The Panic of 2007

By Gary B. Gorton. 2008

489 citations recorded by the source corpus.

How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked 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 often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/a0006ffeca53282fb8695b3b89b2f4f071463a9e

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Citations in the corpus

Dynamic Debt Runs (2010, background): “This paper develops a continuous-time model to analyze how runs occur on rms with 1See comments of various regulators and researchers, e.g., Bernanke (2008), Brunnermeier (2009), Cox (2008), Gorton (2008), Krishnamurthy (2009), and Shin (2009).”
Monetary Policy in Exceptional Times (2012, unknown): “2 e.g. Gorton (2008).”
Deciphering the Liquidity and Credit Crunch 2007-08 (2009, unknown): “In September 2008, AIG faced a “margin run” as explained in Gorton (2008). Several counterparties requested additional collateral from AIG for its credit default swap positions.”
The Euro’s Three Crises (2012, background): “See Fender and Gyntleberg (2008) for a real-time discussion of the progression of the liquidity crunch, and Gorton (2008) for a description of how bank and nonbank funding problems led to a bank run–like crunch in liquidity.”
Housing Finance in the Euro Area (2009, background): “Furthermore, as shown by Gorton (2007), the economic rationale behind typical nonconforming adjustable rate mortgages hinged on the possibility of frequent refi nancing, an event in turn intimately connected to the continuation of house price appreciation.”
Credit Ratings Failures and Policy Options (2010, unknown): “Sources: Gorton (2008), Inside Mortgage Finance, Securities Industry and Financial Markets Association, and Creditflux.”
The role of institutional investors in propagating the crisis of 2007-2008. (2012, unknown): “3 See Gorton (2008, 2009), Gorton and Metrick (this issue), and Brunnermeier (2009) for informative readings. utional investors in propagating the crisis of 2007–2008.”
The Credit Ratings Game (2012, unknown): “As Fender and Mitchell (2005), Gorton (2008), Ashcraft, Goldsmith-Pinkham, and Vickery, (2009) and Benmelech and Dlugosz (2009, 2010) among others have highlighted, issuers of structured …nance products could design the default risk of an asset-backed security both by manipulating the risk…”
Information, Liquidity, and the (Ongoing) Panic of 2007 (2009, background): “This market is central to the "shadow bank ing system," the nexus of structured vehicles that issues bonds into the capital markets (see Gorton 2008).”
Securitization, Transparency, and Liquidity (2012, unknown): “The securitization of mortgage loans is now the consensus culprit in the 2007-08 subprime lending crisis, to the point that it can be regarded as its distinctive feature (Adrian and Shin, 2008; Brunnermeier, 2008; Gorton, 2008; and Kashyap, Rajan and Stein, 2008, among others).”
Financial Spillovers to Emerging Markets During the Global Financial Crisis (2009, unknown): “…2007 was a temporary period where early signs of stress began to emerge in global markets prior to the time when the subprime crisis was revealed in mid-2007 is consistent with The Federal Reserve Bank of Dallas (2008), Gorton (2008) and Gonzalez-Hermosillo (2008) as well as IMF (2008).”