A good paper and model of (part of) the financial crisis

From Gary B. Gorton and Guillermo Ordonez (pdf):

Short-term collateralized debt, private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally-insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output. Financial fragility builds up over time as information about counterparties decays. A crisis occurs when a small shock causes agents to suddenly have incentives to produce information, leading to a decline in output. A social planner would produce more information than private agents, but would not always want to eliminate fragility.

Comments

Would this not qualify as "remarkably obvious"? Admittedly accurate, but still, well, *obvious*?

Say what? You don't think it takes a sophisticated model to predict that lack of information about risk contributes to a credit bubble?

You must be one of those radicals who trusts his intuition without a model to back it up.

Indeed. Those birds must be taught how to fly.

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Tyler,

Love Gary Gorton--been reading his insightful work since the beginning of analyses of the financial crisis. I just had an interesting thought about a couple different things related to finance. I'd say there are generally a couple of premises that are more or less accepted, but I'd suggest that the relationship between them means they can't be true:

Many people who look at the financial crisis from more of a conservative/libertarian perspective bemoan the fact that firms have gotten too large, too complex, and too indebted as a consequence mainly of the implicit government subsidy that exists from the promise of bailouts if a financial crisis occurs. However, at the same time many conservatives caution that if we over-regulate and overtax the financial sector, it will simply migrate elsewhere.

The issue at hand is that if finance is truly dependent on the potential for government bailouts, it can't just up and leave to an obscure Caribbean Island. As we've seen with a country like Ireland, the debts of a domestic financial sector are very distinctly the province and problem of the country where these firms are located. Therefore, the price of escaping "costly" regulations designed to stem moral hazard and tax the negative externalities associated with finance is that if the market were ever to

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find itself in a situation where it required government assistance, it wouldn't be able to secure it.

I think that suggests we should not be so wary that something like a Tobin Tax (just to choose a simple example for illustrations sake) would send finance flocking out of NYC or London. The interesting analogue is also that countries which can't set their own monetary policy (i.e. those of the Eurozone) should also see a comparative disadvantage in developing the financial service industry, precisely because that fact constrains them in the size of the safety net they can provide.

Not sure how true any of this is, just wanted to see if the thought could catch your attention. Your article in The American Interest is still one of the defining pieces on how I think about finance.

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Gary Gorton has a cross after his name, but is not dead?

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I think it can be stated even more simply as a principal-agent misalignment between the ultimate lender and the originator of the loan. Before the CDO boom, people generally expected loan originators (banks) to act as diligent underwriters, because they expected to hold at least some of the risk. The misalignment was compounded by BDCs who were originating loans with other people's money. A rational private market should seek to align interests, primarily by requiring originators to maintain a stake in anything they sell.

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A crisis occurs when a small shock causes agents to suddenly have incentives to produce information, leading to a decline in output.
Reminds me of the Bird and Fortune video... .. what was stupid, at some point, somebody asked, how much money are these actually worth?
http://www.youtube.com/watch?v=mzJmTCYmo9g

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Assumptions about the positive things social planners would do rarely pan out as expected.

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