity of MBS structure. As he described, they often were entirely made of subprime mortgages. Thus, European banks were loading up on senior MBS tranches rated AAA. Meanwhile, they had no idea that what supported those "AAA" credits were mortgages extended to low-income borrowers who had no capacity to repay the mortgages.
Gorton by analyzing a few MBS deals shows how an MBS structure is dynamic over time. Let's say an MBS starts with 90% senior AAA tranches and 10% junior tranches. If home prices go up, because of different cash flow allocation, the senior AAA tranches are paid down and represent now only 85% of the MBS, and the junior tranches represent 15%. That's good. But, if home prices decline the junior tranches taking the first losses get wiped out and soon the senior AAA tranches amount to 100% of the MBS and are fully exposed to the subprime mortgage time bomb. That's really bad. And, that is what happened. So, here was a major case of misinformation. Investors (European banks in good part) thought they had bought AAA securities. They really did not. The rating agencies (Moody's, S&P) bear a huge responsibility in having misrated those MBS and having misinformed investors. Remember for Gorton it is all about information (or lack of).
If MBS were not already complex enough, CDOs ensured to complete a black hole of such intense gravity that no light could come out of it (no information). CDOs simply invested in other MBS. Sometimes, they even invested in other CDOs. For the ultimate CDO investor it was impossible to evaluate the quality of the underlying mortgage collateral of the original MBS. By that time, the information shredder was almost complete.
One last piece of the information shredder was the asset side of the off balance sheet SIVs sponsored by various commercial or investment banks to lower their capital requirements. Those SIVs were heavily invested in such CDOs and other complex structured finance products.
By now, the information shredder is complete. Pity the investors in SIVs short-term funding, they had no idea of SIV repaying capacity. They relied on the SIVs having back up line of credits with their supposedly strong sponsors (major bank, etc...).
Gorton indicated that for a while the black hole of (lack of) information did not hurt. As long as home prices went up, everyone performed up the credit chain starting with subprime borrowers ability to refinance. When home prices flattened, refinancing stopped. The house of cards collapsed.
Gorton indicated that one new piece of information accelerated the collapse. This was the advent of the tradable ABX indices. All of a sudden, all investors in MBS, CDOs, and SIVs could readily observe the deterioration in value in a basket of 20 large MBS deals supposedly similar to the ones they were ultimately holding.
That's when the lack of trust shut down the financial system. Investors did not roll over the short-term funding of SIVs. The latter went bust. Their sponsors had to claim them back on their balance sheet with disastrous consequences to their capital levels. Sometimes, this scenario played out with a sponsored hedge fund instead of a SIV (the Bear Stearns situation) causing the failure of the sponsoring parent (Bear Stearns). Finally, all the large banks and financial intermediaries did not trust each other's capacity to repay and refused to lend even overnight to each other. The short term money market shut down. This forced Lehman into bankruptcy in September of 2008. It also forced Merrill Lynch into the arms of Bank of America (BofA) a few days later. Ultimately, BofA will need nearly $30 billion in TARP funds to stay afloat.
Gorton ends up at the same place as the consensus. A financial crisis is in the end all about trust (lack of). But, they get there following different paths. The consensus follows a trail of moral hazard and short-term economic incentives. Gorton instead follows his own path focused primarily on information (lack of).
Gorton does a pretty good job at debunking the moral hazard theory. He indicates that contrary to what people think, the system was not plagued by egregious short term incentives. He mentions that the senior executives of Lehman Brothers and other investment banks lost huge fortune in the drop in value of their stock options. The stock options amounted to long term incentive to preserve the solvency of their firm. Similarly, mortgage originators had incentives to generate good quality mortgages for several reasons. They were exposed to their own origination by having to warehouse such deals sometimes for a few months. They also were exposed to recall provision if one of their deals defaulted in the first month. They also were in the repeat business and had no incentives to sell crappy mortgages only to be shut out of that market. The investment banks who structured the MBS and CDOs similarly had strong long term incentives as they often had to retain a piece of the most junior tranche (equity) to market a deal. They also invested in their own MBS. They also often conducted warehouse lending to mortgage originators. All those should have insured sound due diligence for the originators of mortgages and developers of MBS and CDOs.
In summary, for Gorton the system faltered because of opacity. Meanwhile, for others it faltered because of moral hazard. Ultimately, it faltered because of both. Gorton's moral hazard rebuttal is good. But, it does not entail that moral hazard behavior did not take place for two reasons. First, the market players ignored the dangers and factors Gorton mentioned. Second, Gorton ignored other really powerful moral hazard related economic incentives that countered the ones he mentioned. One of those is that mortgage originators got paid a lot more for originating subprime mortgages than prime mortgages. This was because of the former higher cash flows. That's what the mortgage securitization market was craving. And, that's what it got. The rest is history. And, Gorton's information theory is a really important part of it.