Q&A About the Financial Crisis

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Unformatted text preview: Best if viewed in color. Questions and Answers about the Financial Crisis * Prepared for the U.S. Financial Crisis Inquiry Commission Gary Gorton Yale and NBER February 20, 2010 Abstract All bond prices plummeted (spreads rose) during the financial crisis, not just the prices of subprime related bonds. These price declines were due to a banking panic in which institutional investors and firms refused to renew sale and repurchase agreements (repo) short term, collateralized, agreements that the Fed rightly used to count as money. Collateral for repo was, to a large extent, securitized bonds. Firms were forced to sell assets as a result of the banking panic, reducing bond prices and creating losses. There is nothing mysterious or irrational about the panic. There were genuine fears about the locations of subprime risk concentrations among counterparties. This banking system (the shadow or parallel banking system) repo based on securitization is a genuine banking system, as large as the traditional, regulated and banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created. *Thanks to Lori Gorton, Stephen Partridge Hicks, Andrew Metrick, and Nick Sossidis for comments and suggestions. 1 Unfortunately the subject [of the Panic of 1837] has been connected with the party politics of the day. Nothing can be more unfavorable to the development of truth, on questions in political economy, than such a connection. A good deal which is false, with some admixture of truth, has been put forward by political partisans on either side. As it is the wish of the writer that the subject should be discussed on its own merits and free from such contaminating connection, he has avoided as much as possible all reference to the political parties of the day (Appleton (1857), May 1841). The current explanations [of the Panic of 1907] can be divided into two categories. Of these the first includes what might be called the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to a lack of confidence as if the lack of confidence was not itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a countrys executive. Such puerile interpretations have commonly been confined to countries like the United States where the political passions of a democracy had the fullest sway. . . . Opposed to these popular, but wholly unfounded, interpretations is the second class of explanations, which seek to burrow beneath the surface and to discover the more fundamental causes of the periodicity of crises (Seligman (1908), p. xi)....
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This note was uploaded on 02/12/2011 for the course FIN 101 taught by Professor Benesh during the Spring '11 term at FSU.

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Q&A About the Financial Crisis - Best if viewed in...

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