Financial Panics: 1600 - 2000

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Financial Panics 1600 - 2000

• Peter Fortune
• Ph.D. Harvard University
• www.econseminars.com
• Email pf_at_econseminars.com

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• Legendary Crises
• in the
• 17th and 18th Centuries

3
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)
4

• ? 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

5

• ? 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

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• ? 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)

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• ? 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

8

• ? 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

9

• 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 Laws System In 1720 France. Federal
  Reserve Bank of Chicago, mimeo.

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• ? 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

12

• ? 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 Louiss Finance
• Minister, Jean Claude Colbert, Left the
  French
• Economy Bound by Rigid Regulations and
• Restrictive Trade Policies (Mercantilism)

13
The French Governments Budget Deficit Under
Louis XIV
14

• ? Key Elements of Laws 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

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• ? 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

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• ? The Banques Equity Structure
• Issued Shares to the Well Connected
• ? The King Was the Largest Investor
• ? Society Subscribed Heavily
• Shares Viewed As A Slam-DunkA Free Call Option
• ? Shares were sold via Call Option with 5,000L
  Strike
• Price20 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)

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• ? 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
• SpecieA Run On Specie Would
  Deplete Reserves,
• Force Sale Of Assets, And Reduce
  Capital
• ? The Banques Stock Repurchase
  Program

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• ? Laws 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

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• ? The Banques 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 dOccident
• ? 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

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• ? The Compagnie dOccidente 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

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• ? The Status Of Laws System By Early 1720
• Law Had Completed an LBO of the Government
• ? Taken Over All Aspects of Frances Finances
• ? Taken over All Government Foreign Trading
• Rights
• ? Become the Sole Issuer of Bank Notes--Which
  Had
• Become Frances 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

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• ? 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

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• ? In May 1720 The Companys Stock Price Collapsed
• ? Initial Causes
• ? Profit-Taking Share Price Had Risen
  To 10,000L
• ? Banques 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

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Banque Notes in Circulation Peaked in May 1720
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The Specie-Value of Banque Notes Began
Rapid Depreciation in May 1720
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The Companys Stock Price Collapsed After May 1720
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• ? What Went Wrong?
• Key Weaknesses
• ? Laws 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
• ? Laws Monetary Theory Was Wrong
• ? Substitution Of Fiat Money For Specie
  Resulted In Inflation,
• Not Greater Trade

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• ? 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

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• Did Laws System Create Additional Trade?
• No, Its Primary Effect was on Inflation

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? Answer An Emphatic NO To All Of The
Following Did Laws System Strengthen the
Governments 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
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• ? Lessons From The Mississippi Bubble
• Monetary Expansion Affects Prices More
  Than Trade
• The Risk of Low Bank Cash Reserves The
  Banques
• High Ratio of Notes Outstanding to
  Reserves
• Exposed It To Runs
• The Risk of Reputational Put Options
  The
• Companys 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!

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• The English South Seas Bubble
• Lawss System Redux
• Reference
• Garber, Peter. Famous First Bubbles The
  Fundamentals of Early Manias, MIT Press,
  Cambridge MA, 2000.

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• ? 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 Companys Shares Remained Strong

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• ? The Government Captures The South Seas Company
• In 1717 the King, Impressed by The Apparent
  Success
• Of Laws 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
  ParAbout Twice
• The Market Value Of Government Bonds

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• A Surge in Speculation on South Seas Shares
  Began

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• ? 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
• Companys Shares Were Dragged Down

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• 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)

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• ? 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
  161
• The Problem Of Bimetallism
• ? When Gold-Silver Market Price
  Deviated From
• 161, One Metal Would Be Hoarded, The
  Other
• Used For Payments
• ? Greshams Law Bad Money Drives Out Good
• Money

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• ? The Rise Of The Gold Standard
• Prior To 1870 Bimetallism Prevailed
• ? Every Country Set A Mint Ratio
  (Usually 161)
• ? Mint Would Exchange 1 oz. of Gold
  For 16 oz. of Silver
• ? 1 oz. Gold 20.64 gt 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

40

• ? 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, Bryans
• 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

41
The Gold Standard after 1873
42

• ? 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
  TogetherBooms
• and Busts Quickly Transmitted
  Abroad
• ? Can Promote Economic Instability
  When Policies in
• Different Countries Arent
  Synchronized

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The U.S. Monetary Framework Under the
Gold Standard
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45
19th and Early 20th Century Monetary Crises
The
Panic of 1893 The Panic
of 1907
46
The Panic of 1893
References
47

• ? 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
  Carnegie-
• Related 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

48

• ? 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 FallInterest Rates
• Would Rise As Credit Demands Rose

49

• ? 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
• StandardLending to U.S. Fell Sharply and
  Gold Flowed Out
• of Country
• ? Reduction in Treasurys 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

50

• ? 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

51

• ? The Economy After 1893
• The 1890s 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

52
The Economy After 1893
53
Interest Rates In 1890-1910
54
The Panic Of 1907ReferencesBruner,
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.
55

• ? The Players
• Commercial Banks
• ? National Banks in Money
  Centers Could Hold Treasury
• Deposits
• ? Rural Banks Held 25 of Deposits in
  Reserves40
• 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
• BanksCheck Clearing, Currency and Coin
• ? Money Center Banks Provided Security Credit
  to
• Brokerage Companies Which Made Margin Loans
  to
• Stock Investors

56

• ? 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

57

• ? 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 Banks 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

58

• ? 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
• PoundBorrow 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

59

• ? 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 SqueezeBuy 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
• Groups 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

60

• ? The Triggers
• Consequences of the Failed Short Squeeze
• ? In Mid-October, 1907 UCC Shares Plunged as
  UCC
• Owners Sold HeavilyLiquidity 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

61

• ? 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

62

• ? 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, JPMs Assistant George Perkins,
  JPMs 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
  CertificatesIOUs That Banks
• Can Use in Clearing Checks
• ? Morgan Invests Heavily in NYC Bonds to
  Prevent Collapse

63

• ? 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 Self-
• Support 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!

64

• ? 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 InelasticGold
• Outflows and The Harvest-Related Demand
  for
• Credit Had Demonstrated the Need for an
  Elastic
• Currency
• ? The Banking Systems Connection to the
  Stock
• Market Via Margin Loans to Brokers was a
  Weak Point
• Led To The Federal Reserve Act Of 1913

65

• ? 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

66
Financial Collapses In The
Great Depression 1929-1933
67

• The 1929 Stock Market Crash
• Reference
• Galbraith, Kenneth. The Great Depression,

68

• ? 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
• (101 debt/equity reported 41 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

69
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

70
The 1929 Stock Market Crash
71

• ? 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

72
Overview OfThe Great DepressionReference
73
Overview Of The 1930s The Real Picture
74
Overview Of The 1930s The Financial Picture
75
Overview Of The 1930s The Stock Market
76
The Banking Panics Of 1930-1931ReferencesFried
man, Milton and Anna Schwartz. A Monetary History
of the United States, Princeton University Press,
Princeton NJ, 1962. (esp. pages 308-332)
77

• ? 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

78

• ? 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

79

• ? 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 High-
• Powered Money and Additional
  Pressure on Bank Credit
• ? U.S. Bank Failures Rose Sharply

80

• ? 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

81

• ? 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

82

• ? 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

83
The Banking Panic Of 1933
84

• ? 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

85

• ? 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 Yorks Governor Lehman (déjà vu)
  Declared A Bank
• Holiday After Reserves at New York Banks
  Fell Below
• Legal Limits
• Unemployment Rate Peaks At 25

86
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)

87
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

88
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

89
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

90
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

91
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)

92

• Modern Financial Crises
• The 1987 Stock Market Crash
• The SL And Junk Bond Episode
• The Enron Debacle

93
The Stock Market Crash Of
1987ReferenceLowenstein, Roger. The Origins
of the Crash The Great Bubble and its Undoing,
Penguin Press, New York, 2004.
94

• ? 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
  Bite30 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)

95
The Event The 1987 Stock Market Crash
96

• ? 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

97

• ? 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
• Didnt Know If Orders Had Been
  Executed
• ? Led To Multiple Sell Orders
• ? Stale Prices
• ? Long Delays In Reporting Trade
  PricesCustomers
• Had Out-Of-Date Price
  Information
• ? Created Inverted Futures-Cash
  Price Relationship,
• Inducing Cash Market Sales

98
? 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
99

• ? 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
• Compound Problems

100
The Savings Loan
And Junk Bond Crises
1989ReferencesBruck, Connie. The
Predators Ball The Inside Story of Drexel
Burnham and the Rise of the Junk Bond Raiders,
Simon Schuster, New York, 1988.
101

• ? The Context
• SL 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 SL Balance Sheets Deteriorated, And
  Liquidity

102
? 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 ? SLs Bought
Junk Bonds On A Large Scale As A
Way To Diversify Beyond Mortgages and Get High
Returns
103

• ? The Policy Responses
• Laws Were Changed To Allow SLs 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 SL
  Portfolio
• Problems And To Insolvency
• ? Created Good Will Certificates
  That SLs Could
• Carry On Their Books As Assets
• ? Made Loans To SLs To Bolster
  Liquidity
• These Responses Perpetuated The Problems

104

• ? What Went Wrong?
• SLs 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 SL
  Investing The Keating
• Episode
• ? Mortgage Foreclosures Increased
  And SLs Began
• Failing, First in The South Then
  Elsewhere

105
(No Transcript)
106

• ? Resolution
• Financial Institution Recovery Program
  (FIRREA-1989)
• ? Forced Insolvent SLs to Fail Or Be
  Bought By
• Stronger Institutions
• ? FDIC Pays Depositors of Failed SLs
  And Acquires SL
• Assets