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March 31, 2020April 1, 2020

Lessons from the Panic of 1907

I have read The Panic of 1907 (by Robert Bruner & Sean Carr) four or five times — I read it at every market crash.

The crash occurred more than 100 years ago and is one of many banking crises that beset the United States in the 19th and early 20th century. What made 1907 stand out is that the financial system was saved by the leadership of a private individual, John Pierpont Morgan, head of the banking firm that later became known as J.P. Morgan & Co. Without the 70-year old Morgan’s force of will, the entire financial system would have imploded.

John Pierpont Morgan – source: Wikipedia

The crisis led to formation of the Federal Reserve Bank in 1913. The US had not had a central bank since President Andrew Jackson withdrew the charter for the second Bank of the United States in 1837. Bank clearing houses prior to 1913 were private arrangements created by syndicates of banks and were poorly-equipped to deal with the challenges of a banking crisis.

The lessons of 1907 are still relevant today. The authors of the book suggest that “financial crises result from a convergence of forces, a ‘perfect storm’ at work in financial markets.”

They identify seven elements that converged to create a perfect storm in 1907:

Complex Financial Architecture makes it “difficult to know what is going on and establishes linkages that enable contagion of the crisis to spread.”
Buoyant Growth. “Economic expansion creates rising demands for capital and liquidity and ….excessive mistakes that eventually must be corrected.”
Inadequate Safety Buffers. “In the late stages of an economic expansion, borrowers and creditors overreach in their use of debt, lowering the margin of safety in the financial system.”
Adverse Leadership. “Prominent people in the public and private spheres implement policies that raise uncertainty, which impairs confidence and elevates risk.”
Real Economic Shock. “Unexpected events hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors.”
Undue Fear, Greed and other Behavioral Aberrations. “….a shift from optimism to pessimism that creates a self-reinforcing downward spiral. The more bad news, the more behavior (erupts) that generates bad news.”
Failure of Collective Action. “The best-intended responses by people on the scene prove inadequate to the challenge of the crisis.”

Compare these seven elements to the current crisis in March 2020:

Complex Financial Systems

The global financial system is far more complex than the gold-based financial system of 1907. Regulation has not kept pace with the growth in complexity, with many products designed to avoid regulation and lower costs. The ability to build firebreaks to stop the spread of contagion in unregulated or lightly regulated areas of the financial system is severely limited. And that is where the fires tend to start.

In 1907 the fire started with poorly regulated trust companies that dominated the financial landscape: making loans, receiving deposits, and operating as an effective shadow-banking system. A run on trust companies threatened to engulf the entire financial system.

In 2020 it started with hedge funds leveraged to the hilt through repo markets but soon threatened to spread to other unregulated (or lightly regulated) areas of our shadow banking system:

Leveraged hedge funds
Risk parity funds
International banks lending and taking deposits in the unregulated $6.5 trillion Eurodollar market (these banks are offshore and outside the Fed’s jurisdiction).
Money market funds
Muni funds
Commercial paper markets
Leveraged credit
Bond ETFs

Many of these offer the attraction of low costs and higher returns, often enhanced through leverage, but what investors are blind to (or choose to ignore) are the risks from lack of proper supervision and the lack of liquidity when money is tight.

Maturity mis-match is often used to boost returns. Short-term investors are channeled into long-term securities such as Treasuries, corporate bonds, munis or credit instruments, with the promise of easy sale or redemption when they require their funds. But this tends to fail when there is a liquidity squeeze, forcing a sell-off in the underlying securities and steeply falling prices.

Rapid Growth

We all welcome strong economic growth but should beware of the attendant risks, especially when financial markets are administered more stimulants than a Russian weightlifter for purely political ends.

Excessive use of Debt

Corporate borrowings are far higher today and rising debt has warned of a coming recession for some time.

Corporate Debt/Profits Before Tax

Public debt is growing even faster, with US federal debt at 98.6% of GDP.

Public Debt/GDP

Adverse Leadership

In the early 1900s, President Teddy Roosevelt led a populist drive to break the big money corporations through Anti-Trust prosecutions. This cast a shadow of uncertainty that fueled the sudden reversal in investor sentiment.

President Theodor Roosevelt

In 2020, we have another populist in the White House. Frequent changes in direction, spats with allies, imposition of trade tariffs, impeachment efforts by Congress, and a heavy-handed approach to trade negotiations have all elevated the level of uncertainty.

Donald Trump

Economic Shock

The great San Francisco earthquake and fire of 1906 created an economic shock that was felt across the Atlantic. The earthquake ruptured gas mains, setting off fires, while fractured water mains hampered firefighting. Over 80% of the city was destroyed. Much of the insurance was carried in London and Europe and led to a sell-off of securities in order to meet claims. The Bank of England became increasingly concerned about the outflow of gold from the UK and hiked its benchmark interest rate from 3.5% to 6.0%. London was then the hub of global financial markets and money became tight.

In 2020 we have the coronavirus impact on global manufacturing, services and financial systems: the mother of all demand and supply shocks.

JHU - CV Confirmed Cases

Undue Fear and Greed

Collapse of highly leveraged ventures in 1907 — with an attempted short squeeze on United Copper shares by connected corporations, banks and broking houses — stirred fears that a leading Trust company was going to fail. The panic soon spread and started a run on a number of trust companies.

A spike in the repo rate in September last year revealed that hedge funds had used repo to leverage their relatively meager capital into a rumored $650 billion exposure to US Treasuries. The Fed had to dive in with liquidity to settle the repo markets, lifeblood of short-term funding by primary dealers. But financial markets were on edge and concerns about funding difficulties in the unregulated $6.5 trillion offshore Eurodollar market and leveraged credit in the US started to grow. But the coronavirus outbreak in Europe and North America was the eventual spark that set off the conflagration.

Failure of Collective Action

Tust companies failed to organize an effective defense in 1907 against a run on their largest member, The Knickerbocker Trust Company, fueling a panic that threatened to engulf other trusts. Responding to appeals for help, J.P. Morgan intervened and marshaled the banking industry and surviving trusts to mount an effective defense.

Today that role falls to the Federal Reserve. Chairman Jay Powell moved quickly and purposefully to flood financial markets with liquidity, but the Fed was forced to reach far outside their normal ambit — increasing dollar swap lines with foreign central banks (to supply liquidity to international banks operating in the Eurodollar market) and providing liquidity to money market funds, muni funds, commercial paper markets, bond funds, hedge funds (through repo markets) and more. In effect, the Fed had to bail out the shadow banking system.

One thing that strikes me about financial crises is that each one is different, but some things never change:

artificially low interest rates;
rampant speculation;
excessive use of debt;
unregulated and highly leveraged shadow-banking with hidden linkages through the financial system;
financial engineering (the latest examples are leveraged credit and covenant-lite loans, hedge funds running leveraged arbitrage, risk parity funds with targeted volatility, and management using stock buybacks to enhance earnings per share, support prices and boost their stock-based compensation);
misuse of fiscal stimulus (to fund corporate tax cuts while running a $1.4 trillion fiscal deficit);
misuse of monetary policy (cutting interest rates when unemployment was at record lows);
yield curve inversion; and
misallocation of investment (to fund unproductive assets)

Jim Grant (Grant’s Interest Rate Observer) sums up the problem:

“The Fed has intervened at ever-closer intervals to suppress the symptoms of misallocation of resources and the mis-pricing of credit. These radical interventions have become ever-more drastic and the ‘doctor-feel-goods’ of our central banks have worked to destroy the pricing mechanism in credit.

….[credit and equity markets] have become administered government-set indicators, rather than sensitive- and information-rich prices… and we are paying the price for that through the misallocation of resources…..

Is there no salutary role for recessions and bear markets? …..they separate the sound from the unsound, they separate the well-financed from the over-leveraged and if we never have these episodes of economic pain, we will be much the worse for it.”

We haven’t learned much at all in the last 100 years.

October 6, 2017

Australian banks under selling pressure

The ASX 300 Banks index are a major drag on the broad market index. Having respected resistance at 8500, a test of primary support at 8000 is likely. Twiggs Trend Index peaks below zero warn of strong selling pressure.

ASX 300 Banks

Return on equity is falling.

Australian Banks Return on Equity

A combination of narrow interest margins.

Bank Net Interest Margins

Soaring household debt.

Bank Net Interest Margins

And rising capital requirements as APRA desperately tries to protect their glass jaw.

Bank Capital Ratios

Don’t let the ratios fool you. They are based on risk-weighted assets. Common Equity Tier 1 (CET1) leverage ratio for at least one of the majors is as low as 4.0 percent.

September 22, 2013

Emperors of Banking Have No Clothes | Bloomberg

The too-big-to-fail problem for banks is greater today than it was in 2008. Since then, the largest U.S. banks have become much larger. On March 31, 2012, the debt of JPMorgan Chase was valued at $2.13 trillion and that of Bank of America Corp. at $1.95 trillion, more than three times the debt of Lehman Brothers Holdings Inc. The debt of the five largest U.S. banks totals about $8 trillion. These figures would be even larger under European accounting rules.

By Anat Admati & Martin Hellwig

September 8, 2013

Vickers calls for doubling of bank capital levels | FT.com

“It is not very sensible to run a market economy on the basis of a banking system that is 33 times leveraged, let alone 40 or 50 times leveraged,” Sir John [Sir John Vickers, Oxford academic who chaired the Independent Commission on Banking] told the Financial Times. He believes the right number is closer to 10 times, equivalent to a 10 per cent ratio.

That is a lot higher than the 3 per cent (33 times leverage) required by Basel III and the 4.1% (CBA) to 4.5% (WBC) of the big four Australian banks.

July 21, 2013

Finally, Bank Regulators Have Had Enough | ProPublica

Jesse Eisinger observes US bank reactions to efforts to raise their minimum capital requirements. Many argue that the new rules will harm their competiveness.

Jamie Dimon, the chief executive of JPMorgan, raised the ominous specter that global rules are out of “harmonization” and that United States banks are now held to a higher standard.

“We have one part of the world at two times what the other part of the world is talking about,” he said. “And I don’t think there’s any industry out there that would be comfortable with something like that in a long run.”

To rebut that, I bring in a banking expert: Jamie Dimon. This side of Mr. Dimon’s mouth has repeatedly boasted about what a competitive advantage JPMorgan’s “fortress balance sheet” is, how the bank was a port in the 2008 storm…….

By raising capital standards and installing tougher derivatives rules, regulators are helping banks that are too foolish (or rather, the top executives who are too narrowly self-interested in increasing their own compensation in the short term) to recognize their own interests.

Increasing bank capital requirements would lower their perceived risk and decrease their cost of capital, giving them an advantage over international rivals with less stringent standards.

May 1, 2013

In Brown-Vitter Bill, a Banking Overhaul With Possible Teeth | NYTimes.com

Jesse Eisinger from ProPublica skewers big banks’ objections to increasing capital buffers as proposed by the bipartisan Brown-Vitter bill:

Goldman Sachs and S.& P. estimate the big banks might be forced to raise $1 trillion or more. That’s a lot, so much that the leviathans’ agents cry out that they couldn’t sell that much stock. But they don’t have to raise it all at once. And they can retain their earnings and stop paying dividends in addition to selling shares.

In putting that argument forward, they don’t realize they make Senator Brown’s and Senator Vitter’s case for them. If investors are so terrified of the big banks that they won’t buy their stock, that’s a terrific problem. Most of the big banks trade below their net worth, an indication that investors don’t trust them. Brown-Vitter might actually help banks by restoring that trust.

April 7, 2013

Lessons for Australian banks: Why Risk Managers Should Be Spymasters | ProPublica

Jesse Eisinger’s interview with risk specialist John Breit highlights an issue facing Australian banks. Residential mortgages are allocated a low risk weighting — 15% to 17% because of historic performance — compared to 50% for US banks. The big four banks piled into this area because of the perceived low risk, leveraging up to 50 times capital. Risk-weighted capital ratios (around 10%) still appear healthy, but they conceal a hidden danger from the resulting housing bubble.

[Breit] despises the concept of “risk-weighted assets,” where banks put up capital based on the perceived riskiness of the assets. Inevitably, he argues, banks will “pile into” the same types of supposedly safe investments, creating bubbles that make the risks far more severe than the initial perceptions. Paradoxically, risk-weighting can leave banks setting aside the least capital to cover the biggest dangers.

“I could not be more disappointed,” he said. “The cynic in me thinks this is all in the interests of senior management and regulators to avoid blame. They may not think they can prevent the next crisis, but they then can blame the statistics.”

November 21, 2012

S&P declares Australia a “one trick pony” | macrobusiness.com.au

By Houses and Holes on November 22, 2012

One-Trick Pony

London-based Kyran Curry, the long-time primary credit analyst for Australia at S&P, is back and the news is getting worse. From the AFR:

“The banks are highly indebted, they’re highly leveraged, they are the main vehicle Australia uses to fund its current account deficit…Australia has, as we see it, got some credit metrics that are right off the scale when it comes to assessing Australia’s external position….It’s got high levels of liabilities, it’s got very weak external liquidity and that basically means the banks are highly indebted compared to their peers….They’re benefiting from a safe haven at the moment – nonetheless investor sentiment can turn very quickly…We just worry that at some point, the people who are funding the Australian banks may decide that enough is enough and may begin to lose confidence in the bank’s ability to roll over their debt….That would come through a weakening in Australia’s major trading partners flowing through to a dramatic weakening in Australia’s fiscal position.”

Curry said this could be a two or three year scenario. But he added:

“Anything that weighs on the ability of Australia to bring forward new energy projects and that weighs on its export growth potential, that’s something that would put pressure on the rating. Australia is looking increasingly like a one-trick pony.”

Regular readers will note that S&P has pretty much captured my entire ‘peak Australia’ thesis. It is simultaneously ripping aside the veil of invisopower that regulators have dispersed around the banks and seeing for it is the singularly backward macroeconomic strategy of embracing Dutch disease. My two great fears.

The last line is the worst. I am of the view that LNG will rationalise – the current set of projects that is – not the fictitious pipeline. That means there is a risk that this is not a two or three scenario at all. Which does offer an answer to the question: why is S&P ramping its warnings now?

Canberra must immediately dispatch to Beijing a high level delegation to demand further stimulus. Perhaps a high-speed rail link from Beijing to the Bush Capital? That way, when they’re ready, the Chinese can relax in comfort on the way down to buy our banks.

Reproduced with thanks to Houses and Holes at Macrobusiness.com.au

October 15, 2012

5 Steps Obama or Romney Must Take to Fix Wall Street

By SUZANNE MCGEE

In [Sheila Bair’s] view ….. we haven’t yet come to grips with many of the problems that produced the crisis.

Too many regulators fall victim to one of several fatal flaws, Bair suggested in a speech to the National Association for Business Economics yesterday. Some of them over or under-regulate (usually at the wrong point in the cycle); they devise impossibly complex rules; they are “closet free-marketeers” proposing convoluted rules to prove it’s impossible to regulate financial institutions, or they are “captive” regulators who, without any corruption or malfeasance involved, have simply subordinated their judgment to those of the organizations they are charged with overseeing.

The former chair of the Federal Deposit Insurance Corporation suggests five steps that presidential candidates should take to fix Wall Street………

via 5 Steps Obama or Romney Must Take to Fix Wall Street.

July 14, 2012

Australia and the Endgame

John Mauldin: We wrote about Australia in a full chapter of Endgame. Their economy never really suffered in the recent debt crisis, in large part due to their growing housing market and their trade with China. If you talk to the average Aussie, they think that all is right with the world. They acknowledge a few issues but see nothing major like the rest of the world has experienced. Jonathan and I think otherwise. Their housing market is by recent standards in a clear bubble (which I know will get me a lot of email). Their banking system is dominated by foreign deposits (shades of Northern Rock, but not as bad as Iceland). They are vulnerable to a Chinese economic slowdown. I should note that Chinese GDP growth was “down” to 7.6% last quarter. That China might slow down should not come as a surprise. No country can grow at 10% forever. Eventually the laws of large numbers and compounding take over. All that being said, Australian government debt and deficits are under control. Any problems should be of the nature of “normal” business cycle recessions and accompanying issues.

Comment:~ Massive Chinese stimulus saved Australia from the GFC but that is no reason to become complacent. As Steve Keen recently pointed out, Australia is in a similar position to Spain in 2006. Spain was generating a fiscal surplus which it used to reduce government debt below 40% of GDP, but its banks were exposed to a large housing bubble funded by offshore deposits. Australian banks are similarly exposed to offshore funding and are leveraged 50 to 1 on residential mortgages (Macrobusiness May 4, 2012) — even after adjusting for mortgage insurance — leaving them highly vulnerable to a contraction. We also need to recognize that Australia is not exposed to a slowdown in China’s GDP growth, but to a slowdown in Chinese spending on infrastructure and housing. While GDP growth may fall to zero, the Chinese economy will still survive, but what are Australia’s chances if that is accompanied by say a 50 percent fall in new infrastructure and housing projects? The fall in iron ore and coking coal exports would have a far greater impact on the Australian economy.