"Collateral Crises": a new research paper examines the impact of small shocks that create big problems

From Yale economists Gary Gorton and Guillermo Ordoñez comes an important, albeit highly technical, paper entitled “Collateral Crises.” The idea of the paper is to look at how crises get started, and why small shocks to the financial system can have an outsized impact. Their focus, and one of our favorite topics, is the role of collateral in financial transactions.

Gorton and Ordoñez argue that information about collateral is key. Collateralized debt is designed to be “information insensitive” – where it is too expensive to find out about the collateral. In periods of economic stability, investors accept the lack of information and happily live in a state of “blissful ignorance.” Information insensitive appears to be a hot buzzword for 2012 – best to use it in conversation with clients and management for the next month, then forget it as it gets too trendy.

The notion of blissful ignorance is reinforced by credit booms, when there is less dispersion about people’s beliefs. In other words, everyone thinks the boom will continue and all collateral ends up looking alike. Bad collateral can increasingly be used to generate credit and leverage in the system grows. The greater the leverage, the more magnified a small shock will be.

From a collateral seller’s point of view, the ideal collateral is paper that is perceived as high quality but costly to obtain information about. Even if there is some information available, the pooling of collateral allows bad collateral to be confused with good collateral. This let, for example, bad quality ABSs get slipped in among the good quality ABS, corporate and government scripts. The more time that goes by with this lack of information, the more “bad” collateral gets mixed in with the good. The trouble with this plan is that when there is a shock, however small, investors realize that some collateral is “bad” but they just don’t know which because there is such little information available. All collateral is then shunned.

This idea rings true to us. Sub-prime paper was complex, but the high ratings obviated the need to know much about it. It was ideal from the collateral seller’s perspective. The period known as the Great Moderation reinforced views that the economy was destined for steady performance over a long period of time – things would just continue the way they were. This including the performance of real estate; “safe as houses” as the British say. A small crisis – distress in sub-prime as housing prices fell – made all collateral suspect.

A link to the paper is here

And a link to Gordon’s recent book Slapped by the Invisible Hand: The Panic of 2007

 

 

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