Author: Paula L. Green

FINDING BALANCE

By Paula Green

Global Finance sat down with Gary Gorton, professor of management and finance at the Yale School of Management, to get his perspective on the latest round of global financial turmoil.

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PHOTO CREDITS: KATE FREY

Gary Gorton looks at how financial crises start in his latest book, Misunderstanding Financial Crises: Why We Don’t See Them Coming . His years of experience in the financial industry include nearly a dozen years working, mostly as a consultant, with AIG Financial Products in Wilton, Connecticut. During that time, Gorton helped the financial arm of insurer AIG develop computer models to gauge risk in credit-default swaps.

If greed or stupidity were the fundamental drivers of financial crises, we would be dealing with a crisis every week, according to Gorton. He says the current crisis mirrored the common factor behind all financial crises: a bank run. But instead of seeing people lined up outside a bank ready to withdraw their money, it could only be viewed on trading floors, as asset prices declined on all structured financial products. Securitized subprime mortgages were the “E. coli in the food chain,” says Gorton, the financial instruments that started “the run on the bank.” House prices fell, maturities shortened on all structured products, and haircuts increased.

Global Finance : How did regulators and policymakers exacerbate matters once the crisis hit?

Gary Gorton : In his first radio fireside chat [“On the Bank Crisis” in 1933], FDR [then-US president Franklin Delano Roosevelt] calmed people. After the first anniversary of Lehman’s demise [Lehman Brothers filed for bankruptcy in September 2008], president Obama needed to explain what was happening. He could have calmed people. Instead, he sent an anti-banker message. We need a banking system. When the banking system has a heart attack, we need to get it healthy again. A narrative took over that banks were bad. That if we bail out the banks we are bailing out these bad bankers. It kept intelligent bank regulation from happening. Now, we’re in a long period of stagnation, and nobody has any ideas.

GF : Was the lack of adequate regulation responsible for the crisis?

Gorton : Asset prices fell on all structured products. When the subprime market starting having difficulties, there was a sniff about risks in all structured products. No one was really sure where the risks were.

GF : What about the repo markets?

Gorton : There was a serious problem with the lack of measurement in the repo markets. The government [still] doesn’t know how much is out there, there is no data.

GF : How can we improve data?

Gorton : We need more sophisticated measurements of risk in general. For example, if housing prices go down 5%, how much equity will a bank lose? But this data is difficult to come by. The people in the trenches—the IMF, the World Bank, the IFC—have some data. The World Bank, for example, has information on 140 previous crises. But it is imprecise.

GF : What are the key benefits to come out of the Dodd-Frank Act?

Gorton : The thing that could have the greatest impact is that Dodd-Frank set up the Office of Financial Research. It is housed in Treasury. It can tax financial firms to make up its budget and it will have subpoena powers. Plus, the head of the OFR reports to Congress, and his or her testimony cannot be vetted by anyone. This is all quite astounding. It aims to fill in the data gaps that were part of the problem. But there is a big question as to whether it will actually be effective.

GF : What can we take away from study of previous crises?

Gorton : The issue is, Where were the vulnerabilities that created the banking crisis? What we can see is that short-term bank debt is vulnerable to bank runs. And credit booms are the best predictor of crises. But the key is to find a balance—credit expansion can be good if it is financing productive growth. We can’t go backwards. We have to go forward intelligently.