Gorton Expands His Haircut Run Theory

Gary Gorton wrote an interesting piece (Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007) documenting that haircuts on a variety of Repo collateral went up severely in the financial crisis, and may be the essence of how this crisis accelerated. He has two papers that expand this idea, and the data underlying it. I think he makes an excellent point, and like how he clarifies his position, even at the risk of repeating himself.

In Securitized Banking and the Run on Repo, Gorton and colleague Andrew Metrick (great economist name) go over the basic idea of how repo haircuts relate to a bank run. He notes the crisis starts in July 2007, just when several AAA ABX-HE (subprime housing) tranches started trading below par.

At that point people realized these assets were not merely a normal bump in default rates, because anytime a large AAA CDO trades below par, you basically have a catastrophe alert. Given that even today commenters do not agree on what was wrong, the failure of informationally insensitive assets caused every informationally insensitive asset to trade as if a junk bond. That is, the problem could have been merely poor underwriting, but it could have been due to something else: Fed policy (Taylor), excessive confidence in models (Taleb), CDO assumptions (Felix Salmon), everything (Roubini), hubris (Tett), h government (Woods), and bubbles (Shiller).

Now, these explanation affect much more than subprime housing, and given the prominence of these hypotheses they are concerns reflected in the general investing public. I sense that many investors changed from taking any AAA rated securities as a given, to going over all the things that could go wrong, which using the minimax principle generates really low prices.

So, with the AAA for subprime went bad, all AAA ABS was suspect, haircuts rose, and through the mechanism described by Gorton, a reduction in the monetary base similar to if customers withdrew deposits. A modern bank run via repo haircuts rising.

If the idea of repo haircuts is not clear to you, no worries. Gorton and Metrick have a short paper, Haircuts, explaining that for all you haircut noobs.