Starving For Good Collateral

Interesting explanation for what really happened in 2008:

Subprime shouldn't have been big enough to cause this sort of crisis. In 2005 and 2006, the market originated about $1.2 trillion in mortgages -- big, but not a vital organ of the American economy.

Subprime was the trigger for the crisis, but not the cause. What happened, rather, was that the subprime crisis set off an old-fashioned bank run in a newfangled market: the shadow banking market, which was, and is, vulnerable to runs.

... The shadow banking market is where big banks, institutional investors, and other folks who have a lot of money do their banking -- particularly their short-term banking. So let's say I'm Ezra Bank. I've got a $100 million that I'm going to invest next month, but for now, I need to put it somewhere. I head to the "repo market," and I ask Bear Stearns to hold my money and pay me interest. They agree. But how do I know Bear Stearns won't just keep my money?

Individual depositors in the normal banking market never have that fear. The government insures our deposits. But they don't insure massive institutional deposits. So Ezra Bank would ask Bear Stearns for "collateral" -- something that is low-risk and valuable they could hold in order to make sure Bear Stearns returned their money. Something like, say, AAA mortgage-backed securities.

This manner of banking created a massive hunger for collateral. And it was this hunger, Gorton thinks, that drove the wild demand for mortgage-backed securities.

But think about the difference between the shadow banking market and your bank: The FDIC's deposit insurance exists to prevent bank runs (which happen when creditors become scared that their bank is insolvent and rush to get their money back, which in turn makes their bank insolvent). The shadow banking market doesn't have deposit insurance. So how does it deal with the problem of bank runs?

Answer: It doesn't. What we had in 2008, Gorton says, was a bank run. No one knew which banks were exposed to the subprime crisis, so everyone froze. But it didn't need to be the subprime market that experienced the shock. A lot of different types of shocks would've done the trick. The underlying problem is that the collateral is "informationally sensitive": That is to say, information can dramatically and unexpectedly change its worth (i.e.. news that subprime mortgages are defaulting makes securities based on subprime mortgages worthless), and then confidence drains out of the whole system. "It's the e coli problem," Gorton says. "When they recall 10 million pounds of burger, it brings all sales of ground meat to a halt because no one knows how much e coli there is or where it is."