Four Financial Crises in a Large Nutshell

Please forgive me for my disappearance, but I currently lack the discipline to post regularly. I’m working on it. I previously announced a post regarding financial crises in emerging markets but I would like to postpone that topic so that I might learn how to explain the regression analyses more thoroughly. I will instead offer you a summary of five four financial crises that have shaped the financial system. I originally intended to include The Great Depression of 1928, but decided to save that for a different discussion post entirely.

In the wake of the 2008 recession, many people were left wondering how it all happened and where we went wrong. Since then there has been a plethora of works on the topic from documentary movies a la Inside Job to feature films like Margin Call. Currently in print there are dozens of books on the topic and six years later, as the business cycle begins to pick up again, the world is still hungry for more answers. In the most recent issue of The Economist, the authors offer not an answer a single reference to the crisis of 2008 but offer a look at five crises that date back to 1786. Upon examination of the crises, we start to notice certain patterns such as systemic failure and moral hazard, and the roles they play in perpetuating financial risk. Though the last crisis they cover is dated 1928, because of its nature, we will not be covering it in overview but instead save it and the plethora of information for a later date.

1786: Alexander Hamilton’s Pet Project

A student of finance, Alexander Hamilton had been interested in the financial institutions of Great Britain and Northern Europe for some time. Once the United States had established its independence from the Royal Crown, Hamilton reasoned that it was time for the United States to grow… monetarily speaking. Hamilton sought to expand the financial system of the newly sovereign country in the form of the Bank of the United States (BUS). The primary goal of the BUS was to establish credit and to create a uniform standard by which to judge federal debt. The bank would also work to form a more cohesive federation. The status quo at the time had been to have several separate banks for each State, the BUS would serve to purify the convoluted waters of interstate finance with ‘One nation, and one bank’. In short, the bank would supplement the growth of the US.

From the start there were problems with the new financial institution, the main one being the open market sale of its bonds. Bonds are a promise of a future sum of money, paid with interest. In order to own a portion of the BUS, a purchase of bonds was required and seedy investors sought out to exploit this niche market. One such investor was William Duer, who would purchase bonds on credit and sell them only to reinvest in more bonds. The issue with Duer’s policy was that there was no cash investment and when investors became speculative, they began to withdraw in droves. It became apparent that Duer was embezzling and he was eventually sentenced to federal prison for his crimes, but not before stressing the need for reform in the newly developed BUS.

Hamilton wanted to protect his lasting legacy to the United States and in doing so provided the first (United States) public bailout. He quickly bought up bonds in order to raise their price in the market. He provided large amounts of liquidity to banks in the form of federal debt, with only a small amount of collateral required and refused to let firms fail for their foibles. His plan worked and the blunders of the bank were overlooked as it managed to weather the crisis. The BUS managed to stay open up until 1812, when its charter expired and congress refused to renew it.

For his financial contributions, a bronze statue was sculpted in the likeness of Alexander Hamilton on May 17, 1923 and currently sits in front of the US Treasury Building.

1825: The Latin American Crisis: Before There Were Asian Tigers.

As the Spanish empire broke apart, it left new burgeoning markets in its place. Investing in these newly sovereign countries became the trend and financiers were flocking to them like flies to honey. The rationale behind it was that since Great Britain (the safest investment in the world at the time) supported their independence, then they would logically support their financial obligations. Bonds from Peru, Colombia, Mexico, Chile, and Guatemala were selling fast as they were seen as risk free. The intuition behind it was fallibly logical, who would purchase a British bond that earned less return than a Chilean bond if both were equally rated, and seen as equally safe investments?

Investors were wrong, and these once safe investments fell victim to speculation and investors wanted out. By 1825 The Bank of England had to bail out lenders and firms at a cost to the English taxpayer. Though this crisis bailout did help soften the blow, it did not meet the demands of the entire financial system and by 1826 10% of Britain's firms and banks had gone bankrupt. Britain was in need of reform and sought to make their financial institutions large enough to not need public sector support. The end result was to allow banks that were burdened by their size (i.e. too small) to grow and expand their capital base so that in the event of another crisis they would be able to withstand the blow. English banks were now allowed to merge with one another and, in time, would become famous for being too big to fail.

1857: Discount Bonds: Discount for Who?

As investors looked elsewhere to invest their money, they found that this time around the most profitable venture was railroad stock. Railroads were seen as a safe investment because their value was not based on the present, but on the assumption that their future payoff would make up for their current deficit. Their stability was also based on lack of technological foresight.  Another major financial innovation was the creation of the discount houses in London which started out as middlemen (matching firms with lenders) but eventually grew to serve as banks themselves. The main difference between the two was that the discount houses did not have to maintain the strict 25% cash reserves that banks did. This left a lot of wiggle room for diversification on part of the discount houses, allowing them to re-invest the cash that would otherwise be sitting in a bank vault.

As railroad stock began to decline and depositors demanded their money in America, it led to a domino effect that reached the overseas markets. The illusion of safety vanished soon after and bank runs became common once more. As British banks came close to becoming completely illiquid, it was apparent that intervention was needed. Discount houses only served to make things worse as they provided credit but found that when depositors demanded their money back, their leverage ratio led to them failing along with several firms. Previously, the Bank of England had allowed discount houses the ability to borrow at will (the discount houses knew this and exploited it) but in 1858 the bank upped its borrowing policies, limiting the dollar amount that they could borrow. By tightening credit, Britain ensured that being prudent today led to a less risky tomorrow. As one can imagine, it was an unpopular decision on the financial market but this more frugal approach led to 50 years of financial calm that stripped the system of moral hazard.

At the start of the 20^th century railroad stock was seen not only as a safe investment but an investment that would last generations.

1907: Trust In No One

Prior to 1907 a new financial institution had come to prominence in the form of trust companies. Trust companies were allowed to own and manage property, distribute shares, and also take in deposits. They were the discount houses of tomorrow and the AIG of yesterday. Once again, they were banks without as stringent regulations. They only had to hold 5% of their assets in cash whereas banks had to hold a minimum of 25% and by 1907, trust companies had grown 250% to be as large as national banks. This proved problematic when of all things the penny caused a ripple effect in the American financial pond.

The crisis began when United Copper began to slow down production and the value of copper dropped domestically. The two primary investors, Augustus Heinze and Charles Morse, in order to manipulate the market and save their shares used funds from the banks they ran in order to bump up Copper stock prices. The attempt failed and it set off a chain reaction that led to several small bank runs. The market was shocked when it permeated the once reliable Trust market and led to the deposit run of the Knickerbocker Trust Company. This was followed by deposit runs of The Trust Company of America and then the Lincoln Trust. In order to prevent a systemic decline financier John Piermont Morgan realized that intervention was imminent and after much debate, provided a 25 million dollar bailout that was financed from the largest banks and businessmen of the time. The bailout worked brilliantly and proved that trickle-down economics works under ideal circumstances. Still, it had become evident that bank was needed to act as a lender of last resort and in 1913 the Federal Reserve Act did just that and set up the third central bank of America.

The Federal Reserve was established on December 23, 1913 and recently celebrated its centennial birthday.

 

Perhaps the most telling about the nature of the market, the United States has adopted the bull to represent the infamous Wall Street.

The United States financial system is a beautiful thing. It has grown and developed alongside the Unite States, and has allowed America to set the standard when it comes to financial regulation and fiscal responsibility. The only problem is that in the rush for growth and prosperity certain behaviors are glossed over, not matter how much moral hazard they present to the market. If the United States is to continue its reign as financial superpower, it is important to learn from the past and to question rapid growth and not assume that it is merely a positive market adjustment without consequence.