What's Happened Since the Crisis?

In a discussion for Yale SOM’s Qn magazine, Yale SOM finance professors Frank Fabozzi, Gary Gorton, and Will Goetzmann reviewed events since the financial crisis of 2008 and discussed the current state and the prospects of the banking system. They also addressed the roots of the crisis and the likely effects of the recent financial reform legislation, and made proposals for safely reviving the mortgage market.

Gorton laid out his influential argument that the crisis was a banking panic dressed up in a new form. He argued that the sale and repurchase, or repo, market had come to function as a shadow banking system without the safeguards against panics that exist in the standard banking system. The failure of subprime securities turned into a systemic financial crisis because the companies and institutions using the repo market withdrew, forcing banks to sell assets at a rate that crashed the value of non-subprime-related bonds.

Gorton called for a new type of bank that would be the only buyer of securitized bonds. Citing work underway in collaboration with SOM professor Andrew Metrick, he described these narrow-funding banks (NFBs) as carefully regulated entities that would buy bonds of securitized bank loans bundled based on clearly defined criteria. The liabilities of NFBs could then be used as collateral in the repo market.

Highlighting the importance of resolving the problems in the housing market, Goetzmann said, "We did a decent job at dealing with the massive institutional crisis, and we put the household credit crisis on hold." He praised aspects of the financial reform legislation, such as the creation of a consumer protection agency, but pointed to a lack of clarity saying what will happen with Fannie Mae and Freddie Mac as institutions, "I think the financial crisis in part got started at the household level."

Fabozzi was critical of politicians for enacting legislation without a clear understanding of markets but at the same time he noted that there is a need for more education about financial tools such as securitization. "If we're asking why regulators and legislators don't understand these products, we really have to look back at the university level and ask why we aren't teaching these concepts. Across the United States, very few schools have a course that covers these topics. At SOM we have a course in structured finance and the bulk of that is securitization."

The complete discussion is available on Qn magazine’s website.