I am always afraid to wade into the world of collateral and repo and rehyp and whatnot because it is big and complicated and smarter people than I splash around in it, but this week has had some good stuff so let’s talk about it for a bit. NBER’s weekly dump of things you could read if you wanted to yielded up a trove of Gary Gorton, including a Gorton-Lewellen-Metrick paper about how much of our economy has historically been composed of safe assets (answer: 33%! weird) and a heavy-sledding but apparently good Gorton-Ordonez paper modelling financial crises as the effect of people deciding that “information insensitive” collateral should be information sensitive. There’s also an interesting paper by Krishnamurthy, Nagel and Orlov (let’s go with K-N-O) that maybe illuminates that point. It’s called “Sizing Up Repo,” and if you’re not already into this sort of thing, here is a picture describing exactly how clear the rest of this will be:
Heheheh no really. Anyway, the basic gist of this whole realm of literature goes something loosely like this:
1. Humans put money in banks and banks lend this money to companies and fulfill their basic role of financial intermediation.
2. Also, there’s a whole lot of other stuff that isn’t “banks” but serves some of the same role, that is, intermediate between human savers and companies that need money.
3. That other stuff is looooooooosely “shadow banking,” and a lot of it consists of humans – and corporations, endowments, etc. – putting their money into things – like money market funds, mutual funds, etc. – that then lend money to each other or the banking system via short-term money-like instruments that sort of fill functions similar to bank deposits. A lot of these instruments take the form of very short-dated loans backed by financial instrument collateral, roughly speaking “repo.”
4. Something broke in that system and helped cause the financial crisis.
The K-N-O paper is a contribution in that vein, and here is the point where I felt like I could stop reading because I had learned something: Read more »