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Slapped by the Invisible Hand: The Panic of 2007 (Financial Management Association Survey and Synthesis) [Hardcover]

Gary B. Gorton

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Book Description

29 April 2010 Financial Management Association Survey and Synthesis
Originally written for a conference of the Federal Reserve, Gary Gorton's "The Panic of 2007" garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown. Now, in Slapped by the Invisible Hand, Gorton builds upon this seminal work, explaining how the securitized banking system, the nexus of financial markets and instruments unknown to most people, stands at the heart of the financial crisis. The securitized banking system is, in fact, a real banking system, allowing institutional investors and firms to make large, short-term deposits. But, as any banking system, it was vulnerable to a panic. Indeed the events starting in August 2007 can best be understood as a panic-a wholesale panic, rather than a retail panic-involving financial firms "running" on other financial firms, resulting in the system becoming insolvent. As the financial crisis unfolded, Gorton was working inside an institution that played a central role in the collapse; thus this book presents the unparalleled perspective of a top scholar who was also a central insider.

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Gorton's book contains extensive insights into the crisis, and anyone interested in undertanding what went wrong and why is recommended to read it. Bill Allen, THE BUSINESS ECONOMIST, Vol 42, No 2 Slapped by the Invisible Hand is essential to understanding the deep weakness in the banking sector that led to the financial crisis. Like consumer banks before the Great Depression, the 'shadow banking market' is vulnerable to runs and panics and hysteria, and we are all, in turn, vulnerable to it. By looking beyond this financial crisis to the systemic flaws that make us vulnerable to all sorts of crises, Gary Gorton has created a necessary guidebook for what's happened, and what needs to be done. Ezra Klein, Washington Post Gorton has produced the clearest account yet of what has happened...Slapped By the Invisible Hand is not a conventional retrospective. Instead it is a real-time chronicle of what the authorities were told at key points in the drama by a practitioner who was steeped in the history of banking as well...it is a major contribution. David Warsh, Economic Principals It's must-reading for anyone who wants to understand the recent economic unpleasantness. Matthew Yglesias, Think Progress Gary Gorton has written an important book, one that clearly identifies the issues surrounding the recent financial crisis and separates them from the ongoing macroeconomic policy turmoil...quite an accomplishment, given that many of us are still trying to figure out happened in earlier panics and crises... By narrowly focusing on the events and institutions of the Panic of 2007, how the economy got to where it is today becomes much clearer. EH.net Think about it. If porcine greed, by itself, is enough to crash the financial sector, why doesn't Wall Street crash every year? For that matter, why should the crash of the subprime market result in a recession so much worse than the one that followed, say, the dotcom bubble? To answer these questions, you should read [this] book. National Post Scholars like Gorton do not get enough attention as we try to understand what caused the crisis and how to prevent a repeat he is one of the people that will play an important role in shaping reform. TheStreet.com The definitive history of the 2007 meltdown. The Electric Review Slapped by the Invisible Hand is certainly "groundbreaking", it is also technical...[If you] have longed to understand the difference between CDO and CDS, and MBS and SPV, then this could still be the book for you. Victoria Bateman, Times Higher Education Supplement.

About the Author

Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Management and Finance at the Yale School of Management, and Research Associate at the National Bureau of Economic Research. He formerly taught at the Wharton School for twenty-four years and worked in the Federal Reserve System. He is also a former consultant to AIG Financial Products, where he worked on credit derivatives and commodity futures for over ten years.

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Amazon.com: 4.2 out of 5 stars  12 reviews
46 of 51 people found the following review helpful
3.0 out of 5 stars A five star insight wrapped in a 3 star book 20 May 2010
By EWC - Published on Amazon.com
Format:Hardcover
Gorton has made an important contribution to the debate on the Financial Crisis (and I was eager to read his book because of it). He argues that government guarantees of retail deposits enacted in the 1930s, and not capital adequacy requirements, (temporarily) ended previously common panicked withdrawals from the entire banking system. As uninsured short-term institutional deposits have grown and become the primary source of funds for money center banking, it was just a matter of time before these runs began anew. But the book just about starts and ends there. At a critical junctures like ours, the country needs clear thinkers like Gorton to provide leadership by addressing the issues comprehensively, speaking out against demagoguery and making recommendations. Otherwise, why step to the microphone with a book instead of the papers he already published? Gordon scarcely draws conclusions and makes no substantial recommendations!

He points out why repurchase agreement failed as an alternative to government guarantees but goes no further. He shows (in many pages of unnecessary detail) that structured finance contributed to the difficulty of knowing how much (sub-prime) risk each bank held but he doesn't analyze whether credit default swaps and flawed credit ratings also contributed to the confusion. Nor does he show that the value of withdrawing funds to reduce risk in fear of others doing likewise wouldn't have occurred no matter the availability of information. He admits that better information likely would not have solved the problem but he offers no alternatives.

He claims, with little support (although surely its true) , that increased capital adequacy requirements will simply contract the boundaries of banking but he doesn't show where, speculate how the resulting unfilled customer needs with be filled and whether these alternatives would be good or bad for the economy in terms of reducing systematic risk. In this context you'd also like to hear his evaluation of convertible bank debt as an alterative solution to the problem but again, nothing. (Increased reserves would likely curtail mortgage lending.) He asserts that the reduced value of monopoly rent conferred by previously restricted bank charters caused banks to take more risk. If his recommendation is to return to something akin to the restrictions of old, it would take a lot more than just pointing out the issue to show how, why and to what effect.

If you put forward a theory, you also have to show why it's better than alternative explanations but he devotes only a couple pages to pooh-poohing the alternative theories that originate-to-distribute and misaligned incentives reduced lending standards (although I agree with his conclusions) . Except for noting that sub-prime finance served as a trigger, he never addresses the role of Freddie and Fannie in spurring on sub-prime mortgage lending and the extent to which the crisis could have been averted were that not the case. (Presumably we can infer Gordon thinks something else just would have come along.) The role of the trade deficit in the build-up of uninsured short-term institutional deposits is never mentioned. If the answer is for the government to guarantee institutional deposits should we also be guaranteeing offshore deposits into US financial institutions?

If you've read Gorton's papers, there is nothing more here. If you haven't, it's a lot to slog through for what could have been summarized in a much shorter piece. Sentences like, "This agent cares about the intertemporal marginal rate of substitution, so the pricing kernel weights the expected returns on the demand deposits in determining the currency-deposit ratio." and many others like it, are not helpful to the public debate. If you've been sucked in by the superficial logic of demagogues... unfortunately I haven't yet seen a better alternative by a serious thinker.
12 of 13 people found the following review helpful
5.0 out of 5 stars An interesting contrarian analysis from an insider 21 Jan 2012
By Gaetan Lion - Published on Amazon.com
Format:Hardcover
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.
6 of 6 people found the following review helpful
4.0 out of 5 stars Educational, Accurate, Insightful, and Difficult 1 May 2011
By R. Spell - Published on Amazon.com
Format:Hardcover|Verified Purchase
I am an investment banker/mortgage trader and have been poring through the many books on the recession. MOST, concern subprime mortgages or reaction to the financial meltdown. This book is the printing of three research papers with wrapped analysis around those papers so calling it a book is somewhat of a stretch. Pretty short book to write since you are just using your previously written material. But what makes this book GREAT is its clinically written analysis of the cause of our banking panic. Instead of describing what happened as so many other books have, this clinical paper puts the recession/disruption in the terms of comparison to other bank runs. Now this wouldn't seem normal as I doubt the majority of working people would define this disruption as a bank run. Yes, Wamu and IndieMac may have had quick drops in deposits. But our real liquidity problems happened outside government guaranteed depository institutions. Rather the exotic security market became severely disrupted and the highly leveraged investment banks, whose debt was basically short commercial paper, could not roll over their paper. This is why the government had to step in, to protect the commercial paper market and our banking industry which supplies the leverage that runs our country.

This book raises the theme of the substantial change in banking, the shadow banking system, and shows that its importance and fragile nature, which had for so long been ignored, was the major cause of the recession and the "new" bank run. It's a well documented book and worthy of reading. But not without flaws. For example, as mentioned earlier, it's really three research papers. No problem, but one of them veers far from the tenet of the book and is actually an analysis of private label securitization structure. While subprime securitization was the catalyst of the crash, do we suddenly three years later need to revisit the basic structure of securitization?

In closing, if you want a serious discussion with flaws about why we had the crash, this is the book for you and I'm strongly recommend this for the serious students of financial history.
10 of 12 people found the following review helpful
4.0 out of 5 stars insight into the panic of 2007 22 May 2010
By Charles R. Williams - Published on Amazon.com
Format:Hardcover
Gorton's explanations of the financial meltdown are the most plausible out there. Gorton has studied banking and banking panics for decades. Unlike other economists he has detailed knowledge of how the banking system has evolved and what exactly happened in the summer of 2007.

In a few words, the little guys bank at regulated commercial banks with deposit insurance. So the little guys don't panic when there are problems in the economy or in the banking system. The big guys put their cash in a shadow banking system where their "deposits" called repos are collateralized by asset backed securities. The system works well until the value of the collateral comes into question. This is what happened in the summer of 2007. The shadow banks had to dump asset backed securities en masse into the financial markets and there was on one to buy them. The price of asset backed securities as a whole began to fall and the shadow banking system froze up. Gorton points out that this is nothing other than a 19th century-style banking panic that occurred behind closed doors and was misinterpreted by economists and regulators who simply had no experience with this sort of event.

As another reviewer points out, the book is a hastily compiled collection of Gorton's papers. One might do better to find the papers on the internet.
3 of 3 people found the following review helpful
4.0 out of 5 stars Unique and extremely important 12 Aug 2011
By W. D ONEIL - Published on Amazon.com
Format:Hardcover|Verified Purchase
There have been a number of stories about the economic crisis of 2007-2008. Many have been more clearly and stylishly told, but this one is unique and extremely important because it is virtually alone in constructing a consistent operational picture of how precisely the sudden deflation of the U.S. housing bubble led, step by step, to a collapse of the world financial system. As some of the reviews here make clear, this is not a story to satisfy you if you come at this from an ideological perspective, whatever it may be. Gorton is writing not as a Keynesian or a neoclassicist or an Austrian, but as a technical financial economist. It is neither a morality tale nor a work of grand theory but an analysis of what Keynes referred to as "magneto trouble."

It is somewhat disconnected and not altogether clear in some places. In part this is because this is a report from the front lines, written during or shortly after the battle. It will take a long time, as Gorton repeatedly emphasizes, to develop real clarity about what happened and why. Many of the details he goes into truly are mind-numbing, this is a feature rather than a bug, because in Gorton's view the details truly made a big difference, and if we don't understand that then we have much less chance of modifying the system so as to avoid repetition.

By precisely identifying a mechanism for the crisis Gorton puts himself in a position to offer precise proposals for action. In the process, he casts a great deal of doubt on the efficacy of much of what has been put forward and in part adopted so far.

He notes with regret that he has not been able to able to test his theses about the causes and mechanisms of the crash, but as he observes, it is scarcely possible to do so for a truly singular event such as this. We are left with no alternative but a case-study approach, and this is a very important start.

Most of the book simply is a compilation of three previously-published papers, which may be read separately, if one prefers. I have been glad to have them in book form, however, and found that the introductory chapter added significantly to their value.
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