Wednesday, October 15, 2008

Recipe for the Panic of 2007

From the introduction of the NBER working paper "The Subprime Panic," by Yale School of Management Professor Gary B. Gorton:

Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers in the U.S. Such borrowers are indeed riskier (also poor and disproportionately minority), and lending to this group involved a particular mortgage design feature, that resulted in linking the outcome to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design, reflecting the subprime mortgage design. Subprime securitization tranches were then often sold into CDOs. Tranches of CDOs were, in turn, often purchased by market value off-balance sheet vehicles, and money market mutual funds. Additional subprime risk was created (though not on net) with derivatives.

This nexus of off-balance sheet vehicles, derivatives, securitization, and, in addition, the growth of the repo (repurchase agreement) market constitute what has come to be known as the "shadow banking system." When the U.S. housing prices did not rise as expected, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors or counterparties in the financial system to determine the location and size of the risks. Faced with this lack of information, financial intermediaries refused to deal with each other and began to hoard cash. The panic of 2007 began.

The ingredients of the Panic of 2007 seem to be (data for charts come from the NBER paper):

1. Increase the subprime share of total mortgage originations from 8% to 20% within just a few short years:
2. Increase the percent of subprime mortgages that are securitized, from 50% to 80% within just a few short years:
3. Ingredients #1 and #2 would have been OK, except that house prices started to fall, and the Panic of 2007 started as the subprime mortgage market collapsed:

11 Comments:

At 10/15/2008 11:52 AM, Anonymous Anonymous said...

The Milken Institute has a good slide presentation.

 
At 10/15/2008 12:17 PM, Anonymous Anonymous said...

I see Mark Perry still wants to blame the (poor and disproportionately minority) for our current economic crisis.

For those who want to read the real cause of the current economic crisis read these excelent reports on site http://gsereport.com/ dating back to 1997.

You would think an economic professor would know something about bad accounting pratices.

http://gsereport.com/

'

 
At 10/15/2008 12:45 PM, Anonymous Anonymous said...

Note that this article implies that it was private sector innovation that created this mess.

Congressional and/or other political desires to spread home ownership had little or nothing to do with it.

 
At 10/15/2008 1:25 PM, Blogger juandos said...

"I see Mark Perry still wants to blame the (poor and disproportionately minority) for our current economic crisis"...

Hmmm, anon I still see you are still a pathological liar or completely delusional... Which is it?

The people who took loans and couldn't pay for it was defended by supposedly patriotic citizens who are leeching off the taxpayer in Congress...

 
At 10/15/2008 1:28 PM, Blogger Arman said...

But WHY did the prices start to fall?? I tell you that this drop in price was due to a contraction of lending activities; a contraction of cash! This contraction of activity was because of the reduction of interest rates by the Fed which started September 07! Lower interest rates discourage lenders from lending. Higher interest rates encourage lenders to lend. The more the Fed tried to fix the cash shortage problem with lower rates, the more that the problem was exasperated.

 
At 10/15/2008 1:32 PM, Anonymous Anonymous said...

"The people who took loans and couldn't pay for it was defended by supposedly patriotic citizens who are leeching off the taxpayer in Congress."

*******************

What about the people who gave the bad loans and are now leeching off the taxpayers to the tune of $800 billion dollars.

 
At 10/15/2008 1:33 PM, Anonymous Anonymous said...

I tell you that this drop in price was due to a contraction of lending activities; a contraction of cash! This contraction of activity was because of the reduction of interest rates by the Fed which started September 07!

I feel like I've heard this song before. Someone kick the jukebox, I think the record is skipping.
db

 
At 10/15/2008 1:35 PM, Blogger Arman said...

Well if you're listening, why have you got nothing to say?

 
At 10/15/2008 1:41 PM, Blogger Dave Narby said...

Leave it to the imfamous 'anonymous':

"I see Mark Perry still wants to blame the (poor and disproportionately minority) for our current economic crisis. "


Newsflash: You're an idiot.


That said, the other major factor is the CDS implosion. C'mon, Mark... Spread the love!

And of course, at the root of it all is fiat currency and fractional banking.

 
At 10/15/2008 1:48 PM, Blogger Arman said...

"fiat currency and fractional banking."
Money is based on the credit of the local bank. It is normally held on the ledgers of the bank. It is supported by the liens that the bank holds. Money is not an asset to the bank. The interest bearing liens are the assets of the banks. This is the way that money is and always has been created. The notes that the Fed creates makes easier the transfer of accounts from one bank's ledger to another, but in no way is it a basis of banking. Your concern over "fiat" expresses an ignorance over what makes money money.

 
At 10/15/2008 10:42 PM, Anonymous Anonymous said...

Thanks, Anon. 11:52,

Very interesting reading. Of particular interest was the leverage of Freddie Mac at 67:1 which exceeds even the imprudent investment banks like Bear Sterns at 32:1. Although Fred & Fan are part of the problem, there are lots of other factors which contribute to the perfect storm.

Would love to have heard the accompanying lecture...especially, the section, where do we go from here since the charts are not explicit on this point.

Where is Shelly Winters when you need her for another disaster movie?

Thanks again for some interesting reading.

 

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