Yale SOM finance professors Frank Fabozzi, Gary Gorton, and Will Goetzmann discuss what caused the financial crisis, what we have learned since then, likely impacts of the financial reform legislation, and proposals to address unresolved issues in the housing and securitization markets.
The fall 2008 issue of Qn featured a discussion with Yale SOM finance professors Frank Fabozzi, Gary Gorton, and Will Goetzmann examining the role of securitization in the credit crisis. The conversation took place in August 2008, just before the collapse of Lehman Brothers and the eruption of a worldwide economic crisis. We asked them to discuss what they've learned in the last two years.
All three have made contributions to the academic understanding of recent events. Gorton's paper "The Subprime Panic," in the journal European Financial Management, was the first to sweep that publication's awards for Best Paper, Readers' Choice, and Top Download, and his work has been cited by policymakers such as Federal Reserve Chairman Ben Bernanke. Fabozzi's 2009 book Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives elucidated the instruments and markets critical to corporate finance. Goetzmann's working paper "The Subprime Crisis and House Price Appreciation" analyzed the impact of assumed positive price trends in models used to make loan decisions. And another paper, "Securitization in the 1920s," advanced understanding of the history of collapse in real estate securitization.
Q: When we last talked the financial crisis was unfolding. How do things look two years later?
Gary Gorton: It's surprising to me the extent to which people still have no idea what actually happened, which I think is one of the reasons that my paper in the European Financial Management won awards—people are curious and want to understand. Many bank regulators and other experts can make a list of events, but they can't explain how those things turned into a systemic financial crisis. And that's what I have been working on trying to explain. I don't think I have all the answers, but I think the core of what I was saying has held up.
One way to think about the crisis is as follows: Why did the prices of non-subprime-related bonds fall? We can all understand why the prices of subprime-related securities went down. That part is not a mystery. The question is how and why did it spread? That's what you have to explain. You can take two points of view on this. One point of view is to think that the crisis is a unique event—nothing like this has ever happened before because it involved all sorts of new things that combined to cause the problem. I take the second point of view. I think it was a problem inherent with bank money creation, and that's a banking panic.
Banking panics are very familiar in U.S. history. They've plagued this country for over 200 years. And in this particular case, the panic happened in a market that most people aren't familiar with: the sale and repurchase agreement market, or repo market. Omitting the details, the repo market is a kind of checking account for big companies—pension funds and nonfinancial firms like Microsoft. Those companies ran on their banks, much like in the movie It's a Wonderful Life, and that caused the banks, mostly the old investment banks, to have to sell assets. The assets they ended up selling were non-subprime-related bonds. That's the mechanism that caused concerns about subprime to be translated to the rest of the asset classes. As soon as everybody has to sell, all asset prices go down and there are going to be problems. In a way, it's a very old story, but it's in a new guise.
Will Goetzmann: Gary has set the terms of the current debate about the financial crisis. To view it as a form of a banking crisis means that you start understanding new institutions that have been created over the last 10 or 15 years as proxies for classic banking functions. So there has been considerable excitement among researchers over his hypothesis.
Frank Fabozzi: I agree. He provided the macro framework. Now the issue is to figure out how to respond at the micro level. You can see from the recent financial reform legislation, as well as congressional hearings, that now the focus will be on to what extent we get more involved in regulating banks, or to what extent we start regulating mortgage bankers, regulating ratings agencies, and so on.
Q: Maybe we can talk a little bit about the financial reforms that have been signed into law. What do you expect the likely impacts will be? And does this law address the fundamental issues?
WG: From my perspective, creating a consumer protection agency for financial products was a step in the right direction. I think that's a really helpful tool to look after the interests of retail consumers. I think the financial crisis in part got started at the household level. Anything we can do to have some oversight on the kinds of financial products that are sold to households is going to be good. That always has to be weighed against individual financial freedom, but I think the way it's been done is probably a step in the right direction.
One of the problems that came up immediately following the Dodd-Frank Wall Street Reform and Consumer Protection Act is what to do with respect to the rating agencies. That was addressed in the short term by putting it off for a year—the Act suggests that alternatives to ratings agencies be developed. But I don't see that being resolved well in the coming year. I think there's a need for ratings agencies and I think the government has a view that they're an evil that has to be dispensed with. That worries me a bit.
Something that's missing entirely from the bill is any kind of perspective on Fannie Mae and Freddie Mac as institutions. I'm still very much in favor of some entity like Fannie Mae or Freddie Mac, which operated, I think, fairly well before the explosion of offerings of mortgages by non-agency banks. Amid the anti-Fannie-and-Freddie rhetoric, it's possible the institutions are going to be shut down over the next year, and then what we'll have is a bunch of banks like those that issued the subprime mortgages and basic standards about conforming mortgages would become a thing of the past. The role of home mortgages in the economy is a glaring problem in my mind.
GG: I think there are a lot of good things in the law, and the extent of their impact is going to depend in large part on the nature of the rules that are written to implement the law. And because the financial crisis was quite complicated and very extensive in the financial system, there's a lot to do. Having said that, the financial legislation didn't address the core issues. Perhaps they'll be addressed in some further legislation.
What exactly should be done is a long topic, but it's something I'm working on with another Yale colleague, Andrew Metrick, for the Brookings Institution. And we would like to see a more direct approach to some of these problems, and in some sense, significant change in the architecture of the financial system.
I should add that this is a pressing issue. Keep in mind that the repurchase market, which I described before as a checking account for big companies, is based on using collateral for deposits. I put my money in the bank and they give me collateral, and that collateral, oftentimes, is a securitized bond, which is a bond backed by a big portfolio of bank loans. The way the modern banking system has worked for the last 30 years is that banks sell their loans. These loans are turned into bonds and sold to investors around the world. And if banks cannot sell their loans, then they don't lend. So the idea of repairing the banking system in this regard is not just a matter of avoiding the next panic, it's also much more pressing in that we would like to see banks want to lend, and to do that, they need to be able to sell loans.
Q: What would improve that situation?
GG: I think the first thing we have to do is we have to recognize that the process of securitization—turning bank loans into securities, and the use of those securities as collateral for repo—has become a real banking system, and we want to protect it. Just the concept that this is a banking system is important.
What we specifically propose is that a new category of bank be licensed, called narrow-funding banks (NFBs), that would be the sole buyers of securitized product. These banks would be overseen by the government. They would be extremely constrained. They couldn't take deposits or do proprietary trading or much of anything other than buy securitized bank loans. They would have capital requirements like other banks, but they'd be a different category of bank because they are so constrained. Their liabilities would be one of the categories which would be eligible to be collateral for repo. There are more details, but that's the gist of it.
FF: Will opened up so many doors, but let me respond to Gary first. All of our friends who teach agency theory will have a ball looking at all the conflicts that existed at every level in this process of trying to use the public markets as an alternative supplier of capital as opposed to using banks. The general suggestion that there be another entity that would be regulated differently than banks are today, I think, should be considered. I haven't read the paper.
If we're looking at creating NFBs, they're going to buy and securitize—is that what you're saying, Gary?
GG: I didn't mean to spring this on you. We're still working on the paper. The securitization process would happen the way it does now, through SPVs [Special Purpose Vehicles], but NFBs would be the only eligible buyers of the bonds.
FF: You're telling me that you would not like to see, for example, a PIMCO or a Blackrock, buy these bonds?
GG: Right. Here's the idea. We'd like to have the government oversee securitization. And so the government is going to specify what narrow-funding banks are allowed to buy, and specify portfolio criteria. And they're going to have to agree that the ratings are credible. Then, if PIMCO wants to buy asset-backed securities, they're not going to be able to buy them directly, but they will be able to buy the liabilities of narrow-funding banks, which could be repo, could be long-term bonds, or whatever they are. We're inserting narrow-funding banks between PIMCO and the SPVs.
FF: My concern is this: When portfolio managers participate in the asset-backed securities market, the securitization market, sometimes it's for purchasing generic types of securities. Other times it's actually to make a play on whether they think the market has properly valued a particular asset pool. Now, if I understand you, that play would be taken away by this NFB?
GG: That's correct.
FF: All right. I guess two years from now we can huddle up and determine whether that would be successful. I like the idea. But I might make an exemption for sophisticated investors to go out and buy directly, because the question then becomes, what is the funding cost? Is it higher or lower in this type of system for the consumer who is ultimately going to be paying the note rate? The panic of 2007 clearly showed there are people who should not have purchased this product, so I think that to have an alternative, a bank like that, is fine. But I think taking away the flexibility of investors to go directly into these products certainly will not be received well.
GG: Will raised a couple of important points that we should get back to, including the issue of Freddie and Fannie. [Secretary of the Treasury Timothy] Geithner said the government was going to continue to have a presence in the mortgage market. And I think that's the first time since the crisis that the government has said anything about housing policy. It's something they have avoided talking about because it's hard. If we're going to continue having some kind of public subsidy for housing, which we have had in this country for many years rightly or wrongly, then they have to come up with a form that this is going to take. They have to decide what Freddie and Fannie are going to become. And they have yet to even float an idea about what the government's role in the mortgage market will be. I think it's pretty clear that they're a little mystified by it.
And let me just mention that using the idea of NFBs, you could allow a class of these institutions to focus on providing mortgages, and allow them to be competitive. We wouldn't get the widespread mortgage issuance we had under Freddie and Fannie, but that's a cost of having a more conservative housing policy. So I think the general idea of another category of financial institution may have more widespread applicability.
FF: I agree with that. If you look at some of the legislation, it has had the band-aid approach: what was the problem and how do we fix it within the current system? Maybe that's not going to work. Maybe we need a new framework.
For the immediate fix, consider that Ginnie Mae issued its first product in 1969. Shortly after, Freddie and Fannie became entities that issued securities. Fannie and Freddie survived from 1970 and 1972 to 2007. That market is the largest investment-grade market in the world. They were a major success story. We had a housing finance market that every other country envied.
The question is, then, why did it fail? The failure, I think, was the rippling effect that occurred in the housing market. We never thought that we would get contagion from the subprime mortgage market to prime mortgages. My view is that maybe we can strengthen Fannie and Freddie through credit requirements, so that they can continue doing what they're doing now. That goes to the micro level. Who is looking at these loans? Who is originating these loans? What are you going to do on the micro level to make sure those loans are properly structured? This also applies to NFBs. If they buy poor quality loans that are poorly originated, you're not going to have a successful banking system.
Will also brought up the ratings agencies. The government finally stepped up to the plate and said, maybe we share the blame with respect to ratings agencies. Every time that we ask for regulated entities to report to the government in any type of transaction, we require that they rely on ratings. As a result, the government admits it has investors and regulators highly dependent upon ratings, with no independent analysis. And I think that there's been a series of papers that have been coming out lately talking about discussing this exclusive reliance on ratings by investors. So I think the government shares the blame because, even under TARP, if you want to go through any of the government programs, everything is done purely based on ratings.
GG: I think it's important to have in the back of your mind some idea of what the ratings agency function actually is. And I think that the common view—not among my colleagues but out there in the world—is that the ratings agencies in fact are supposed to be telling you something about risk. And it just is patently obvious that if you're trying to infer something about risk from a letter grade, that is insufficient. It seems pretty clear that this is not really about risk in the same way that we normally think about risk because, if it were, then you would think that the most risky securities, namely equities, would have ratings and they don't. The function of ratings is something which is not very well understood.
I do think it's clear that we need ratings in capital markets. And we're going to have to have them in some form.
Q: Regulation is one piece of governmental intervention that's occurred since 2008, but there's also been the TARP, the stimulus, Fed activity. What sort of balance should we be looking for between markets and government?
WG: This has been a perpetual problem throughout the 20th century and into the 21st. There are competing, deeply held philosophies and academic arguments that go back decades about what that balance is, so I'm not going to be the one to clarify that. But as an empiricist, one thing I do is look at periods in the past and ask what worked and what didn't. I think one of the approaches that the president took when he built his Council of Economic Advisors was to seek out people who had some experience looking at those events in the past. And, of course, Bernanke himself is somebody who studied the banking system closely. I guess I'm just pleased that policymakers took that approach, rather than simply dressing themselves up in one kind of armor or the other, as proposed by pundits in the New York Times and Wall Street Journal.
The bottom line is we don't really understand, entirely, what the effects of either stimulus or easy money policy will be on the current crisis. But doing nothing is equally frightening. I have my own opinions about where I'd rather see relief going, and that would be more towards households at this stage, as opposed to institutions. I think we did a decent job at dealing with the massive institutional crisis, and we put the household credit crisis on hold because solving that one takes us far away from the laissez-faire economy, and would be much more politically difficult. That being said, keeping mortgage rates really low is just not the right answer for the housing crisis.
GG: Modern macroeconomics never contemplated a crisis like this. And modern macro models do not have banking systems in them, typically. When policy advice was needed, it was stunning how macroeconomists suddenly became Keynesians and very quickly decided—although it wasn't unanimous—that we should have a stimulus package. From an academic point of view, the jury is still out as to whether that was a good or a bad idea. But one thing that's interesting is that there weren't any alternative ideas other than a tax cut. There's a real gap in economics that needs to be filled. And that should occupy the profession for about 50 years.
FF: At the macro level, the programs that were instituted, I think, brought us back from the brink. We'll find out details as some of these people who were involved eventually write books about this crisis, but I think they did a very good job. But I'm still not convinced that the government understands markets.
When I heard about programs such as TARP and how much money was being allocated to it, I thought that the government would make money in the end if it didn't get involved after deciding to allocate money to different asset managers. This is basically a U.S. sovereign wealth fund or a government-run but externally managed hedge fund.
The concern that I have is that politicians still just don't understand markets. For example, when politicians talk about loan-modification programs, where you go back and modify mortgages, they don't seem to recognize that the loans themselves are no longer owned by the originators. They're now owned by funds and countries throughout the world. Or when politicians call for the ultimate investor to be accountable for violations in underwriting, it is clearly a sign they don't understand who the participants are in this market. I mean, the states they represent hold mortgage-backed securities. Do they want their constituents who are beneficiaries of state pension programs to be held responsible for any underwriting violations that are in the loan pool?
GG: That's a really interesting point. And yet they rushed these reforms through even before the financial crisis inquiry commission had a chance to report its findings. It is kind of astounding.
Q: What is happening with securitization now?
GG: The securitization market, basically, is moribund at the moment. It's not nonexistent, but I would describe it as broken and not functioning. And it's almost a tragedy for this country to have unemployment as high as we do and not have some proactive steps to try to help the securitization market recover.
WG: I'm basically of a mind that we've got about as much as we're going to get out of the legislative process with respect to trying to address major problems. I don't think it was really enough. The big fear I have, and I know it's shared by both of my colleagues here, is that the securitization market is going to continue to drift and will not recover anytime soon. That's a great loss in terms of financial architecture. It was something that enabled a lot of improvements to society. And I think we're perilously close to throwing the baby out with the bathwater because of public anger and fear and a lack of understanding of exactly how it works.
When subprime mortgages and related securities were characterized in the press as too complicated and instruments that nobody understood, that was really destructive, because it implied that these things were some kind of sophistry. In fact, most of them are just simple packaging of cash flows, and rules for what to do under certain conditions. To scare people off of them is driving society back into the Dark Ages.
We know from financial history that there are periods of great financial innovation and advancement and those are often associated with economic booms. But then financial markets can also take a step backwards. China, for example, is seeking ways to experiment with financial innovation and looking forward to developing the kind of technology that we're on the borderline of rejecting. China is interested in derivative securities and securitization precisely because the country sees the potential benefits it affords them in being able to finance the development and expansion that they need to improve the quality of life for its citizens. It would be a great irony to see other countries adopt this technology that we used to great effect, and to see us build a set of regulations that essentially prevents them from being effectively applied in this country.
FF: If we're asking why regulators and legislators don't understand these products, we really have to look back at the university level and ask why we aren't teaching these concepts. Across the United States, very few schools have a course that covers these topics. At SOM we have a course in structured finance and the bulk of that is securitization. That doesn't mean you necessarily need a course to understand this, but if you look at the curriculum at most universities you just don't see it as a topic covered within traditional finance courses.
GG: I not only agree with that, but I would also say if you look at the academic literature, you don't see enough work on it there, either.
Q: What are the consequences in the long term of the reputational hit that's happened to the financial industry?
GG: It's hard to see what the structure of the industry is going to be in 10 or 20 years. Talent goes where there's money. We know that. But if the old investment banks don't exist, it's not clear where the talent is going to move. Hedge funds are not corporations. They're basically short-lived entities, usually centered on one or two people, and when those individuals retire, the hedge fund ends.
WG: To me this is just a fascinating question—the long-term reputational issues. And what's funny about it is that one of the very first books that was published about the financial markets was written in the middle of the 17th century by Joseph de la Vega, and it was called, somewhat sarcastically, Confusión de Confusiones. It was about stock trading in Amsterdam. It's written in a way that pokes fun at the participants in the financial industry. I think that ever since then, there has been a deep-seated negative archetype that society holds with respect to financiers.
I think this has a bit to do with the abstraction of finance. It's fundamentally less concrete in terms of people's ability to understand how it works than, say, real estate or farming or manufacturing. That makes it easy to criticize and stigmatize financiers as dealing in the ethereal. We've gone through that process in the U.S. following this crisis. I think we're coming out the other end. As Gary says, ultimately when you see where very talented people go, and they continue to go into the finance industry. As they do so, that negative stereotype will again diminish. It's never going to go entirely away, because it's been with us for 400 years. A large part of society thinks that finance is a necessary evil. And I think this view is just wrong.
Interview conducted and edited by Ted O'Callahan