Haircuts— by Gary Gorton
Markets with heavy trading are often described as “liquid” markets. The financial crisis of 2007-09 was a banking panic in the sale and repurchase agreement (repo) market, a highly liquid market that shrank dramatically when the “depositors” withdrew their money, as we explain later (see Gorton, 2010, and Gorton and Metrick, 2009).1 The average daily trading volume in the repo market was about $7.11 trillion in 2008, compared with the New York Stock Exchange, where the average daily trading volume in 2008 was around $80 billion.2
Repos are considered part of the money supply—like demand deposits or private bank notes before the Civil War3—and, like other forms of money, they involve trillions of dollars in exchanges without extensive due diligence. As with past U.S. banking panics, the core of the recent financial crisis was a problem of private money creation, which has always been difficult. In banking crises private markets fail to function; “liquidity dries up” because of a “loss of confidence.” In this paper, we investigate this liquid- ity problem in the context of the recent financial crisis and provide evidence for our explanation.
In the case of our current crisis, the “depositers” are the high level investment entities, withdrawing their funds in response to a fear of insolvency. Gorton went into detail on his comparison in the paper and subsequent book: Slapped in the Face by the Invisible Hand: Banking and Panic of 2007.
The paper took a hard night of real study to get thru. The Amazon book review are worth reading. This paper Haircuts is a good and shorter paper to read on the subject, although not as educational.
Gorton proposes that Banking Panics are inevitable. Our Crisis is, in large part, similar to the Banking Panic of 1907. Lack of central regulation of the Shadow Banks and a lack of transparency being the main cause.
One thing he makes very clear is that the Securitzation Products we hear so much about are not going away and are essential if we are going to have a vibrant economy in our Brave New World.
