Streetwise Professor

November 3, 2008

That’s Not How You Want to Become the Subject of a WSJ Feature Article

Filed under: Uncategorized — The Professor @ 8:51 pm

I only know Gary Gorton through his work, which is quite impressive. He is a recognized leader in scholarship about banking, and about financial crises. According to the WSJ, Prof. Gorton also developed default loss models that AIG used to value mortgage backed securities, and default swaps on such securities. According to the article, these models did not adequately characterize the risks that AIG took on when entering into the default swaps. The article acknowledges that “Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.” That’s all very nice, but fairly or unfairly, the association of Gorton with the AIG collapse will undoubtedly lead many to blame him for providing incomplete models that led the company astray.

The article is too sketchy to support any definitive conclusion on exactly what Gorton’s models did or did not do, but ironically, it suggests that an issue that I discussed yesterday in “The Market Price of Risk” is at the heart of the matter. From the article I infer that Gorton’s models were intended to calculate the distribution of cash flows on the swaps. To get a value from that information, or to assess risk, it is necessary to discount those cash flows. If Gorton/AIG failed to take into account the substantial systematic risk inherent in the design of the underlying securities (as discussed in Coval-Jurek-Stafford), they would have underdiscounted these cash flows, overestimated the value of the securities and swaps, and underestimated the risks on these positions.

This article is also intriguing when considered in the context of some of Bernanke’s testimony in September or October. In advocating the TARP program, Bernanke argued that the market values of mortgage securities and mortgage derivatives were far below what they were worth based on estimates of their cash flows. Bernanke (citing work by Franklin Allen and Gorton) claimed that this was evidence that there was a huge illiuqidity discount embedded in the prices, and that creating a more liquid market for them through government purchases at an auction (anybody heard any more about that, BTW?) would lead to substantial increases in market value.

Bernanke’s statements about the disconnect between cash flows and market prices sound like they were based on a model like Gorton’s/AIG’s. He obviously admires Gorton’s work. So my guess is that directly or indirectly Gorton convinced Bernanke that the low market prices of mortgage derivatives excessively discounted their cash flows. This, in turn, gave impetus to–and perhaps birth to–the TARP auction plan. Just a guess, but the dots do connect.

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