The Panic of 2007

Is that what they'll be calling it? The first decade of the new millennium turned out to be a real doozy. Bush had some impossible bookends to his administration, with a bunch of natural disasters and everything else in-between. Anyway, Yale economist, Gary B. Gorton, has a new working paper at NBER entitled The Panic of 2007. Here's what he says of the panic in the abstract.

Abstract

How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.

The chain of events he notes is exactly what I was explaining to my macro students last spring. Good to know I didn't completely screw their minds up. These information asymmetries are coming up a lot right now from a lot of people, and that's something I'm only just now starting to learn about. This working paper, though, looks like a very good primer of the current situation. I'm sure it will not be the last one written.

On a related note, I encourage you to read the Erik Hurst guest post over at Freakonomics where he's put into the uncomfortable and non-enviable position of defending subprime lending. He writes,

Knowing what we know now, what is the optimal approach to regulating the subprime sector? Some argue that we should outlaw subprime lending completely. But do we really want to return to the world where the well-off have access to credit, but the historically denied (the poor, the young, African-Americans) can’t access the housing market or other credit markets? Is it really O.K. for only some households to use credit to help them ride out bad times, while others must just do without?

There is no such thing as a free lunch, unfortunately. If we learn one day that to increase equity along those poverty dimensions, it resulted in a near collapse of the American financial sector, we will have to seriously reconsider our poverty programs - all of them.