In the 1970s, however, two far-reaching changes in the system began to take hold, both of them described with considerable economy in Slapped by the Invisible Hand. Financial deregulation commenced when Wall Street ended fixed commissions on May Day 1975. The old partitions began crumbling. Money market mutual funds began accepting deposits. Junk bond underwriters entered the highly profitable lending business that had previously belonged mainly to the banks. Banks responded with innovations of their own, securitization chief among them. For centuries, banks held the mortgage loans they made to maturity. Now they learned to assemble mortgages into large pools, to slice and package the anticipated payment streams into “tranches” according to the seniority of the claim, and to sell the strange new securities that resulted to fast-growing institutional investors looking for a safe, steady return. This was the “originate to distribute” system.
Deregulation, securitization, and financial innovation became the foundation for the shadow banking system — though today it is probably better to call it the financial intermediation industry, since it is banking grown far out of its boots. Its lifeblood had become “repos” (sale and repurchase agreements), meaning the cash on hand of pension funds, investment houses, insurance companies, money market mutual funds, banks, corporations, governments, and every other kind of organization under the sun. Repos were the institutional equivalent of demand deposits.
But there could be no government insurance for sums like these. Collateral was required to make this short-term borrowing work. Along with a promise to return the principal on demand, repo lenders received a claim on bonds, often in the form of asset-backed securities, sometimes held by a third party. Thus did giant financial-services firms learn to finance themselves in the age of Fannie Mae, subprime borrowing, and Walmart. Gorton compares the money grid to the electricity grid. Everyone takes it for granted — writing checks, investing in AAA securitized products, etc. — until something goes wrong. Then, he says, the inner workings of the financial system turn out to be very complicated, just like the network that supplies electricity.
The shock that triggered the panic came in the summer of 2007, a few months after a new market for credit default swaps — the ABX index — was introduced, permitting arbitrageurs to take sides for the first time on the future of the subprime mortgage market. For seven days in August, quantitative funds, especially those in the high-flying subprime market, found themselves in a vertiginous twist. The Fed staved off the panic with a half-point cut in its discount rate.
By then, however, the smart money had been put on notice: Something had gone badly wrong with mortgage lending. For the next 13 months, the authorities in Washington tiptoed around the problem while banks sought to raise capital and confidence waned. What might have prevented the meltdown from occurring? A frank recognition of the problem and a guaranteed floor on the value of subprime mortgages in late 2007 or early 2008 might have done it, says Gorton.
Even at Jackson Hole, crucial aspects of the situation remained unclear to central bankers and their economic advisors. Only after an exchange between Gorton and another participant, Bengt Holmström of the Massachusetts Institute of Technology, did economists begin to zero in on the significance of all the tranches of asset-backed securities. Debt value is supposed to be immune to most information about it, just as US$100 bills are supposed to be difficult to counterfeit. In normal times, the complexity of collateral didn’t matter. When it became clear that greater scrutiny was required, transactions slowed down. In the case of repos, they stopped altogether for a time.