Slapped by the Invisible Hand: The Panic of 2007

Published by EH.NET (October 2010)

Gary Gorton, Slapped by the Invisible Hand: The Panic of 2007. New York: Oxford University Press, 2010.? v + 223 pp. $35 (hardcover), ISBN: 978-0-19-973415-3.

Reviewed for EH.NET by Jon R. Moen, Department of Economics, University of Mississippi

Gary Gorton has written an important book, one that clearly identifies the issues surrounding the recent financial crisis and separates them from the ongoing macroeconomic policy turmoil.? Even though parts of it were written close to if not during the financial collapse, it nevertheless provides perspective on what happened and why.? This is quite an accomplishment, given that many of us are still trying to figure out happened in earlier panics and crises.

The book has six chapters, four of which are drawn from papers previously presented or published.? The first chapter is a new introduction that presents the issues Gorton will discuss in more detail in subsequent chapters. These include defining a systemic panic and drawing parallels from National Banking Era panics to the current crisis.? He then explains that the rest of the book is all about how the overnight repo market and the subprime mortgage market were intertwined ? and how that led to a bank panic.

The second chapter is based on a paper presented at a conference sponsored by the Federal Reserve Bank of Atlanta in 2009 at Jekyll Island. This chapter is perhaps the most accessible to economists not familiar with banking history and modern financial instruments and structures, and it provides a remarkably transparent discussion of the complex mortgage-backed financial derivatives of the recent crisis.? Gorton argues that the current financial crisis is not that much different from the earlier National Banking Era panics, particularly the Panic of 1907.? I think he is correct on this point in that during both crises disruption to short-term, overnight lending led to more serious financial and real disturbances.? In both panics this disruption took place in what Gorton refers to as the shadow banking system, a banking system arising outside normal commercial banking structures to accommodate the banking demands of very large institutional ?depositors.?? The overnight repo market comprised much of the shadow banking system until very recently, while during the National Banking Era the New York call loan market played a similar role a century ago. I feel that Gorton could have made the parallel stronger by clearly identifying the overnight repo market of today with the New York call loan market of the National Banking era.? New York City trust companies and out of town lenders in the call loan market are the counterpart to today?s shadow banking system.? The near collapse of the call loan market threatened to bring the New York money market to a complete halt had big bankers like J.P. Morgan and the big six New York national banks not intervened.? To a great extent they were the lender of last resort in 1907.? There was no one around to prevent the collapse of the overnight repo market this time around, as investment banks like Lehman Brothers had no lender of last resort.

Chapters three and four are from a long paper presented at the Kansas City Federal Reserve Bank?s Jackson Hole Conference in 2008.? Chapter three goes into great, if not excruciating, detail on the derivatives built on top of the securitization of mortgage-backed securities.? You will have to do a lot of work on your own to get through this chapter, as it assumes that you already are quite familiar with these complex instruments.? While it is not mathematically complex, keeping track of the terminology and jargon is.? But working through it pays great rewards in the end, and it becomes painfully clear just how hard it was to value these instruments.

Chapter four offers some relief from the technical onslaught of chapter three, but not much.? It traces out the chain of events in the Panic of 2007 and provides an excellent account of what happened in the overnight repo market starting in August 2007.? Gorton also examines critically a few explanations for the Panic of 2007, including the ?originate to distribute? view, the misalignment of incentives in securitization, and the decline in underwriting standards.? All three are found lacking.? Rather, it is the fact that the viability of the pyramid of derivatives ultimately backed by subprime mortgages was based on ever-rising housing prices, and subprime mortgages were designed to work only if housing prices kept rising.? Not all securities are designed this way, making subprime mortgages unique.? The pyramid collapsed when housing prices stopped rising.? The conclusion to chapter four is especially illuminating, arguing that it was the structure of subprime mortgages and not securitization that was the root of the problem.

Having survived chapters three and four, we get to chapter five, originally published in 1994.? It nicely describes the role of banks and what happens when banking is undertaken by intermediaries who are innovating around increased bank regulation, leaving a chunk of banking activities outside the purview of regulators.? While this chapter does not directly deal with recent events, it sets out areas of concern for regulators, the most important of which seems to be identifying intermediaries that are taking in what in effect are deposits and making bank-like loans even though they do not have a bank charter.? The recent overnight repo market is one such example.? Chapter six is a note to folks reading the book in 2107, hoping they may have learned something from 2007 (and 1907?), that is, panics are dangerous but not that mysterious.

There is a lot to take in and learn in this deceptively brief book, and I suspect I will have to read it several times to capture all that it contains.? There is not a great deal related to specific regulatory recommendations other than some type of deposit insurance for securitizations; intermediaries engaged in securitization should be viewed as banks and treated as such and supervised; and that entry into securitization should be limited.? Gorton mercifully stays away from the current fiscal policy versus monetary policy debate, leaving macroeconomic policy to others.? By narrowly focusing on the events and institutions of the Panic of 2007, how the economy got to where it is today becomes much clearer.

Jon R. Moen is Associate Professor of Economics and Chair of the Economics Department at the University of Mississippi. He has published several articles on the Panic of 1907 and is currently working on a detailed study of the Panic with Ellis Tallman of Oberlin College.

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