Steve Landsburg on Gary Gorton and the origins of the financial crisis

The last time I blogged on this subject, our astute commenter Bennett Haselton raised a very good question: Bear Stearns is presumably not just sitting on Fidelity’s money; they’re investing it somewhere. Why can’t that investment serve as Fidelity’s collateral? The answer, if I understand Gorton correctly, is that the repo market is a very short-term market, typically 24 hours. For Fidelity to verify the quality of Bear Stearn’s investment project would take a week or so, by which time it’s too late for the information to be of any use. Fidelity’s ongoing concern is that Bear Stearns is pawning off its shakiest investments; to allay that concern requires due diligence; due diligence takes time; the repo market is all about getting things done NOW.

So what should we do about all this? Gorton, along with his colleague Andrew Metrick, argues that the repo market, like any banking market, is inherently susceptible to runs and therefore ought to be regulated. In this case, the regulations should focus on insuring the availability of sufficient high-quality collateral to keep depositors calm. Gorton observes that the existing policy responses to the crisis (e.g. the Dodd-Frank bill) do pretty much nothing to address this fundamental need. The Gordon/Metrick paper contains some specific proposals, which unfortunately Gorton never got to in yesterday’s talk.

(via Thoma)