Gary Gorton Meets The FDR Framework

Frequently, this blog looks at the latest ideas on how to fix the financial system coming out of the academic world.

For the most part, these ideas are very positive, but implemented by themselves not as effective a solution as implementing the FDR Framework by itself.  If implemented in the real world without the FDR Framework, the potential downside of these ideas would be a lot like taking chicken soup when your are sick, they could not hurt.

If implemented with the FDR Framework, these ideas would be really powerful.

Examples of positive ideas discussed on this blog include Anat Admati's push for higher bank capital requirements, Simon Johnson's pursuit of breaking up the Too Big to Fail and Laurence Kotlikoff's prescribing limited purpose banking.

Sometimes, however, an idea for fixing the financial system comes out that if implemented in the real world would have the potential for devastating consequences for the global economy.  The poster child for this is Gary Gorton's informationally-insensitive debt.

What is informationally-insensitive debt?

In a May 9, 2009 paper for the Atlanta Fed, Gorton defines it as

Intuitively, information insensitive debt is debt that no one needs to devote a lot of resources to investigating.  It is exactly designed to avoid that.  

He has two examples of information-insensitive debt:

• Demand deposits; and 
• The senior tranches of securitized debt.  

He notes that the senior tranches of securitized debt are

informationally-insensitive, though not riskless like demand deposits.

Why would regulators care about informationally-insensitive debt?

According to Gorton,

A 'systemic shock' to the financial system is an event that causes such debt to become informationally-sensitive, that is, subject to adverse selection because the shock creates sufficient uncertainty as to make speculation profitable.  

Regular readers of this blog know that the concept of information-insensitive debt is incompatible with the FDR Framework.

Why is the concept of information-insensitive debt incompatible with the FDR Framework?

Because debt, like all investments, is informationally-sensitive!  What differs between investments is how much effort it takes to analyze the information.

Under the FDR Framework, investors are suppose to have access to all useful, relevant information about the debt in an appropriate, timely manner when they make an investment decision.

When depositing money with a FDIC insured bank, the investor is told that their money is insured up to $250,000 per account.  This is information.  With the information about the government guarantee, investors do not need to devote a lot more resources to investigating the financial solvency of the bank to know how much of their investment will be returned.

Contrast depositing money in a bank with investing in the senior tranches of structured finance securities.

All the useful, relevant information for making an investment in a senior tranche of a structured finance security includes the current asset-level performance of the underlying collateral as well as the terms of the deal.  The investor then uses this information in the analytical and valuation models of their choice to determine if the cash flow on the underlying collateral will be adequate to return their investment.

Clearly, an investor who does his homework is going to use dramatically more investigative resources before investing in the senior tranches of a structured finance security than before investing in demand deposits.

Only the FDR Framework explains what triggered the credit crisis

Finally, it might be useful to test the informationally-insensitive model against the FDR Framework to see how they describe the events of August 2007 and therefore how the entire subsequent financial crisis should be interpreted.

According to  the November 9, 2010 version of Gorton and Metrick's Securitized Banking and Run on the Repo paper,

The banking system has changed, with “securitized banking” playing an increasing role alongside traditional banking. One large area of securitized banking – the securitization of subprime home mortgages – began to weaken in early 2007, and continued to decline throughout 2007 and 2008. But, the weakening of subprime per se was not the shock that caused systemic problems. The first systemic event occurs in August 2007, with a shock to the repo market that we demonstrate using the “LIB-OIS,” the spread between the LIBOR and the OIS, as a proxy. The reason that this shock occurred in August 2007 – as opposed to any other month of 2007 – is perhaps unknowable. We hypothesize that the market slowly became aware of the risks associated with the subprime market, which then led to doubts about repo collateral and bank solvency. At some point – August 2007 in this telling – a critical mass of such fears led to the first run on repo, with lenders no longer willing to provide short-term finance at historical spreads and haircuts.

Under the informationally-insensitive model, what happened in August 2007 is an unknowable mystery that resulted in the first repo run.

According to an article by Larry Elliott, the Economics Editor for The Guardian,

On the face of it, there was nothing especially memorable about August 9 2007.  

... It was, however, the day the world changed. As far as the financial markets are concerned, August 9 2007 has all the resonance of August 4 1914. It marks the cut-off point between "an Edwardian summer" of prosperity and tranquillity and the trench warfare of the credit crunch - the failed banks, the petrified markets, the property markets blown to pieces by a shortage of credit. 

On that day, the European Central Bank and the US Federal Reserve injected $90bn (£45bn) into jittery financial markets.

What happened on August 9, 2007?

According to a report by BBC News,

Investment bank BNP Paribas tells investors they will not be able to take money out of two of its funds because it cannot value the assets in them.

Specifically, it could not value the subprime mortgage backed securities in these funds.

Why could it not value these securities?

As was disclosed by the rating agencies in their testimony before the US Congress a month later, these securities could not be valued because there was no access to the data needed to monitor them and to make timely rating changes.

As all market participants know, ratings are just a form of valuing a security.

Under the FDR Framework, what happened in August 2007 is not a mystery.  It was the month in which BNP Paribas announced that all the useful, relevant information about the subprime mortgage backed securities was not available in an appropriate, timely manner and therefore the securities could not be valued.

Once this announcement had been made, both the cause (the lack of data) and how to stop the global credit crisis (provide the data) were easy to identify under the FDR Framework.