The Panic of 2007

Gary Gorton

No 14358, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E1 E32 G2 (search for similar items in EconPapers)
Date: 2008-09
New Economics Papers: this item is included in nep-fmk, nep-mac, nep-rmg and nep-ure
Note: AP CF EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (297)

Published as Gary Gorton, 2009. "Information, Liquidity, and the (Ongoing) Panic of 2007," American Economic Review, American Economic Association, vol. 99(2), pages 567-72, May.
Published as Gary B. Gorton, 2008. "The panic of 2007," Proceedings â Payments System Research Conferences, Federal Reserve Bank of Kansas City, pages 131-262.
Published as Gary Gorton, 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.

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