IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/14358.html
   My bibliography  Save this paper

The Panic of 2007

Author

Listed:
  • Gary B. Gorton

Abstract

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.

Suggested Citation

  • Gary B. Gorton, 2008. "The Panic of 2007," NBER Working Papers 14358, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14358
    Note: AP CF EFG ME
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w14358.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Bank for International Settlements, 2001. "Collateral in wholesale financial markets: recent trends, risk management and market dynamics," CGFS Papers, Bank for International Settlements, number 17.
    2. Gary Gorton & Richard Rosen, 1995. "Banks and Derivatives," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 299-349, National Bureau of Economic Research, Inc.
    3. Gary Gorton, 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
    4. Alan Greenspan & James Kennedy, 2008. "Sources and uses of equity extracted from homes," Oxford Review of Economic Policy, Oxford University Press, vol. 24(1), pages 120-144, spring.
    5. Marco Pagano, 1989. "Endogenous Market Thinness and Stock Price Volatility," Review of Economic Studies, Oxford University Press, vol. 56(2), pages 269-287.
    6. R. Glenn Hubbard, 1991. "Financial Markets and Financial Crises," NBER Books, National Bureau of Economic Research, Inc, number glen91-1.
    7. Anthony Pennington-Cross & Souphala Chomsisengphet, 2007. "Subprime Refinancing: Equity Extraction and Mortgage Termination," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 35(2), pages 233-263, June.
    8. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    9. David B. Gross, 2002. "An Empirical Analysis of Personal Bankruptcy and Delinquency," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 319-347, March.
    10. Gary Richardson, 2006. "Bank Distress During the Great Contraction, 1929 to 1933, New Data from the Archives of the Board of Governors," NBER Working Papers 12590, National Bureau of Economic Research, Inc.
    11. Calomiris, Charles W & Mason, Joseph R, 1997. "Contagion and Bank Failures during the Great Depression: The June 1932 Chicago Banking Panic," American Economic Review, American Economic Association, vol. 87(5), pages 863-883, December.
    12. Charles W. Calomiris & Gary Gorton, 1991. "The Origins of Banking Panics: Models, Facts, and Bank Regulation," NBER Chapters, in: Financial Markets and Financial Crises, pages 109-174, National Bureau of Economic Research, Inc.
    13. Guillaume Plantin & Haresh Sapra & Hyun Song Shin, 2008. "Marking‐to‐Market: Panacea or Pandora's Box?," Journal of Accounting Research, Wiley Blackwell, vol. 46(2), pages 435-460, May.
    14. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-781, December.
    15. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
    16. Miller, Merton H., 1986. "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(4), pages 459-471, December.
    17. Christopher J. Mayer & Karen Pence, 2008. "Subprime Mortgages: What, Where, and to Whom?," NBER Working Papers 14083, National Bureau of Economic Research, Inc.
    18. Moen, Jon & Tallman, Ellis W., 1992. "The Bank Panic of 1907: The Role of Trust Companies," The Journal of Economic History, Cambridge University Press, vol. 52(3), pages 611-630, September.
    19. Allen N. Berger & Anil K. Kashyap & Joseph M. Scalise, 1995. "The Transformation of the U.S. Banking Industry: What a Long, Strange Trips It's Been," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 55-218.
    20. Cormac O Grada & Morgan Kelly, 2000. "Market Contagion: Evidence from the Panics of 1854 and 1857," American Economic Review, American Economic Association, vol. 90(5), pages 1110-1124, December.
    21. François-Louis Michaud & Christian Upper, 2008. "What drives interbank rates? Evidence from the Libor panel," BIS Quarterly Review, Bank for International Settlements, March.
    22. Charles Calomiris & Joseph Mason, 2004. "Credit Card Securitization and Regulatory Arbitrage," Journal of Financial Services Research, Springer;Western Finance Association, vol. 26(1), pages 5-27, August.
    23. Bank for International Settlements, 1999. "Implications of repo markets for central banks," CGFS Papers, Bank for International Settlements, number 10.
    24. Gary Richardson & William Troost, 2006. "Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from the Federal Reserve District Border in Mississippi, 1929 to 1933," NBER Working Papers 12591, National Bureau of Economic Research, Inc.
    25. Gary Gorton, 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
    26. Yuliya Demyanyk & Otto van Hemert, 2007. "Understanding the subprime mortgage crisis," Supervisory Policy Analysis Working Papers 2007-05, Federal Reserve Bank of St. Louis.
    27. Gorton, Gary & Mullineaux, Donald J, 1987. "The Joint Production of Confidence: Endogenous Regulation and Nineteenth Century Commercial-Bank Clearinghouses," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(4), pages 457-468, November.
    28. Gorton, Gary, 1994. "Bank Regulation When 'Banks' and 'Banking' Are Not the Same," Oxford Review of Economic Policy, Oxford University Press, vol. 10(4), pages 106-119, Winter.
    29. John Farris & Christopher Richardson, 2004. "The geography of subprime mortgage prepayment penalty patterns," Housing Policy Debate, Taylor & Francis Journals, vol. 15(3), pages 687-714.
    30. Karl E. Case & Robert J. Shiller, 2003. "Is There a Bubble in the Housing Market?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2), pages 299-362.
    31. Ó Gráda, Cormac & White, Eugene N., 2003. "The Panics of 1854 and 1857: A View from the Emigrant Industrial Savings Bank," The Journal of Economic History, Cambridge University Press, vol. 63(1), pages 213-240, March.
    32. Allen Frankel, 2006. "Prime or not so prime? An exploration of US housing finance in the new century," BIS Quarterly Review, Bank for International Settlements, March.
    33. Gary Gorton & Ping He & Lixin Huang, 2006. "Asset Prices When Agents are Marked-to-Market," NBER Working Papers 12075, National Bureau of Economic Research, Inc.
    34. Calomiris, Charles W. & Schweikart, Larry, 1991. "The Panic of 1857: Origins, Transmission, and Containment," The Journal of Economic History, Cambridge University Press, vol. 51(4), pages 807-834, December.
    35. Benveniste Lawrence M. & Singh Manoj & Wilhelm Jr. , William J., 1993. "The Failure of Drexel Burnham Lambert: Evidence on the Implications for Commercial Banks," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 104-137, October.
    36. Michael D. Bordo, 1985. "Some Historical Evidence 1870-1933 on the Impact and International Transmission of Financial Crises," NBER Working Papers 1606, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Gary Gorton, 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
    2. Gary Gorton, 2009. "The Subprime Panic," European Financial Management, European Financial Management Association, vol. 15(1), pages 10-46, January.
    3. Gary Gorton, 2009. "The Subprime Panic," European Financial Management, European Financial Management Association, vol. 15(1), pages 10-46, January.
    4. Gary B. Gorton, 2012. "Some Reflections on the Recent Financial Crisis," NBER Working Papers 18397, National Bureau of Economic Research, Inc.
    5. Jaremski, Matthew, 2018. "The (dis)advantages of clearinghouses before the Fed," Journal of Financial Economics, Elsevier, vol. 127(3), pages 435-458.
    6. Gorton, Gary & Winton, Andrew, 2003. "Financial intermediation," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, pages 431-552, Elsevier.
    7. Gary Gorton & Andrew Metrick, 2010. "Haircuts," Review, Federal Reserve Bank of St. Louis, vol. 92(Nov), pages 507-520.
    8. Charles Calomiris, 2009. "Banking Crises and the Rules of the Game," NBER Working Papers 15403, National Bureau of Economic Research, Inc.
    9. Gary Gorton & Andrew Metrick, 2010. "Haircuts," Review, Federal Reserve Bank of St. Louis, vol. 92(Nov), pages 507-520.
    10. Stijn Claessens & M. Ayhan Kose, 2013. "Financial Crises: Explanations, Types and Implications," CAMA Working Papers 2013-06, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    11. Khandani, Amir E. & Lo, Andrew W. & Merton, Robert C., 2013. "Systemic risk and the refinancing ratchet effect," Journal of Financial Economics, Elsevier, vol. 108(1), pages 29-45.
    12. Giampaolo Gabbi & Alesia Kalbaska & Alessandro Vercelli, 2014. "Factors generating and transmitting the financial crisis: The role of incentives: securitization and contagion," Working papers wpaper56, Financialisation, Economy, Society & Sustainable Development (FESSUD) Project.
    13. Kristian Blickle & Markus Brunnermeier & Stephan Luck, 2021. "Who Can Tell Which Banks Will Fail?," Working Papers 2021-5, Princeton University. Economics Department..
    14. Calomiris, Charles W. & Flandreau, Marc & Laeven, Luc, 2016. "Political foundations of the lender of last resort: A global historical narrative," Journal of Financial Intermediation, Elsevier, vol. 28(C), pages 48-65.
    15. W. Scott Frame & Lawrence J. White, 2009. "Technological change, financial innovation, and diffusion in banking," FRB Atlanta Working Paper 2009-10, Federal Reserve Bank of Atlanta.
    16. Rajkamal Iyer & José-Luis Peydró, 2011. "Interbank Contagion at Work: Evidence from a Natural Experiment," Review of Financial Studies, Society for Financial Studies, vol. 24(4), pages 1337-1377.
    17. Adalbert Winkler, 2012. "The Financial Crisis: A Wake-up Call for Strengthening Regional Monitoring of Financial Markets and Regional Coordination of Financial Sector Policies?," Chapters, in: Masahiro Kawai & David G. Mayes & Peter Morgan (ed.), Implications of the Global Financial Crisis for Financial Reform and Regulation in Asia, chapter 7, Edward Elgar Publishing.
    18. Hirshleifer, David & Teoh, Siew Hong, 2008. "Thought and Behavior Contagion in Capital Markets," MPRA Paper 9164, University Library of Munich, Germany.
    19. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 97-116, November.
    20. Ellis W. Tallman & Jon R. Moen, 2018. "The transmission of the financial crisis in 1907: an empirical investigation," Cliometrica, Springer;Cliometric Society (Association Francaise de Cliométrie), vol. 12(2), pages 277-312, May.

    More about this item

    JEL classification:

    • E1 - Macroeconomics and Monetary Economics - - General Aggregative Models
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G2 - Financial Economics - - Financial Institutions and Services

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14358. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: . General contact details of provider: https://edirc.repec.org/data/nberrus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (email available below). General contact details of provider: https://edirc.repec.org/data/nberrus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.