The Panic of 2007
I've just read a fascinating piece of economic and financial markets history - The Panic of 1907: Lessons Learned from the Market's Perfect Storm. This is from the final chapter (p. 152-153):
"The recounting of the events of 1907 suggests that the storm gathers as follows. It begins with a highly complex financial system, whose very complexity makes it difficult to for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral."
The book came out this year before any of the subprime mess was revealed but Bruner and Carr could be describing exactly what we are going through today. Have we not read that holders of complex mortgage-backed securities like CDOs are unable to determine just what it is they own? Have we not witnessed the distress of banks in the UK and Germany over the rise of foreclosures here in the US? Don't we hear that Alan Greenspan sowed the seeds of the crisis through too loose monetary policy or that Ben Bernanke lit the fuse by tightening money too much and/or too fast?
What's especially interesting is that the storm in 1907 centered on a fast-growing innovation to the financial system - the trust company - before it spread to other areas of the system. The trust company was a relatively new phenomenon in the early 20th century and they tended to have riskier portfolios of assets as they were new and not as linked to the broader financial system. Fast forward a hundred years...can anybody say "hedge funds"? There is no doubt that the riskiest pools of assets today, the newest and most innovative brand of securities such as CDOs, were to be found within the world of hedge funds. We don't have runs on banks these days, but we certainly had a run on the hedge funds. Credit strategy funds that were understood to be exposed to mortgage-backed securities or with even a whiff of poor performance saw massive redemptions. Like the trusts back in 1907, hedge funds don't have any linkages or systems to bind them together in a liquidity crisis; they are islands unto themselves and when the banks can't provide liquidity (because the collateral is so opaque) many of them went under.
In 1907, the liquidity crunch traveled to the brokerages houses too. E*Trade, anybody? In 1907 there were shady figures, like Otto Heinze, trying to game the system and they ultimately undermined all that surrounded them. Who is the Otto Heinze of today? Maybe this guy.
The parallels are stunning, at least in taking measure of the spiral down. Are there parallels in the herculean efforts that were expended to contain the crisis by the likes of J. Pierpont Morgan? Clearly there is no one figure like Morgan and the parallels are not as overt, but I would say there are some. As the muni bond market feared that the financial guaranty industry would vanish, Warren Buffett declares that his Bershire Hathaway would start insuring muni bonds. In 1907 Secretary of the Treasury Cortelyou made emergency deposits of gold into key banks, today Ben Bernanke opened wide the discount window. In 1907, the signature M&A deal that averted further deepening of the crisis was US Steel's acquisition of Tennessee Coal & Iron. You could make the case that Bank of America's rescue of Countrywide averted further damage this time around. JP Morgan's men had to make a midnight run to Washington to get a loudly anti-business president to agree to the US Steel/TC&I deal. Today, you can imagine Bob Rubin meeting with loud, protectionist Senator Chuck Schumer and asking him not to raise a stink as the Saudis and Kuwaitis invest billions into Citi and Merrill Lynch.
While history never repeats exactly, the optimistic view is that the Panic of 1907 was difficult, but faded quickly once the heroic players started taking action. By the second half of 1908, the expansion had resumed and the stock market began regaining lost ground. On the pessimistic side of the ledger, government was much less of a factor in our commercial life back then, there was little danger that the government would step in with policy that made the crisis worse. Not so today. Our government is massively larger and deeply embedded in our commercial dealings and the risk that policy attempts to ameliorate the problem will have unintended and damaging consequences is distressingly real. One thing is certain though, we probably won't have to wait 100 years to get a similar book that illuminates the Panic of 2007 as well as Bruner and Carr have done with the one in 1907.
UPDATE: Don Luskin points out another parallel. Executives killing themselves. Charles T. Barney, the President of the Knickerbocker Trust Company, killed himself in November 1907, just as the worst of the panic was passing.
"The recounting of the events of 1907 suggests that the storm gathers as follows. It begins with a highly complex financial system, whose very complexity makes it difficult to for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral."
The book came out this year before any of the subprime mess was revealed but Bruner and Carr could be describing exactly what we are going through today. Have we not read that holders of complex mortgage-backed securities like CDOs are unable to determine just what it is they own? Have we not witnessed the distress of banks in the UK and Germany over the rise of foreclosures here in the US? Don't we hear that Alan Greenspan sowed the seeds of the crisis through too loose monetary policy or that Ben Bernanke lit the fuse by tightening money too much and/or too fast?
What's especially interesting is that the storm in 1907 centered on a fast-growing innovation to the financial system - the trust company - before it spread to other areas of the system. The trust company was a relatively new phenomenon in the early 20th century and they tended to have riskier portfolios of assets as they were new and not as linked to the broader financial system. Fast forward a hundred years...can anybody say "hedge funds"? There is no doubt that the riskiest pools of assets today, the newest and most innovative brand of securities such as CDOs, were to be found within the world of hedge funds. We don't have runs on banks these days, but we certainly had a run on the hedge funds. Credit strategy funds that were understood to be exposed to mortgage-backed securities or with even a whiff of poor performance saw massive redemptions. Like the trusts back in 1907, hedge funds don't have any linkages or systems to bind them together in a liquidity crisis; they are islands unto themselves and when the banks can't provide liquidity (because the collateral is so opaque) many of them went under.
In 1907, the liquidity crunch traveled to the brokerages houses too. E*Trade, anybody? In 1907 there were shady figures, like Otto Heinze, trying to game the system and they ultimately undermined all that surrounded them. Who is the Otto Heinze of today? Maybe this guy.
The parallels are stunning, at least in taking measure of the spiral down. Are there parallels in the herculean efforts that were expended to contain the crisis by the likes of J. Pierpont Morgan? Clearly there is no one figure like Morgan and the parallels are not as overt, but I would say there are some. As the muni bond market feared that the financial guaranty industry would vanish, Warren Buffett declares that his Bershire Hathaway would start insuring muni bonds. In 1907 Secretary of the Treasury Cortelyou made emergency deposits of gold into key banks, today Ben Bernanke opened wide the discount window. In 1907, the signature M&A deal that averted further deepening of the crisis was US Steel's acquisition of Tennessee Coal & Iron. You could make the case that Bank of America's rescue of Countrywide averted further damage this time around. JP Morgan's men had to make a midnight run to Washington to get a loudly anti-business president to agree to the US Steel/TC&I deal. Today, you can imagine Bob Rubin meeting with loud, protectionist Senator Chuck Schumer and asking him not to raise a stink as the Saudis and Kuwaitis invest billions into Citi and Merrill Lynch.
While history never repeats exactly, the optimistic view is that the Panic of 1907 was difficult, but faded quickly once the heroic players started taking action. By the second half of 1908, the expansion had resumed and the stock market began regaining lost ground. On the pessimistic side of the ledger, government was much less of a factor in our commercial life back then, there was little danger that the government would step in with policy that made the crisis worse. Not so today. Our government is massively larger and deeply embedded in our commercial dealings and the risk that policy attempts to ameliorate the problem will have unintended and damaging consequences is distressingly real. One thing is certain though, we probably won't have to wait 100 years to get a similar book that illuminates the Panic of 2007 as well as Bruner and Carr have done with the one in 1907.
UPDATE: Don Luskin points out another parallel. Executives killing themselves. Charles T. Barney, the President of the Knickerbocker Trust Company, killed himself in November 1907, just as the worst of the panic was passing.
posted by Donny Baseball at 6:08 PM
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