One of my former students asked me about the Gorton-Metrick theory of the financial crisis. I have a lot to say about it. Basically, although I agree that what they call the run on repo is an element of the crisis, I think they are wrong in some important respects.

1. There are three financial aspects of the crisis that few economists knew about and that you need to understand in order to have a chance of getting your arms around it. The first is the role of the repo market. The second is the role of embedded options. The third is the role of capital requirements in determining the allocation of mortgage credit risk.

2. Economics courses traditionally have ignored the repo market. On p. 34 of the .pdf version of my macro memoir, I write,

Contrary to what the textbooks say, the Fed’s open market operations do not consist of buying and selling bonds outright. Instead, the Fed operates in the repo loan market. Government securities dealers, like Goldman Sachs or Morgan Stanley, maintain inventories of bonds to sell to customers, just as a grocer will have inventories of fruits and vegetables. Just as a retailer will finance inventories using bank loans, the dealers finance their inventories of bonds with very short-term borrowing, for periods of one day to one week. They do this by using repurchase agreements. If I as a dealer have a ten-year bond that I want to carry for 7 days, then I sell it to you as a money manager with an agreement to repurchase it at a slightly higher price 7 days from now. For those seven days, I have cash, and you have the bond. At the end of the seven days, you get your cash back and I get my bond back (unless, as often happens, we renew the agreement for another week). Because I buy the bond back at a higher price (as promised), you earn interest on your cash. I pay interest, but when I get my bond back its value has gone up because it has moved one week closer to the date on which it will make its first interest payment. (However, depending on market conditions, my bond might gain more in value or even lose in value. That is the risk I take as a dealer for keeping the bond in inventory.)

That is what the repo market originally was for. Recently, the investment banks evolved from being dealers, who held long-term securities only as inventory for sale, into speculators, with “trading portfolios” and “investment portfolios.” About this long-term financing role for investment banks as institutions, and about repo as a funding mechanism, I would say:

1. Gorton and Metrick seem to think repo has always been used that way. They do not discuss the contrast between its 21st-century use and its use as of, say, 1980, when the investment banks acted as dealers, not speculators.

2. Gorton and Metrick write as if it is a good thing that the investment banks evolved into speculators. They think that shadow banking is a necessary component of a modern financial system, and it needs government backing along the lines of deposit insurance or lender-of-last-resort. My own view is that funding speculation in long-term assets with repo is inherently dangerous and ought to be discouraged (by getting rid of the too-big-to fail subsidy) rather than supported by government.

3. I think we need to view the financial crisis as more than just the run on repo. See Not What They Had in Mind.

4. Mortgages have embedded options. The securitization process layered on even more optionality, with AIG (for which Gorton consulted) taking the largest position selling out-of-the-money options. Very few economists talk about this. Robert Merton talked about it at a panel at Harvard in the fall of 2008, but the video seems to have been removed from the Web. But none of the key policy makers, including Bernanke, seemed to understand that mortgage securities and their derivatives were characterized by tail risk, as opposed to just maturity-matching risk.

5. For AIG, the tail risk was converted to maturity-matching risk by the peculiar nature of the contracts, which allowed AIG’s counterparties to make “collateral calls” when the options were still out of the money. So companies like Goldman Sachs could say to AIG, “We know you have not lost your bets yet, but you are getting a lot closer to losing your bets, and because of that, we are entitled to grab billions of dollars in short-term securities from you as a guarantee that you will pay your bets if you end up losing.” So all of a sudden AIG had too many long-term assets and not enough short-term assets.

6. My view was that the key short-term problem in financial markets was these collateral calls. I thought that the government should have stepped in and stopped the collateral calls, and instead told Goldman and the others to wait until their bets actually should be settled. I think that this would have stopped the liquidity squeeze without getting the government in the business of bailout out banks, like Citcorp, that were actually insolvent. Instead, the government went the bailout route, including TARP and lots of Fed generosity, such as handing banks profits in the form of hundreds of billions of dollars in interest-bearing reserves.

For more on point (5) see p. 52 of my macro memoir. In fact, p. 47-56 of the macro memoir explain how my view on (6) came to be. Gorton and Metrick would take nearly the opposite view of mine as to the propriety of the government actions during the crisis.

7. Finally, I think it is important to understand how so much mortgage credit risk ended up on Wall Street in the first place. There, I think that capital requirements played an important role. My “Not What They Had in Mind” paper delves into this. For more background on the factors affecting the allocation of mortgage risk, see Robert Van Order’s Dueling Charters paper.