"A Run On the Shadow Banks"

From RepoWatch:

The Panic of 2007-8: What happened? 

Ten years after the Panic of 2007-8, there’s still major disagreement about what caused the financial crisis and the Great Recession.

That’s the sobering revelation in a flurry of commentary written for the 10th anniversary of the Lehman bankruptcy. Lehman filed on Sept. 15, 2008, and that’s generally considered to be the day the crisis erupted, although a panic had been building since early 2007.

From Yale professor Gary Gorton:

Ten years after the crisis began in the first quarter of 2007, there is no consensus on the cause of the crisis. Explanations abound. It is unfortunate that there is a lack of data on the shadow banking system, which makes it difficult to understand what happened.

This confusion matters. It matters a lot. Because we can’t fix, and we can’t prevent, what we don’t understand.

According to top experts including Gorton, the Panic of 2007-8 was a run on shadow banks. Lenders, whose short-term loans to those banks had helped finance the housing boom, panicked when housing collapsed and demanded that the shadow banks immediately return their money.

When these lenders “ran,” credit dried up and that caused the Great Recession. It was similar to the runs by depositors on commercial banks in the era of the  stock market crash of 1929, which led to the Great Depression.
But many Americans don’t know this, and some prominent economists and financiers dispute it.
The debate comes down to this: Was the painful Great Recession caused by the collapse of bloated housing prices or by the collapse of the risky lending to shadow banks that financed the bloated housing prices?

What follows is a look at this important national conversation, in this order:

• One view: The Panic of 2007-8 was about runs on shadow banks
• Another view: The Panic of 2007-8 was about housing
  
• The view from the press
• The RepoWatch view

(RepoWatch editor’s note: To jump around, search for those exact words.)

One view: The Panic of 2007-8 was about runs on shadow banks

As RepoWatch readers know well, the panic was explained as a run on the repurchase market by Yale economist Gorton at Federal Reserve conferences in 2008 and 2009. In speeches in 2008 Federal Reserve Chairman Ben Bernanke and then-New York Fed President Timothy Geithner, who both had front-row seats to the crisis, also described the panic as shadow bank runs, especially on the tri-party repurchase market.   Said Geithner:

The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks.

Many students of the financial panic have accepted this understanding (including your RepoWatch editor) and believe the bank bailouts that followed the Lehman bankruptcy were necessary to stop the runs and prevent a Great Depression.

In 2013 Yale University created its Program on Financial Stability to train regulators to respond to financial panics. Bernanke, Geithner and former U.S. Treasury Secretary Henry Paulson Jr. are on the advisory board. A pivotal class, taught by Geithner and program founder Andrew Metrick, is available free online, to spread understanding.

But some politicians, regulators, journalists and – therefore – Americans think of the crisis the way they first heard it described and personally experienced it, as an explosion in risky subprime lending, a housing bubble that burst, a madhouse of derivatives, corrupted credit rating agencies, households drowning in debt, trillions of dollars of losses in mortgage-backed securities, six to eight million foreclosures, duplicitous Wall Street traders and too-big-to-fail banks.

(All of that is true, of course, but “run-ners” would say it stops short of the next critical step, which was when the housing problems triggered runs on shadow banks and that ignited the panic.)

Many Americans are still furious that Congress and regulators bailed out banks instead of homeowners. That public anger led Congress to restrict future bailouts, a scenario so frightening to Bernanke and others who understand the dynamics of a financial panic that this year they launched a 10th-anniversary campaign to explain why the emergency powers they used in 2008 to stop runs were critical to preventing another Great Depression....

...MUCH MORE