Transcript Financial Panics

Financial Panics: 1600 - 2000
Peter Fortune
Ph.D. Harvard University
www.econseminars.com
Email: [email protected]
1
Legendary Crises
in the
17th and 18th Centuries
2
The Dutch Tulip Mania
Of 1636-37:
A Famous Non-Event
References
Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias,
MIT Press, Cambridge MA, 2000 (esp. pages 20-86)
3
 The Context
¶ The Netherlands in the 1630s
 Bubonic Plague in the Netherlands (1634-1637)\
 17% of Amsterdam died
 The National Psyche Turned To The Short Term
¶ The Botony of Tulips




Bulbs Were Planted in September, Bloomed in May
One Bulb Could Produce Several Bulbs via Buds
Exotic Bulbs Always Rare: A Known Commodity
Common Bulbs Could Become Rare if Infected
by a Specific Virus, Making Them A Perfect
Speculative Commodity
4
 The Tulip Bulb Market
¶ The Exotic Bulb Market
 Exotic Bulbs Traded in a Sophisticated Dealer Market
 Exotic Bulbs Were Traded by the Bulb
 Exotic Bulbs Were Very Expensive Both Before and After
the Tulip Mania
¶ The Common Bulb Market
 Common Bulbs Were Traded in Bulk
 Common Bulbs Traded in Taverns (“Colleges”)
 Common Bulbs Traded in a Forward Market:
Bulbs Were Bought in the Fall for Delivery in May
5
 Characteristics Of Forward Contract
¶
¶
¶
¶
No Margin Required from Buyer
No Bulb Required of Seller (Naked Contracts)
All Contracts Were for Forward Delivery
Most Contracts Cash Settled: Delivery of Actual
Bulb Was Rare
¶ Contracts Were Not Marked to Market (Limited
Lender Protection)
¶ Contracts Traded in Taverns (“Drinking Game”)
¶ Contract Trading And Prices Peaked at Height
Of The Plague (1636)
6
 Tulip Bulb Prices During The Bubble
¶ Exotic Bulb Prices
 Prices Rose Steadily Throughout 1634-1636
 Prices Remained High After 1636
¶ Common Bulb Prices
 Prices Remained Steady Until Sharp Spike in
November 1636
 Prices Fell Sharply After January 1637
7
 Effects on Dutch Economy
¶ Government Suspended Tulip Contracts in
April 1637
¶ No Evidence That Any Contracts Were
Enforced By Courts
¶ No Indications of Bank Failures
¶ The Tulip Mania Was A Non-Event
8
The French “Mississippi Bubble”
And
John Law
The First Financial Engineer
1716-1722
References
Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias, MIT
Press, Cambridge MA, 2000. (esp. pages 87-102)
Velde, Francis. 2004. Government Equity And Money: John Law’s System In
1720 France. Federal Reserve Bank of Chicago, mimeo.
9
10
 John Law
¶ A Brilliant Scottish Monetary Theorist
¶ An Iveterate Gambler, Probable Murderer, And
An International Black Sheep
¶ Peripatetic, Chased Out of Many Cities, Settled in
Paris in 1715
¶ Became Financial Advisor to the Duke of Orleans,
Regent for Louis XV After Convincing Him That A
State Bank Would Improve The Public Credit
11
 The Historical Context
¶ Louis XIV, The Sun King, Died in 1715
¶ After Versailles, Profligate Spending, and
Numerous Wars, the French Government Was
Near Bankruptcy
¶ The Economic Policies of Louis’s Finance
Minister, Jean Claude Colbert, Left the French
Economy Bound by Rigid Regulations and
Restrictive Trade Policies (“Mercantilism”)
12
The French Government’s Budget Deficit Under Louis XIV
13
 Key Elements of Law’s Monetary Theory
¶ Substitution of Fiat Money for Specie Will Allow
Increased Credit Resulting in Increased Trade
and Higher Tax Revenues
¶ Privatizing the French National Debt Will
Strengthen the Public Credit and Prevent
“Crowding Out” of Private Investment
¶ These Goals Can Be Achieved By Creating A
State Bank To Sell Shares to the Public, Use the
Proceeds to Buy French Government Bonds (A
Debt for Equity Swap), And Increase the Money
Supply by Lending and Issuing Bank Notes
14
 Formation of the Banque Generale (1716)
¶ Functions of the Banque
 Deposit And Note Issue
 Took Specie Deposits Convertible Into Bank Notes
 Made Private Loans Issuing Bank Notes In Exchange
 Investments And Asset Management
 Purchased French Government Debt at Par, Paying
In New Bank Notes
 Held Tax Farming Rights And Foreign Trading Rights
¶ Protection Of Deposits And Notes
 Initially Held High (50%) Reserves in Specie
 Value of Notes Protected Against Devaluation of
Coinage
 By 1720 the Government Prohibited Large Payments in
Specie And Made Bank Notes the Sole Legal
15
 The Banque’s Equity Structure
¶ Issued Shares to the Well Connected
 The King Was the Largest Investor
 “Society” Subscribed Heavily
¶ Shares Viewed As A Slam-Dunk—A Free Call Option
 Shares were sold via Call Option with 5,000L Strike
Price—20% Up Front, Remainder in 5 Months, with
Right to Cancel
 Payment for Shares was 25% Specie and 75%
Government Bonds at Par (Market Price was
60% of Par)
 Investors could borrow from the Banque to
Pay for Shares (“Margin Debt”)
16
 The Market For Banque Shares
¶ A High Share Price Was Essential To Banque Viability
 Shareholders Received Value Increase If Price-Earnings
Ratio on Stock Exceeded The Price-Dividend Ratio On
Government Debt That Was Tendered For Shares
 Three Sources Of High Stock Price
 Strong And Increasing Revenues From Government
Bonds Held, Tax Farming Rights, Foreign Trading
Rights, And Return On Loan Portfolio
 High Confidence In Convertibility Of Notes Into
Specie—A Run On Specie Would Deplete Reserves,
Force Sale Of Assets, And Reduce Capital
 The Banque’s Stock Repurchase Program
17
 Law’s Share Price Support Plan
¶ If Share Prices Fell Below A Threshold, The Banque
Would Engage In Stock Repurchases
 Print Notes And Buy Shares To Maintain Required Price
¶ The Inherent Contradiction
 Effect Of Share Support Would Be Increased Note
Issue
 As Notes Outstanding Grew Relative To Specie,
Noteholders Would Convert Notes To Specie
 A Run On The Banque Might Result
 The Note Issuance Would Create Inflation
 Foreign Noteholders Would Convert Notes To
Specie And Repatriate The Specie
 Credit Would Tighten In France And A Credit
Crunch Would Emerge
18
 The Banque’s Middle Stage (1717 – 1718)
¶ In 1716 to 1717 The Banks Was Wildly Successful
 Shareholders Received A 64% Annual Dividend
 The Business Model Was Confirmed
¶ In 1717 Law Formed the Compagnie d’Occident
 Purchased the Louisiana Company and the Canada Company
with All Development Rights in Canada and “Mississippi”
 IPO Was at 500L Per Share, Payable Entirely in Government
Bonds
 IPO Was Executed Via Call Option Sale, As In General Bank
¶ In 1718 The Government Nationalized The Banque
 The King Bought All Existing Shares
 Provided the King With a Printing Press
19
 The Compagnie d’Occidente Buys The Government
¶ In 1718 The Company of the West Undertook a Series
of Major Acquisitions
 Bought the Rights to All “Tax Farming” in France
 Acquired Other Trading Companies (Senegal, West
Indies, Africa)
 Was Granted the Right to Run the Royal Mint and
Receive All Seignorage (10-20% Premium)
¶ The Company Was Renamed the Compagnie des Indes
 Shares Sold For 500L At IPO
 Subscribers Coud Delay Payment And Had Right To Cancel
¶ The Company Acquired the “Royal Bank” in Feb 1720
20
 The Status Of Law’s System By Early 1720
¶ Law Had Completed an LBO of the Government
 Taken Over All Aspects of France’s Finances
 Taken over All Government Foreign Trading
Rights
 Become the Sole Issuer of Bank Notes--Which Had
Become France’s Sole Legal Tender Except for Company
Use of Specie in Foreign Transactions
¶ Use Of Banque Notes To Finance LBO Created
Excessive Note Issuance And Major Economic Problems
 Significant Inflation Began As Money Supply Exploded
 The French Livre Began To Decline Relative To Specie,
Reducing Confidence In Note Convertibility Into Specie
 The French Currency Depreciated Relative To Foreign
Currencies, Creating More Inflation And Specie Outflows
21
 The Late Stage (1720-1721)
¶ In May 1720 The Baque Experienced Runs As
Noteholders Converted To Specie
 Surge In Notes Outstanding Relative To Specie Reserves
Created Loss Of Confidence In Paper Money
 The Banque Lost Specie Reserves
 The Loss In Reserves Led To Further Conversions
 The Banque Was Forced To Sell Assets
 Asset Prices Declined, Reducing Bank Capital
 Government Delared Notes To Be The Sole Legal
Tender
 Goal Was To Prevent Conversion Of Notes To Specie
22
 In May 1720 The Company’s Stock Price Collapsed
 Initial Causes
 Profit-Taking: Share Price Had Risen To 10,000L
 Banque’s Capital Was Eroding
 Paltry Revenues From Foreign Trading Rights
 Law Implemented Stock Repurchases
 The Company Set A Repurchase Price Of 9,000L
 Stock Repurchases Added To Note Issue And
Additional Banque Problems
23
Banque Notes in Circulation Peaked in May 1720
Banque Notes in Circulation
Silver-Equiv alent Value
April 1719 to December 1720
Silver Livres Equivalent
End-of-Month
1800
1600
1400
1200
1000
800
600
400
200
0
J
F
M A
M
J
J
1719
A
S
O N D
J
F
M A
M
J
J
A
S
O N D
1720
24
The Specie-Value of Banque Notes Began Rapid
Depreciation in May 1720
25
The Company’s Stock Price Collapsed After May 1720
26
 What Went Wrong?
¶ Key Weaknesses
 Law’s Business Model Flawed
 Subscribers To Company Shares Could Pay Modest
Amount Down, Remainder Later, With Right To Cancel
 Viability Required a High Share Price But Stock
Repurchase Program Exacerbated The Economic Problems
 After Initial Success, Company Revenues Failed To Meet
Expectaions
 Banque Had Seriously Overpaid For Government Bonds
 Law’s Monetary Theory Was Wrong
 Substitution Of Fiat Money For Specie Resulted In Inflation,
Not Greater Trade
27
 The Aftermath
¶ Several Attempts to Save the Company by Converting
Banque Notes to Banque Bonds Failed
¶ Law Fled France in 1720, Died in 1729
¶ The Government Reversed the System, Converting
Banque Notes and Bonds to Government Bonds
¶ The Indies Company Was Given Additional
Monopolies and It Survived
¶ The Clean-Up Was Completed in April 1722
¶ France Prohibited the Creation of Organizations
Named “Banque,” Substituting the words “Credit” or
“Societe,” as in “Credit Agricole” or “Societe Generale”
28
Did Law’s System Create Additional Trade?
No, Its Primary Effect was on Inflation
29
 Answer An Emphatic “NO” To All Of The Following:
¶ Did Law’s System Strengthen the Government’s Credit?
¶ Did The System Create Financial Stability?
¶ Did The System Create More Production And Trade?
¶ Did The System Develop the “Mississippi” Area?
 No Significant Investments Were Made in Louisiana
 The Spanish Were Unwilling to Let France Take Away
Its Trade Routes in the Americas
30
 Lessons From The Mississippi Bubble
¶ Monetary Expansion Affects Prices More Than Trade
¶ The Risk of Low Bank Cash Reserves – The Banque’s
High Ratio of Notes Outstanding to Reserves
Exposed It To Runs
¶ The Risk of “Reputational Put Options” – The
Company’s Efforts to Set a Floor on Its Stock Price
via Buy-Backs Contributed to Its Weakness
¶ The Risk of High Leverage – The Company Had High
Indebtedness And Its Capital Was Easily Threatened By
Declines In Asset Prices
All Of These Have Re-Emerged In Later Financial Crises!
31
The English South Seas Bubble
Laws’s System Redux
Reference
Garber, Peter. Famous First Bubbles: The Fundamentals of Early Manias, MIT
Press, Cambridge MA, 2000.
32
 The Background
¶ 1711 - The South Seas Company Is Formed to
Develop Trade With The East Coast of South America
 Gold and Silver in Spanish Americas: Mexico, Peru, Chile
 Spain was Expected to Allow English Trade Presence In
The “South Seas”
 Spain Allowed Only One Vessel Per Year, Demanding
25% of Profits and a Tax of 5% On Remainder of
Profits
 First Vessel Not Sent Until 1717 But Spain Allowed
No More
 Even So, The Company’s Shares Remained Strong
33
 The Government Captures The South Seas Company
¶ In 1717 the King, Impressed by The Apparent Success
Of Law’s Scheme, Proposed Refunding the Public Debt
 South Seas Company and Bank of England Both Invited to
Propose Plans to Sell Shares and Buy Government Debt,
Then Renegotiate Debt With Government
 The Company Embarked on Extensive Bribery of
Parliament to Obtain Favorable Terms
 After Lengthy Debates, the South Sea Company Won
the Contract
 The First Act Allowing Refunding Passed Parliament in
March 1720
 Investors Could Covert Government Bonds to South
Seas Shares, Bonds, and Cash at Par—About Twice
The Market Value Of Government Bonds
34
A Surge in Speculation on South Seas Shares Began
35
 The End
¶ The Speculation Resulted in Formation of
Numerous “Bubble Companies,” Many of Them
Scams
 Parliament Passed “Bubble Act” In June 1720 to
Prevent Competition With The Company
 Shares of Bubble Companies Fell, Forcing Margin
Calls and Sales of Shares in “Good” Companies
 A Liquidity Crisis Emerged In Which The South Seas
Company’s Shares Were Dragged Down
36
The U.S. Monetary System 1870 – 1936
Essential Background Information
Reference
Friedman Milton. Money Mischief: Episodes in Monetary History, Harcourt Brace &
Co., New York, 1994. (esp. pages 51-79)
37
 Bimetallism Before 1870
¶ Until 1873 Most Of The World Was On A
Bimetallic Monetary Standard
 Both Gold and Silver Were Legal Tender
 The Mint Would Buy or Sell Silver at a Silver-Gold
Ratio of 16 Ounces of Silver to 1 Ounce of Gold
 The U.S. was Effectively on a Silver Standard
Before the 1870s Because the Silver-Gold Market
Price Ratio Exceeded the Mint Parity of 16:1
¶ The Problem Of Bimetallism
 When Gold-Silver Market Price Deviated From
16:1, One Metal Would Be Hoarded, The Other
Used For Payments
 Gresham’s Law”: Bad Money Drives Out Good
Money
38
 The Rise Of The Gold Standard
¶ Prior To 1870 Bimetallism Prevailed
 Every Country Set A Mint Ratio (Usually 16:1)
 Mint Would Exchange 1 oz. of Gold For 16 oz. of Silver
 1 oz. Gold = $20.64 => 1 oz. Silver = $
¶ The Start of The Gold Standard
 Germany Won The Franco-Prussian in 1871
Germany Levied Reparations on France Payable in Gold
Germany Then Went on a Gold Standard
In 1873 The U.S. Went On The Gold Standard
By 1900 All Western Countries Had Demonetized Silver
And Adopted a Gold Standard
 China and Other Asian Countries Adhered to a Silver
Standard

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
39
 The U.S. Goes To Gold
¶ Fourth Coinage Act of 1873 (The Crime Of ’73)
 Ended Purchases of Silver by U.S. Mint
 Created A Gold-Based Currency and U.S. Adherence to an
International Gold Standard at 1 oz. = $20.64
 Resulted in a Decline in Silver Prices and Economic Difficulties
in the Western U.S.
 Called “The Crime of ’73” by Western “Silverites”
 Shaped the Political Debate for 30 Years, for example, Bryan’s
“Cross of Gold” Speech in 1896
 Had U.S. Stayed on a Silver Standard, the Depression of the
1890s Might Have Been Mitigated
 Dollar Would Have Depreciated Relative To Gold Area
 Periodic Gold Outflows That Troubled The Economy Would
Not Have Occurred
40
The Gold Standard after 1873
41
 The Pros And Cons Of The Gold Standard
¶ Positive Aspects Of Fixed Exchange Rates
 No Exchange Rate Risk
 Easy to Compute Prices of Foreign Goods
 International Lending Less Risky
 Encourages “Globalization” of Trade and Finance
 Reduces Possibility of Prolonged Inflation
¶ Cons
 Limits Control Over Domestic Money Supply
 Links International Economies Together—Booms
and Busts Quickly Transmitted Abroad
 Can Promote Economic Instability When Policies in
Different Countries Aren’t Synchronized
42
The U.S. Monetary Framework Under the Gold Standard
43
44
19th and Early 20th Century Monetary Crises
The Panic of 1893
The Panic of 1907
45
The Panic of 1893
References
46
 The Ecnonomic Context
¶ Railroad and Steel Consolidations
 Declining Rail Tariffs led to Increased Competition,
Especially For Short Haul Routes
 JP Morgan Led a Railroad Consolidation Movement
 Morgan Formed U.S. Steel, A Consolidation of CarnegieRelated Steel Companies
¶ Declining Commodity Prices
 Western Farmers Under Pressure As Ag Prices Fell
 Silver Prices Declined in Utah and Nevada
 Coalition of Western Senators Pushed for Increased
Credit From Eastern Banks and Return to Bimetallism
47
 The Monetary Context
¶ Supply of Bank Notes Was Linked to Gold
Reserves at Banks And The U.S. Treasury
(High-Powered Money)
¶ Predictable Credit Cycle Associated with Crop
Harvests
 Bank Notes And Gold Moved Westward as Farmers
Borrowed In The Fall Planting Season
 Gold Imports Rose as Eastern Banks Borrowed
Abroad in The Fall To Finance Farm Credit
 A Regular Credit Crunch in Fall—Interest Rates
Would Rise As Credit Demands Rose
48
 The Triggers
¶ Sherman Silver Purchase Act of 1890
 Required U.S. Treasury to Buy 4.5M Ounces of Silver
Monthly Using Silver Certificates (Bank Notes
Convertible Into Silver)
 Created Foreign Fears That U.S. Would Abandon the Gold
Standard—Lending to U.S. Fell Sharply and Gold Flowed Out
of Country
 Reduction in Treasury’s Gold Reserves Created Incentives to
Convert Gold Certificates into Gold for Non-Monetary Uses
 Treasury Suspended Convertibility of Gold Certificates
 Result Was A Severe Credit Crunch as Bank Lending Fell
 The Sherman Act Was Suspended in 1893
49
 The Economy In The Early 1890s
¶ Continued Decline of Agricultural Prices
Bumper Crops in U.S.
 Farm Loans Defaulted in Midst of Prosperity
 Farmers Reduced Purchases
¶ Important Industrial Company Failures
 Philadelphia and Reading Railroad
 National Cordage Company
 Many Banks (Mostly Western)
¶ Labor Strikes
50
 The Economy After 1893
¶ The 1890’s Had Several Money-Related Episodes
¶ Unemployment Remained High Throughout the
Decade
¶ The 1896 Campaign Was Between the Easy-Money
“Silverites,” Led by Bryan, and the Hard-Money
Gold Standard Advocates led by McKinley
¶ The Debate Over The Gold Standard Continued For
51
The Economy After 1893
U.S. Unemployment Rate
1890 - 1900
14
Percent of Labor Force
12
10
8
6
4
2
0
1890
1891
1892
1893
1894
1895
1896
1897
1898
1899
1900
52
Interest Rates In 1890-1910
53
The Panic Of 1907
References
Bruner, Robert and Sean Carr. The Panic of 1907: Lessons Learned from the
Perfect Storm, John Wiley & Sons, Hoboken NJ, 2007.
Tallman, Ellis and John Moen. “Lessons From The Panic of 1907,” Economic
Revew, Federal Reserve Bank of Atlanta, 1990.
54
 The Players
¶ Commercial Banks
 National Banks in Money Centers Could Hold Treasury
Deposits
 Rural Banks Held 25% of Deposits in Reserves—40%
Cash And 60% In Deposits at Reserve City Banks
 Reserve City Banks Held 25% of Deposits in Reserves—
50% Cash and 50% in Deposits At Major Money Center
Banks
 Money Center Banks Provided Services to Lesser
Banks—Check Clearing, Currency and Coin
 Money Center Banks Provided Security Credit to
Brokerage Companies Which Made Margin Loans to
Stock Investors
55
 The Players
¶ The Trust Companies
 Tended Toward More Aggressive Investments Than Banks
 More Lightly Regulated Than Banks
 Provided Deposits Like Banks
 No Reserve Requirements Before 1906
 15% Reserve Requirements Imposed in 1907—
33% In Cash
56
 The Players
¶ The New York Clearing House (NYCH)
 Cleared Checks for Money Center, Reserve City, and
Rural Banks
 Made Net Payments at End of Day
 Provided Loans if a Bank’s Balances at NYCH Were
Insufficient
 Served as the Lender of Last Resort
¶ The New York Stock Exchange (NYSE)
 Member Firms Traded Stocks
 NYSE Responsible For Clearing (Settlement)
 Member Firms Borrowed from Money Center Banks to Make
Margin Loans to Customers
 NYSE Provided Loans To Members With Insufficient
Balances to Meet Net Payments
57
 The Economic Context
¶ A Deteriorating Economy
 Stock Prices Down 8% Sept ’06 to Feb ’07
 Stock Decline Accelerated in March ’07
¶ Gold Outflows After Britain Prohibited “Finance Bills”
 Finance Bills Were Loans to U.S. to Speculate Against the
Pound—Borrow Sterling, Buy Dollars
 Gold Outflows Reduced Bank Reserves and Bank Lending
 Interest Rates Increased
¶ Tight Money Was Compounded by Annual Fall Credit
Demand Associated With Agricultural Harvests
58
 The Triggers
¶ Stock Manipulation: A Short Squeeze on United
Copper Company Shares
 Otto Heinze (Heinze & Co. Broker), F. Augustus Henize
(President, Mercantile Bank), and Charles Morse (Chairman,
Mercantile Bank) Believed that There was a Large Short
Position in UCC Shares
 Hatched Plan for a Short Squeeze—Buy UCC Shares on
Margin, When Short Sellers Try to Cover The Heinze-Morse
Group Would Profit From Price Spike
 Problem: UCC Price Increase Was Not Due to Short Positions
But To Copper Supply Restrictions By a UCC Competitor
 Heinze Tried to Force Shorts to Cover by Requiring Return of
Group’s Shares That Had Been Loaned to Short Sellers
 Instead, UCC Price Fell When Competitor Returned to Normal
Copper Production
 Heinz Bros. Faced Margin Calls When UCC Price Weakened
59
 The Triggers
¶ Consequences of the Failed Short Squeeze
 In Mid-October, 1907 UCC Shares Plunged as UCC
Owners Sold Heavily—Liquidity Disappeared
 Heinze Bros. Defaulted on Margin Loans, Forcing
Brokers Into Default on Bank Loans from Mercantile Bank
 Heinze & Co. Was Suspended by NYSE; Mercantile Bank Fired
Augustus Heinze
 A Run on Mercantile Bank Began; Its Cash Was Drained and
It Was Unable to Repay Loans or Redeem Checks
 NYCH Concluded that Mercantile was Solvent and Decided to
Lend to It To Restore Payments
 A General Banking Panic Was Averted by NYCH Intervention
and by Redeposit of Mercantile Withdrawals at other NYC
Banks
60
 Development of A General Panic
¶ The Early Stages
 Knickerbocker Trust Fires its President, Perhaps Guilt by
Association with Heinze-Morse; Confidence in Knickerbocker
Weakens
 National Bank of Commerce Refuses to Clear Checks for
Knickerbocker
 A Run on Knickerbocker Begins, both Retail and Wholesale
 Call Money Rates Rise Sharply, Forcing Stock Sales and Margin
Loan Defaults
 Bank Runs Begin at Other Trust Companies
 As Money Center Banks Weaken, Reserve City and Rural Banks
Experience Runs
 J. P. Morgan Determines that Knickerbocker Can Not Be Saved
61
 Development of A General Panic
¶ J. P. Morgan Personally Intervenes
 Doubts About NYC Credit As European Investors
Withdraw and Uncertainty Rises About Safety of NYC
Deposits at Banks
 Morgan Calls Meeting of Financial Leaders: Benjamin
Strong, JPM’s Assistant; George Perkins, JPM’s Partner;
James Stillman,National City Bank; George Baker, National
City Bank; Other Bank and Trust Company Presidents
 Group Organizes Pool to Make Loans to Trust Companies
(JD Rockefeller Pledges $50M)
 Pool Temporarily Helps, But Stock Market Begins to Tank
 NYCH Issues Clearing-House Certificates—IOUs That Banks
Can Use in Clearing Checks
 Morgan Invests Heavily in NYC Bonds to Prevent Collapse
62
 Continuation Of The General Panic
¶ Problems Continue into November
 Trust Companies Still Under Pressure
 On Nov 2 Morgan Calls Trust Company Presidents to His
Office and Locks Them In Until They Agree to a SelfSupport Fund
 Trust Companies Subscribe to a $25M Pool to be Used
for Loans to Weaker Trust Companies
 A Major Brokerage Company in Near-Bankruptcy for
Cash-Flow Reasons is Rescued By Morgan, who
Arranges via Henry Frick for US Steel to Buy Its
Holdings of a Coal Company
 With This, the Worst Was Over!
63
 Lessons from the 1907 Panic
¶ Weaknesses of the Financial System
 The US Financial System Had No “Lender of Last
Resort”-Reliance on People Like Morgan To
Organize Support Was a Weak Reed to Lean On
 The Currency in the U.S. was Inelastic—Gold
Outflows and The Harvest-Related Demand for
Credit Had Demonstrated the Need for an Elastic
Currency
 The Banking System’s Connection to the Stock
Market Via Margin Loans to Brokers was a Weak Point
¶ Led To The Federal Reserve Act Of 1913
64
 The Federal Reserve Act Of 1913
¶ Major Features Of The Act
 Created a Lender of Last Resort: Provided Loans to Banks
by Discounting Commercial Bills at the Discount Rate
 Supervised Banks to Ensure Adequate Capital and Asset
Quality
 Limited Currency to Federal Reserve Notes No More than
4 Times Gold Stock at Fed
 Held Bank Reserves as Deposits at Fed
 Established and Monitored Required Reserve Ratios
 Established 12 Regional Banks Following the Reserve City
Classification as Model
 Centralized Authority in the Board of Governors in DC
 Act Was Amended 1934 to Set Margin Requirements
65
Financial Collapses
In The
Great Depression
1929-1933
66
The 1929 Stock Market Crash
Reference
Galbraith, Kenneth. The Great Depression,
67
 The Context
¶ Significant Rise in Stock Prices IN 1920s
 The Bubble Was Largely In New Technology Stocks (Radio,
Electric Utilities, Automobiles)
 Widespread Public Participation
 Easy Broker-Dealer Margin Credit
(10:1 debt/equity reported; 4:1 more realistic)
¶ The Triggers
 Federal Reserve Concern About Margin Loans
 Warning Letter to Banks in Late 1928
 Discount Rate Increase from 1.5% to 5% During
Jan-July 1929
 GNP Peaked in September 1929
 Stock Market Peaked On September 3; DJIA = 381.17
68
The 1929 Stock Market Crash
 The Crash
¶ The Sequence
 From September 3 To Friday October 25 The DJIA Fell
By 21 %
 On Monday, October 28, And Tuesday, October 28, The
DJIA Fell By An Additional 23.6%
 The DJIA Did Not Reach Its October 25, 1929 Level
During the Decade
¶ Why The Sharp Selloff?
 Forced Liquidation Due To Margin Calls By Brokers And
Loan Calls By Banks
 Anticipation Of Defaults On Non-Security Bank Loans
 General Fear And Panic
69
The 1929 Stock Market Crash
70
 Did The Crash Cause the Great Depression?
¶ The Yes Vote
 The Crash Destroyed Confidence
 The Crash Reduced Consumers’ Wealth, Hence
Discouraging Spending On Consumers’ Goods, Particularly
Durables
 The Crash Discouraged Business Investment
 By Raising The Cost Of Equity Capital
 By Reducing Consumer Spending
¶ The No Vote
 A Serious Recession Was Already In The Works
 The 1920s Consumer Spending Boom Was At An End
 The Auto And Utility Boom Was At An End
 The Stock Market Is Forward-Looking And The Crash
Reflected Anticipations Of A Serious Recession
 The Depth and Length Of The Depression Was Due To Bank
Failures, Bad Policies, And Non-Stock Market Factors
71
Overview Of
The Great Depression
Reference
72
Overview Of The 1930s: The Real Picture
73
Overview Of The 1930s: The Financial Picture
74
Overview Of The 1930s: The Stock Market
75
The Banking Panics Of 1930-1931
References
Friedman, Milton and Anna Schwartz. A Monetary History of the United States,
Princeton University Press, Princeton NJ, 1962. (esp. pages 308-332)
76
 The Context
¶ Economic Environment




Stock Market Crash (Oct 1929)
Smoot-Hawley Tarriff (June 1930)
Real Interest Rates Rose Very Sharply, by at least 10%
During 1930 GNP and Prices Dropped by 10% and 2.5%,
Respectively
¶ Borrowers Experienced Difficulty Paying Principal and
Interest on Bank Loans, Especially in Midwest
 Non-Paying Loans at Banks Increase Sharply in November
 Capital at Banks Was Seriously Impaired, Forcing Reduction
New Loans Loans
 Internal Drains from Bank Reserves to Gold Outside Banks
And Interior Banks
 Shift Assets Toward Cash To Build Liquidity
 Bank Loans Contract Sharply
77
 The Unfolding Of The 1930-31 Banking Panics
¶ The First 1931 Banking Panic
 A Major Credit Crunch Occurred: (Oct 1930 - Feb 1931)
 Bank Asset Values, Capital, And New Loans Fell Sharply
 The Real Short Term Interest Rate Rose Sharply
 The First 1931 Banking Panic Eased By February 1931
¶ The Second 1931 Banking Panic
 Bank Failures in Austria and Germany In May, 1931
 Led To Shift Into Dollars And Gold Inflows to the U.S.
 Gold Inflows To The U.S. Initially Helped U.S. Banks
 Deposits At Foreign Banks Were Frozen
 Foreign Bank Failures Led to Sympathetic Runs on
Domestic Bank Deposits
 Internal Gold Drains Forced Banks To Sell Assets And
Impaired Bank Capital
78
 The Third 1931 Banking Panic
¶ Britain Faces Large Gold Flows to the France and
Leaves The Gold Standard in September, 1931
 A Speculative Attack On U.S. Gold Reserves Begins
 U.S. Gold Outflows Led to Further Declines in HighPowered Money and Additional Pressure on Bank Credit
 U.S. Bank Failures Rose Sharply
79
 The Economy In 1931
¶ Financial Markets
 A Flight To Quality Reduces Treasury Bond Rates And
Increases Rates On Corporate Bonds
 The Rise in Interest Rates Combined With Continuing Falls
in the Price Level Kept Real Interest Rates High
 Reduced Bank Credit and High Real Interest Rates
Contributed to Further Economic Malaise
¶ The Economy
 The Price Level Fell by 9% From 1930 To 1931
 Real GNP Declined by 15%
 Employment Declined by 9%
80
 Federal Reserve Actions in 1931
¶ Actions To Increase Bank Reserves
 Loaned Heavily to Banks Through the Discount Window
 Did Not Engage In Open-Market Operations
 Did Not Restrictions on Bank Withdrawals, so Bank Runs
Were Not Contained by Inconvertibility
 Efforts Were Insufficient To Increase Money And Credit
¶ Why Minimal Fed Action?
 Did Not Yet Understand the Impact and Effectiveness
Of Fed Purchases of Securities (Death of Benjamin
Strong in 1929)
 Thought That Its Primary Tool Was The Discount Rate,
Which Was Very Low
 Did Not Understand That It Is Real Interest Rates That
Determine Spending, Not Nominal Interest Rates
81
 Policy Actions During 1932
¶ Major Financial Legislation
 Formed The Reconstruction Finance Corporation (RFC) to
Make Treasury Loans to Banks; Eventually RFC Bought
Preferred Stock Of Troubled Banks
 Formed The Federal Home Loan Bank to Make Loans to
Mortgage Lenders on First-Mortgage Collateral
¶ Federal Reserve Actions
 First Open-Market Purchases Begin in July, 1932
 Thereafter, Discounting and the Discount Rate
Began to Fade in Use
¶ The Economy Began to Strengthen and Real Interest
Rates Fell
82
The Banking Panic Of 1933
83
 The Context
¶ In Late 1932 A Wave of Bank Failures in the West and
Midwest Led To Another Period of Bank Runs
 The New Government Institutions (RFC, FHLB) Were
Insufficient To Maintain Confidence
 Federal Reserve Discounting and Open-Market Operations
Did Not Provide Sufficient Liquidity
¶ Pressures on Interior Banks Created Internal Drains In The
Form Of Losses of Gold (Reserves) At Reserve City Banks
¶ A Wave of Bank Holidays Began
 Bank Holidays Were Initiated By States
 Bank Holidays In One State Led to Runs In Other States.
 By March, 1933 About Half Of The States Had Initiated
Bank Holidays
84
 External Drains Add To Banking Collapse
¶ Fears That The U.S. Would Be Forced To Devalue As Gold
Reserves Were Drained From Banks Led To Foreign Runs
On U.S. Banks
 The Fed Followed The Classic Central Bank Rule Of
Protecting The Gold Standard: It Raised The Discount Rate
To Increase U.S. Interest Rates
 No Open-Market Purchases Occurred
¶ New York’s Governor Lehman (déjà vu) Declared A Bank
Holiday After Reserves at New York Banks Fell Below
Legal Limits
¶ Unemployment Rate Peaks At 25%
85
Government Actions Under FDR
 Securities Legislation
¶ Securities Exchange Act Of 1933
 Required Registration Of Investment Advisors
¶ Securities Exchange Act Of 1934
 Required Full Disclosure Of Material Facts
 Required Registration Of New Security Issues
 Established the Securities Exchange Commission (SEC)
¶ Investment Company Act Of 1940
 Regulated Investment Companies (Mutual Funds)
86
Government Actions Under FDR
 Banking Legislation
¶ Bank Act Of 1933 (Glass-Steagall Act)
 Separated Investment Banking, Insurance, and
Commercial Banking
 Established The FDIC To Insure Bank Deposits And
Prevent Bank Runs
87
Government Actions Under FDR
 Industrial And Labor Legislation
¶ National Industrial Recovery Act (June, 1933)
 Gave President Broad Authority To Regulate Businesses
 Created National Recovery Administration (NRA)
 Established Floors On Wages And Prices By Industry
 Established Detailed Regulations On Businesses
 Guaranteed Right To Collective Bargaining (Title 1)
 Created National Labor Relations Board
 Prohibited Unfair Labor Practices
 Established Rules For Collective Bargaining
88
Government Actions Under FDR
 Legacy Of The NIRA
¶ Contributed To Depth Of Depression
 Excessive Bureaucracy--Detailed Regulations Added To
Business Costs
 Wage-Price Fixing Added To Depth Of Depression
 Employment Dropped 25% In First Six Months
¶ Title 1 Of NIRA Found Unconstitutional In May, 1935
89
Government Actions Under FDR
 National Labor Relations Act Of 1935 (Wagner Act)
¶ Affirmed Labor Relations Features Of NIRA




Right To Collective Bargaining
Renewed The National Labor Relations Board
Established Criteria For Union Formation
Established Procedures For Union Elections
90
Government Actions Under FDR
 FDR Ends The U.S. Gold Standard In 1936
¶
¶
¶
¶
Gold Outflows Since 1931 Had Impeded Recovery
Prohibited Sales Of Gold To Foreign Entities
Ended Internal Convertibility Of Gold (“Privatized Gold”)
Negated Gold Clauses In Contracts)
91
Modern Financial Crises
The 1987 Stock Market Crash
The S&L And Junk Bond Episode
The Enron Debacle
92
The Stock Market Crash Of 1987
Reference
Lowenstein, Roger. The Origins of the Crash: The Great Bubble and its Undoing,
Penguin Press, New York, 2004.
93
 The Context
¶ Several Years of Above-Average Stock Price Increases
 Started After The Reagan-Volcker Recession in 1982
 Further Encouraged By Oil Price Collapse In Mid-1980s
¶ Possible (But Unlikely) Triggers
 No Specific Macroeconomic, Financial, Or Foreign Events
 Rising Interest Rates Begin To Bite—30 Year Treasuries
Reached the “Magic” 10%
 Dow-Jones Industrial Average Had Peaked on August 17
 Legislation Limiting Tax Advantages Of Mergers
 Market Poised To Crash--Between Peak on August 17 And
October 15 The DJIA Had Fallen 500 Points
¶ On October 16 The DJIA Fell By 23% (500 Points)
94
The Event: The 1987 Stock Market Crash
95
 What Happened? Financial Innovation
¶ Development of Index Futures, Stock Options and
Synthetic Options
 Examples
 Portfolio Insurance Strategies
 Index Arbitrage Through Cash-Futures Transactions
 Problems
 Created Illusion of Hedges Against Risk of Complex
Instruments
 Incomplete Hedges Induce High Volume Of Transactions
¶ Development of Computerized Trading (DOT)
 Instantaneous Order Transmission When The Cash-Futures
Relationship Is Out Of Line (Index Arbitrage)
 Triggered Massive Order Volume
96
 What Happened: Problems On The Trading Floor
¶ Specialists On The NYSE Took a Walk
¶ Information Overload
 Overwhelmlng Volume Of Orders
 Long Delays In Printing Confirmations-Customers
Didn’t Know If Orders Had Been Executed
 Led To Multiple Sell Orders
 Stale Prices
 Long Delays In Reporting Trade Prices—Customers
Had Out-Of-Date Price Information
 Created Inverted Futures-Cash Price Relationship,
Inducing Cash Market Sales
97
 What Happened: Disconnects Across Related Markets
¶ Cash vs. Futures Relationship
 Cash Markets Closed But Options And Futures Markets
Remained Open
 The Panic Depressed Futures Prices But Cash Prices
Were Stale
 Result Was Strong “Phantom” Sell Signal In Cash
Markets
98
 Lessons Learned
¶ In A Panic, Everyone Tries To Exit At Once
 Offers To Sell Surge, Bids Dry Up
 Prices Free Fall
¶ Markets Are Highly Interconnected
 The Futures Market Rapidly Transmitted The Effects of
Bad Information And Exacerbated Sell Orders In The
Cash Market
¶ Technology Is A Double-Edged Sword
 Electronic Trading (DOT) Transmitted Problems Quickly
 Mixed Technology (Old Paper Trading On NYSE, New
Electronic Trading In Futures) Can Add To Problems
 New Instruments (Derivatives Like Stock Index
Futures) and New Methods (Portfolio Insurance) Can
99
Compound Problems
The Savings & Loan
And
Junk Bond Crises
1989
References
Bruck, Connie. The Predator’s Ball: The Inside Story of Drexel Burnham and
the Rise of the Junk Bond Raiders, Simon & Schuster, New York, 1988.
100
 The Context
¶ S&L Institutions Had Limited Financial Opportunities: They
Borrowed Short-Term (Deposits) And Made Long-Term
Loans (Mortgages)
¶ In The 1970s and 1980s Interest Rates Rose, With Short
Rates Rising Faster Than Long Rates
¶ The Rise In Short Rates Led To A Loss In Deposits
And Forced Sales of Mortgages (Regulation Q)
¶ The Rise In Long Rates Led To Declines In Asset Values
And Deterioration Of Capital
¶ As S&L Balance Sheets Deteriorated, And Liquidity
Problems Increased, The S&L Industry Became Unviable.
101
 The Advent Of Junk Bonds
¶ Milken Sees That Below-Investment-Grade Bonds Earn More
Than High-Rated Bonds After Adjusting For Defaults
¶ Drexel, Burnham, Lambert Creates A Market For Junk
Bonds
 Junk Bonds Allowed Smaller Companies To Get Access To
Long-Term Financing
 S&Ls Bought Junk Bonds On A Large Scale As A
Way To Diversify Beyond Mortgages and Get High
Returns
102
 The Policy Responses
¶ Laws Were Changed To Allow S&Ls To Broaden Their
Assets Beyond Mortgages to Shorter-Term Loans, and
Liabilities Beyond Deposits To Longer Term Debt
(Garn-St. Germain 1982)
¶ The FHLBB Turned A Blind Eye To S&L Portfolio
Problems And To Insolvency
 Created “Good Will Certificates” That S&Ls Could
Carry On Their Books As Assets
 Made Loans To S&Ls To Bolster Liquidity
¶ These Responses Perpetuated The Problems
103
 What Went Wrong?
¶ S&Ls Invested Heavily In Bad Loans
 Oil Prices and Home Prices Broke In The Mid-1980s
 Lack of Familiarity With New Lending Opportunities
 Scandalous Abuses In S&L Investing: The Keating
Episode
 Mortgage Foreclosures Increased And S&Ls Began
Failing, First in The South Then Elsewhere
104
105
 Resolution
¶ Financial Institution Recovery Program (FIRREA-1989)
 Forced Insolvent S&Ls to Fail Or Be Bought By
Stronger Institutions
 FDIC Pays Depositors of Failed S&Ls And Acquires S&L
Assets
 The FHLBB Is Dissolved And The Office Of Thrift
Supervision (OTS) Is Formed To Regulate All Thrift-Type
Institutions (S&Ls And Mutual Savings Banks)
 Resolution Trust Company (RTC) Is Formed to Sell
Foreclosed Homes And Other Assets Acquired From
S&Ls
 RTC Sold Junk Bonds Acquired From S&Ls, Causing
Collapse Of Junk Bond Market
 RTC Dissolves in 1993 After Cost To Taxpayer Of
106
$150-$300 Billion
Long Term Capital Management:
The First Hedge Fund Failure
1998
Reference
Lowenstein, Roger. When Genius Failed: The Rise and Fall of
Long Term Capital Management, Random House, New York, 2000.
107
 Formation Of Long-Term Capital Management
¶ Formed in 1994 By John Merriwether (ex-Solomon
Brothers) And Two 1997 Nobel Prize Winning
Economists, Myron Scholes And Robert Merton
 Traded In Currencies, Fixed Income Instruments,
Equities, And Anything Else
 No Disclosure Of Positions To Clients Or Public
 Had Outstanding Performance Until 1998, When It Hit
The Wall
108
 LTCM’s Trading Strategies
¶ Convergence Trades
 Positions In Very Close Substitutes Whose Prices Are
Out Of Line
 Example: Long On “Off-The-Run” Treasuries (less liquid,
lower price), Short On “On-The-Run” Treasuries
 Profit When Prices Of On-The-Runs Fell Relative To
Off-The-Runs
 Perfectly Hedged Against Interest Rate Changes
¶ Equity-Paired Trades
 Long On Some Equities, Short On “Equivalent” Equities
 Example: BP and RDS
 Market-Neutral Position: Hedged vs. Market
Movements
109
 LTCM’s Trading Strategies
¶ Debt-Paired Strategies
 Long On Treasuries and Short On High-Yield (Junk) Bonds
 Profit When Credit Risk Premium Falls
 Hedged Against Interest Rate Changes
 LTCM Had Very High Leverage
 Small Margins On Each Position Required Many Large
Positions In Play
 Debt:Equity Ratio Of About 100:1
 VERY Exposed To Any Losses
110

What Went Wrong?
¶ International Financial Crises In 1998
 Asian Financial Crisis
 Russian Default On Government Bonds
¶ Flight To Quality Occurred
 Interest Rates On High-Yield Corporate Debt Rose
While Treasury Yield Fell, Creating Capital Losses Both
Sides Of Hedge
 Other Hedges Also Failed
111
 What Went Wrong?
¶ LTCM Had Very High Leverage

Small Margins On Each Position Required Many Large
Positions In Play
 Debt:Equity Ratio Of About 100:1
 VERY Exposed To Any Losses
 Banks Called Loans To LTCM
 Forced LTCM To Sell Into Markets With No Bids
 Asset Price Declines Wiped Out LTCM Capital
 LTCM Bankruptcy Threatened Capital Base At Major
Banks
 Systemic Risk: Potential For Bank Failures And Credit
Lock-Up
112
 Resolution
¶ Shades Of J.P. Morgan In 1907!
 President Of FRBNY Calls All Involved Banks To A
Meeting
 Urged Them To Work Out Plan To Extend Credit To
LTCM While Its Portfolio Is Being Liquidated
 Banks “Agree”
¶ LTCM Liquidated Gradually
 Banks Were Fully Paid
 LTCM Management Made Profits For Clients
And Themselves
 No Losses To Public Treasury—No Bail-Out
113
The Enron Debacle
2001
Reference
McLean, Bethany and Peter Elkind, The Smartest Guys In The
Room: The Amazing Rise and Scanalous Fall of Enron,
Penguin Group, New York, 2003.
114