The current crisis has its roots in the transformation of the banking system, which involved two
important changes. First, derivative securities have grown exponentially in the last twenty-five years,
and this has created an enormous demand for collateral, i.e., informationally-insensitive debt. Second,
there has been the movement of massive amounts of loans originated by banks into the capital markets
in the form of securitization and loan sales. Securitization involves the issuance of bonds (“tranches”)
that came to be used extensively as collateral in sale and repurchase transactions (“repo”), freeing other
categories of assets, mostly treasuries, for use as collateral for derivatives transactions and for use in
settlement systems. As discussed above, repo is a form of banking in that it involves the “deposit” of
money on call (as repo is short-term, e.g., mostly over night) backed by collateral. The current panic
centered on the repo market, which suffered a run when “depositors” required increasing haircuts, due
to concerns about the value and liquidity of the collateral should the counterparty ‘bank” fail.8 Thisinterpretation is developed below and evidence is provided for this viewpoint. Also, see and Gorton and Metrick (2009).

Uninsured bank debt is vulnerable to panic. In the 19th century, before deposit insurance, there were
periodic real shocks which caused depositors to be anxious about their banks, described below, in which
case they would run to their banks en masse demanding cash.9 In the current period, there was a shock
in that house prices began to fall. Gorton (2008, 2009) argues that this shock to fundamentals was
revealed by the ABX index, which is linked to subprime securitization transactions and started trading in
January 2006. This is reviewed below. The panic starting in August 2007 involved firms “withdrawing”
from other firms by increasing repo haircuts. So, a “banking panic” occurs when “informationallyinsensitive”
debt becomes “informationally-sensitive” due to a shock, in this case the shock to subprime
mortgage values due to house prices falling.