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April 18, 2010
David Warsh, Proprietor


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Constructing The Narrative

To the policy makers dealing with the next really big financial emergency – the crisis he  imagines might arrive perhaps a hundred years from now – Gary Gorton offers some advice in the last chapter of Slapped By the Invisible Hand: The Panic of 2007 (“I wish I were there to see [your futuristic] new banking system,” he writes).

Spell out as clearly as possible what actually happened, he says.  “The future of the financial system is a function of the explanation of the past, so the narrative of what happened in the crisis is very important.”

Gorton, 58, a professor at Yale University School of Management, is well qualified to pronounce on these topics.  His 1983 dissertation, at the University of Rochester, was on banking panics.  He worked for a time for the Federal Reserve Bank of Philadelphia. 

By the early 1990s, as a professor at the Wharton School of the University of Pennsylvania, he was an expert, briefing other economists, on the enormous, elaborate, and little-understood “shadow banking system” that arose parallel to the familiar heavily-regulated version after financial deregulation began in the late 1970s.

From 1996 on, he consulted to AIG Financial Products, creating models of all manner of credit products and derivatives for the firm. He was an advisor to Moody’s Investor Services, the bond rating firm, as well. Although highly paid, he seems to have maintained a professional disinterestedness, publishing regularly throughout.

And in Slapped by the Invisible Hand, Gorton has produced the clearest account yet of what has happened.  He compares a banking panic to a massive electrical blackout. Once the lights go out, the inner workings of a system that people ordinarily take for granted suddenly matter.  It turns out that those inner workings are very complicated, he says. People are angry that there is no light and that it is very complicated. Meanwhile, it takes time and money to restore the system, and, in the case of banks, confidence.

Hence the importance of looking beyond personalities to the inner workings of banking and finance, and concentrating on what constitutes a satisfying explanation.

It was never better counsel  than last week, when the Securities and Exchange Commission charged Goldman Sachs & Co. of designing, at the behest of one of its customers (hedge funder operator John Paulson), products that were almost certain to fail, then selling them to other customers, mostly European banks, so that Paulson could bet against them.

Investors in the deal, known as Abacus 2007-ACI suffered loses of more than $1 billion, according to the SEC, and Paulson gained a corresponding amount. Goldman received $15 million for structuring and selling the bonds.

“The product was new and complex, but the deception and conflicts are old and simple,” Robert Khuzami, chief enforcement officer for the SEC, told a press conference. 

Paulson was not charged.  “Goldman made the representations, Paulson did not,” Khuzami said. Goldman vigorously denied the charges.

The SEC’s civil suit will vault a new financier into the pages of Vanity Fair – 31-year-old Fabrice Tourre, the Goldman vice president who created and sold the Abacus series. It is the federal government’s most important litigation since the Federal Deposit Insurance Corporation took Michael Milken to court for looting savings and loan associations and compelled a $1 billion settlement.

Depending on who is named among the senior executives that the SEC asserts approved the deal, it may even turn out to be government’s most far-reaching symbolic act on Wall Street since J.P. Morgan partner Richard Whitney was charged with embezzlement in 1938.  

But one thing it doesn’t do is explain the crisis. 

In fact, says Gorton, a recession became highly likely on August 7, 2007.  That was when the first panic in more than 75 years struck the banking system, in the form of a class run, not by retail customers on traditional banks, but by financial firms by financial firms in the little-known repo market – an enormous, (ordinarily) safe, interest-earning category of transactions known as repurchase agreements that constitute the foundation of what has come to be known as “the shadow banking system.”

This panic went mostly unobserved, Gorton continues, “because the repo market does not involve regular people but firms and institutional investors.” The panic was triggered by movements of a newly-introduced derivative product known as the ABX index, based on a basket of residential mortgage-backed securities.  By then, insiders knew that housing prices would soon begin to fall, but not exactly where or when. 

The system recovered after August 17, when the Federal Reserve Board abruptly cut interest rates to 5.75 percent from 6.25 percent.  And for a little while at least, a deep recession could have been avoided, Gorton thinks, if the Federal Reserve Board had known what to guarantee (a floor on subprime mortgages might have done the trick, he suggests).

By late 2007 or early 2008, however, a bad outcome was guaranteed. All that was required was some unexpected and alarming piece of news about bank solvency to get the panic going again, and bring inter-bank lending to a screeching halt. And so it did, in September 2008, after the Federal Reserve Board permitted Lehman Brothers to enter bankruptcy.

Slapped By the Invisible Hand is not a conventional retrospective.  Instead it is a real-time chronicle of what the authorities were told at key points in the drama by a practitioner who was steeped in the history of banking as well. As a result, Gorton’s book is not easy to digest. Aside from an introduction (and that concluding “Note to Those Reading This in 2107”), it consists entirely of three previously-published papers. (Questions and Answers About the Financial Crisis, his February testimony to the US Financial Crisis Inquiry Commission, is more succinct.)

Regional Federal Reserve banks requested two of the papers for conferences as the situation built towards its climax. One was for a dramatic meeting in May 2009 on Jekyll Island, Georgia (where plans for the Federal Reserve System had been hashed out 99 years before); the second for the Jackson Hole Conference in August 2008, on the eve of the crisis itself. The third paper was a prescient take on “Regulation When ‘Banks’ and ‘Banking’ are Not the Same” that Gorton wrote in 1994. 

They do not have the verve of, say, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, by Scott Patterson, which deals with some of the same events. Patterson, a Wall Street Journal reporter, is so smitten with his colorful cast of characters that his book is all trees and no forest. Gorton makes up in clarity what he lacks in color. And while Slapped is clearly an intermediate product, of interest mainly to crisis buffs, it is a major contribution to precisely the narrative he recommends.

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