{"id":20162,"date":"2020-03-31T08:03:22","date_gmt":"2020-03-31T08:03:22","guid":{"rendered":"https:\/\/thepatientinvestor.com\/?p=20162"},"modified":"2020-04-01T03:10:28","modified_gmt":"2020-04-01T03:10:28","slug":"lessons-from-the-panic-of-1907","status":"publish","type":"post","link":"https:\/\/thepatientinvestor.com\/index.php\/2020\/03\/31\/lessons-from-the-panic-of-1907\/","title":{"rendered":"Lessons from the Panic of 1907"},"content":{"rendered":"

I have read The Panic of 1907<\/em> (by Robert Bruner & Sean Carr) four or five times \u2014 I read it at every market crash.<\/p>\n

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.<\/p>\n

\"John
\nJohn Pierpont Morgan – source: Wikipedia<\/em><\/p>\n

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.<\/p>\n

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.”<\/p>\n

They identify seven elements that converged to create a perfect storm in 1907:<\/p>\n

    \n
  1. Complex Financial Architecture<\/strong> makes it “difficult to know what is going on and establishes linkages that enable contagion of the crisis to spread.”<\/li>\n
  2. Buoyant Growth<\/strong>. “Economic expansion creates rising demands for capital and liquidity and ….excessive mistakes that eventually must be corrected.”<\/li>\n
  3. Inadequate Safety Buffers<\/strong>. “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.”<\/li>\n
  4. Adverse Leadership<\/strong>. “Prominent people in the public and private spheres implement policies that raise uncertainty, which impairs confidence and elevates risk.”<\/li>\n
  5. Real Economic Shock<\/strong>. “Unexpected events hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors.”<\/li>\n
  6. Undue Fear, Greed and other Behavioral Aberrations<\/strong>. “….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.”<\/li>\n
  7. Failure of Collective Action<\/strong>. “The best-intended responses by people on the scene prove inadequate to the challenge of the crisis.”<\/li>\n<\/ol>\n

    Compare these seven elements to the current crisis in March 2020:<\/p>\n

    Complex Financial Systems<\/h3>\n

    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.<\/p>\n

    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.<\/p>\n

    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:<\/p>\n