Lessons from the Panic of 1907

I have just finished reading The Panic of 1907: Lessons Learned from the Market's Perfect Storm, written by Robert Bruner and Sean Carr in 2007. It is extraordinarily well documented step by step study of one of the worst bank panics and stock market crashes in modern times. (The broad stock market declined 37% from peak to trough in less than 15 months.)

Here is an extended quote from the author's closing remarks.

"Why do markets crash and bank panics occur? Any single case study, such as the one we have presented here, is subject to a range of interpretations, and we encourage the reader to draw one's own conclusions from the foregoing narrative.

Yet we think that the story of the panic and crash of 1907 inspires consideration that major financial crises can be the result of a convergence of certain unique forces - the forces of the market's perfect storm - that cause investors and depositors to act with alarm.

The recounting of the events of 1907 suggests that the storm gathers as follows.

It begins with a highly complex financial system, whose very complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others.

Buoyant growth in the economy makes the financials system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent.

Leaders in government and the financials sector implement policies that advertently or inadvertently increase the exposure to risk of crisis.

An economic shock hits the financials system. The mood of the market swings from optimism to pessimism, create a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness which they act ultimately determines the length and severity of the crisis."

My own reaction is similar, except for some different emphasis and a slightly different slant, based on extensive readings about other panics and crashes, including a first hand look at the tech bubble collapse of 2001.

First, almost all panics and crashes are preceded by sustained periods of artificial growth, not based on improvements in productivity, but by a false expansion in the money system, aided and abetted by speculators and financiers. Although they do not act in overt cooperation, yet there is an unmistakable collusion of purpose. It suggests that the impulse to benefit in this way is present in a portion of the people at all times, as there are impulses to do many other things for personal benefit without regard to the public good. But at certain times the prohibitions which normally hold this behaviour in check are weakened, sometimes through active interventions against regulation, at other times from a decline in moral conscience.

Seocnd, almost all panics and crashes involves relatively small groups of people who seem to be at the heart of the matter, and are closely interlinked into small cartels of corrupted self-dealing involving the accumulation of enormous personal fortunes. One is struck by the interconnectedness of the primary players in the Panic of 1907 in each others companies, banks, investments, and boards of directors.

In this instance there did not seem to be any significant corruption of the government, which was actually in a progressive mood under Theodore Roosevelt, although he was by now a lame duck. Rather, the central government at this time was weak, and regulation was largely in the hands of the business principals, of which no greater example than J. Pierpont Morgan. They will act to protect their own interests when threatened, but their benevolent reputations are greatly exaggerated.

Lastly, there is always the overextension of credit and excessive leverage. Always. This is how the Ponzi scheme grows, for that is in every case what precedes and precipitates the growth of a crisis and panic - the unreasonable overvaluation and expansion of assets concentrations provoked again by a relatively small number of men, interlinked loosely through business associations.

As in the case of 1907 and its aftermath, a few visible persons are offered up for punishment and destruction, but the largest and most substantial of the predators remain unscathed, often being lionized as saviours who attempted the rescue of the nation from a few bad apples and the public from its own folly.

Although the authors make a great deal of the need to take swift and decisive action to stem the crisis, they miss the point that the place to stop this is before the leverage and excess build to the point where almost anything will set the overextended system into crisis and panic. Even if decisive action is taken, it is the greater public that is invariably harmed by the cure, with a few becoming even more enriched, although the harm be less than if nothing had been done at all. By the time the crisis is underway, you will be making deals of convenience, and at terms with the devil.

It should be stressed that there is no evidence in the correspondence of any of the principals that they desired to cause this Panic of 1907 for their own benefit. And there does not have to be.

If a general atmosphere of looting is fostered by the provocations of a few like-minded individuals, their subsequent actions need no coordination, other than the insufficient response of society to stop them before they gain sufficient momentum from their desires. It is the apathy and weakness of the many that provides the stimulus and the encouragement for their plans.

The authors do recount the subsequent meeting of many of the principals at Jekyll Island in 1910, to craft a reform of the banking system to be known as The Federal Reserve System. Again, I do not see anything in the system itself that is improper or malignant; it is only in it ability to increase and amplify leverage that makes it a powerful tool in like-minded individuals to seek to defraud the many of their life savings through unscrupulous abuse of anything and everything that comes under their power and control.

If you wish to take the measure of a society, look to how its weakest members are protected from its strongest, and its predators skulking at the fringes.

More concisely, you will receive the results that you incent, the behaviours that you cultivate, the society that you promote, if only by doing nothing and allowing small groups of like-minded individuals to set your greater agenda. We have seen this repeatedly in companies both large and small, in entire industries, and we think in the national economy.

If you wish a hell on earth, do nothing for the benefit of others, for the greater good, or to inhibit those who act solely out of greed, fear, and hate. Soon enough you will have a society that is intensely self-interested, self-concerned, superficial, destructive and self-consuming.

A free and just society is not a prize to be won or a gift that can be bestowed; it is a recurring commitment, and an enduring obligation.

The Worst of the Credit Crisis Is Yet to Come - Ted Forstmann

COMMENTARY: THE WEEKEND INTERVIEW
Theodore J. Forstmann
The Credit Crisis Is Going to Get Worse
By BRIAN M. CARNEY
July 5, 2008
The Wall Street Journal
New York

Twenty years ago, Ted Forstmann contributed a scathing – and prescient – op-ed to this newspaper warning that the junk-bond craze was about to end badly: "Today's financial age has become a period of unbridled excess with accepted risk soaring out of proportion to possible reward," he wrote in October 1988. "Every week, with ever-increasing levels of irresponsibility, many billions of dollars in American assets are being saddled with debt that has virtually no chance of being repaid."

Within a year, the junk-bond market had collapsed, and within 18 months Drexel Burnham Lambert, the leading firm of the junk-bond world, was bankrupt. Mr. Forstmann sees even worse trouble coming today.

For a curmudgeon, he is a cheerful man. When we met for lunch recently in a tony midtown restaurant, he was wearing a well-tailored suit, a blue shirt and a yellow tie. He spoke with the calm self-assurance of someone who has something to say but nothing left to prove.

"We are in a credit crisis the likes of which I've never seen in my lifetime," Mr. Forstmann warns. He adds: "The credit problems in this country are considerably worse than people have said or know. I didn't even know subprime mortgages existed and I was worried about the credit crisis."

Mr. Forstmann denies being an expert in the capital markets. But he does have some experience with them. He was present at the creation of the private-equity business. The firm he co-founded, Forstmann Little, rode the original private-equity boom in the 1980s while skirting the excesses of the junk-bond craze in the later years. It was for a time the most successful private-equity firm in the world, renowned for both its outsize returns and its caution. For two years after Mr. Forstmann wrote his 1988 op-ed, Forstmann Little sat on $2 billion in uninvested funds, waiting for the right opportunities. Savvy investments in Dr. Pepper and Gulfstream, among others over the years, helped make Mr. Forstmann a billionaire.

These days, he devotes most of his professional attention to IMG, the sports and entertainment agency. But the economy has him worried.

Mr. Forstmann's argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance. (That distortion of risk, the extreme lowering of the bar in assessing the viability of projects and investments, is known as "moral hazard." Some economic commentators attack the notion as 'old-fashioned moralism' as a rhetorical device. It is nothing of the sort. It is a defense of private finance. - Jesse)

He illustrates this with what he calls his "little children's story": Once upon a time, when credit conditions and the costs of borrowing money were normal, the bank opened at 9:00 a.m. and closed at 5:00 p.m. For eight hours a day, bankers made loans and took deposits, and then they went home.

But after 9/11, the Fed opened the spigot. Short-term interest rates went to zero in real terms and then into negative territory. When real interest rates are negative, borrowing money is effectively free – the debt loses value faster than the interest adds up. This led to a series of distortions in the financial sector that are only now coming to light. The children's story continues: "Now they [the banks] have all this excess money. And they open at nine, and from nine to noon or so, they're doing all the same kind of basically legitimate things with it that they did before."

So far, so good. "But at noon, they have tons of money left. They have all this supply, and the, what I would call 'legitimate' demand – it's probably not a good word – but where risk and reward are still in balance, has been satisfied. But they're still open until five. And around 3:30 in the afternoon they get to such things as subprime mortgages, OK? And what you guys haven't seen yet is what happened between noon and 3:30."

Straightforward economics tells us that when you print too much money, it loses value and prices go up. That's been happening too. But Mr. Forstmann is most concerned with a different, more subtle effect of the oversupply of money. When it becomes too plentiful, bankers and other financial intermediaries end up taking on more and more risk for less return. (Among others we were pointing this out as early as 1998 as it was apparent in the tech bubble of which we were participating. When the Fed started the cycle again in 2003 we were astounded, incredulous. It did cost us some money, because we could not believe the Fed could be that wantonly reckless. - Jesse)

The incentive to be conservative under normal credit conditions is driven in part by what economists call opportunity cost – if you put money to use in one place, it leaves you with less money to invest or lend in another place. So you pick your spots carefully. But if you've got too much money, and that money is declining in value faster than you can earn interest on it, your incentives change. "Something that's free isn't worth much," as Mr. Forstmann puts it. So the normal rules of caution get attenuated. (Anyone who has functioned in a corporate finance position or owned and managed a significant business understands this notion intimately, almost second nature. - Jesse)

"They could not find enough appropriate uses for the money," Mr. Forstmann says. "That's why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much." So you start thinking about new ways to lend the money, which inevitably means riskier ways.

"I don't know when money was ever this inexpensive in the history of this country. But not in modern times, that's for sure."

Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.

In fact, for six years, a lot of people made a lot of money in this environment. (At the time we preferred to call it the looting of America's future - Jesse) So much money that, as Mr. Forstmann notes, the price of admission to the Forbes 400 list of the richest Americans has gone from $500 million 10 years ago to over $1 billion today. (Mr. Forstmann was bumped from the list two years ago, his reported 10-figure net worth no longer enough to keep pace.)

At the same time, both the size and the number of hedge funds and private-equity funds have ballooned. "I used to have one of the biggest private-equity funds in the world," he says matter-of-factly. "It was, I don't know, $500 million or a billion dollars. If you don't have a $20 billion fund now, you're kind of a [nobody]," Mr. Forstmann says. (The term he used to describe those of us without $20 billion PE funds was both more colorful and less printable than "nobody.") "And so what does that tell you?"

Mr. Forstmann hasn't raised a new fund in four years. But he doesn't blame the hedge funds or the private-equity funds – they are not the villains in his story. "Fundamentally, I don't see them as a cause," he says. "Obviously the proliferation of hedge funds and private-equity funds has created its own dynamic. But this proliferation is simply a result of the vast increase in the money supply."

Mr. Forstmann has been around a long time, so he's seen a lot. But is it possible that he's simply fallen behind the times? By his own description, he's a bit of a figure from another age – "a bit like Wyatt Earp in 1910."

But it would be a mistake to dismiss Mr. Forstmann's pessimism too quickly. After all, he knows something about both credit and crises.

"You've got [Treasury Secretary Henry] Paulson saying 'Oh, you see the good news is it's over.'" The problem, according to Mr. Forstmann, is that it's far from over. "I think we're in about the second inning of this." And of course, the credit crisis wasn't even supposed to last this long. "This all started in August [of 2007], and it was going to get cleared up by October. It hasn't gotten cleared up at all."

One reason is that the proliferation of new financial instruments has left the system more closely intertwined than ever, making a workout, or even a shakeout, much more difficult. Take what happened to Bear Stearns. "What should the health of one brokerage firm in America mean to the entire global financial system? To an ordinary person, probably not much. But in today's world, with all the interdependence, a great deal."

This circular creation of new credit, used to buy more newly created debt, all financed by ultracheap money and all betting with each other, has left the major firms hopelessly intertwined. "It's very interrelated," he says, locking his fingers together. "There's trillions and trillions of dollars that slosh around between all these places and if one fails . . ." He doesn't finish the thought. (On a scale from 1 to 10, we're fucked - Jesse)

Early in our conversation, Mr. Forstmann describes his conversational style as "Faulknerian." The word fits. He jumps between thoughts, examples and anecdotes in a pure stream of consciousness. One such aside is about Warren Buffett and the rule of the three "I"s.

"Buffett once told me there are three 'I's in every cycle. The 'innovator,' that's the first 'I.' After the innovator comes the 'imitator.' And after the imitator in the cycle comes the idiot. Which makes way for an innovator again." So when Mr. Forstmann says we're at the end of an era, it's another way of saying that he's afraid that the idiots have made their entrance.

"We're in the third 'I' for sure," he interjects an hour after first introducing the "rule." "And that always leads to something. Innovators don't just show up. Some disaster takes place because of the idiots, and then an innovator says, oh, look at this, I can do this, that or the other thing." That disaster is now.

In other words, "In order to fix what's going on in the United States there's going to have to be a certain amount of pain. The market's going to have to clear somehow. . . and it's hard for me to believe that it gets fixed without" upheaval in the financial system, the economy and the country as a whole. "Things are going to fail. Enterprises are going to fail. The economy is going to slow," he warns.

To be clear, although Mr. Forstmann talks about "fear and greed" getting out of whack, his is not a condemnation of "greedy speculators" or a "culture of greed" or any of the lamentations so popular among the populists in Washington. It is a diagnosis of the ways in which the financial sector responded to a government policy of printing money that was free, or nearly so. "The creation of much too much money caused all of this excess," he says. In other words, his is not an argument for draconian regulation, but for sound money. (If he really believes that the monied powers were not major precipitants behind this, were not actively lobbying the Congress for the relaxation of long standing reforms, were not packing government positions with their alumni, and were not in part behind the election of a willing tool, the prince of Idiots, then we lose all respect for him - Jesse)

Nor does he blame Alan Greenspan, even though he argues that this all started with the dot-com bubble and 9/11. "Greenspan," he allows, "had really tough decisions to make, so I don't think it's a black-and-white kind of thing at all." It was, and is, rather, "a case of first impression." Mr. Greenspan, he says, admits that he was "totally sure" that what he was doing was right. But he had "no idea what the consequences [were] going to be." (ROFLMAO. So who would be to blame, the dog? The dog ate our economy? No one wants to name names, because they know before its over that there will be blood. - Jesse)

According to Mr. Forstmann, we are now living with those consequences. And the correction has only begun.

Mr. Carney is a member of the editorial board of The Wall Street Journal.

Barclays Warns on Inflation and Equities

Economic Times
Barclays Wealth sees stubborn inflation, cuts stocks
5 Jul, 2008, 0544 hrs IST

LONDON: (REUTERS) - Wealth managers at Barclays are stepping away from equities and telling their clients to prepare for central banks to have difficulty controlling inflation.

In a strategy note released on Saturday, the bank's wealth management arm, Barclays Wealth, said inflation will not peak until at best the end of this year.

"Oil prices and inflation are unlikely to fall back sharply, and there are potentially severe problems stemming from wage/price spirals in some of the major developing economies," wrote Michael Dicks, head of research and investment strategy.

"The outlook looks increasingly gloomy for 2009, and Barclays Wealth has reduced its overall equities overweight," he added.

The reduction was particularly focused on European stocks, including Britain. "Better US consumer spending news should allow US equities to regain some ground soon," Dicks wrote. (Dream on - Jesse)

Barclays Wealth remains short on fixed income, which tends to get hurt in inflationary times. The wealth management firm trimmed it global economic growth forecast to just under 3 percent next year from a previous estimate of just over 3 percent.

UBS Warns of 'Further Heavy Write-Downs'

UBS confirms facing further write-downs
By Haig Simonian in Zurich
July 4 2008 12:12
Financial Times

UBS on Friday confirmed it faced further heavy write-downs on exposures to troubled US credits, meaning earnings for the second quarter would be “at or slightly below” break even.

Europe’s biggest casualty of the US subprime crisis did not quantify its latest write-downs, which analysts have estimated at up to $7.5bn. The Swiss bank said it had continued to make money in wealth and asset management, but suffered renewed losses in investment banking.

UBS said the impact of the latest losses left its Tier 1 capital ratio at about 11.5 per cent on June 30, and stressed it had no need to raise fresh capital.

The news reassured investors. UBS shares jumped 8.2 per cent higher at the open but settled back to stand 1 per cent higher at SFr21.24. The shares have lost two-thirds of their value over the past year.

The bank has raised about SFr30bn ($29bn) in recent months, mainly through a rights issue and sale of shares to strategic investors.

UBS gave an indirect indication of its latest markdowns by noting that its second quarter results would benefit from a tax credit of about SFr3bn in connection with its massive losses to date.

Working backwards, and assuming roughly normal profitability of up to SFr2bn in wealth and asset management combined, that implies a loss of at least SFr5bn in investment banking to produce break-even.

UBS said its latest write-downs had stemmed from the effect of “further market deterioration” on previously disclosed positions, particularly adjustments to the value of its exposures to monoline insurers.

At the time of its first quarter results, UBS disclosed it had exposures of about $6bn to monoline insurers – a position viewed as ominous by many analysts given the concerns, and subsequent ratings downgrades – of many monolines.

The bank also confirmed fears that its problems with subprime, and broader reputational damage, had eroded its until-recently blue chip private banking franchise. UBS said group net new money had been negative in the second quarter, though it did not distinguish between wealth and asset management.

It added that outflows had been most severe in April, but had improved in May and June, especially in wealth management.

The profits warning had been expected, but for July 1, immediately after the end of the second-quarter trading period and in line with the bank’s practice in two earlier quarters. Instead, UBS that day released information about important corporate governance changes, but said nothing about earnings.

UBS officials said Friday’s statement represented “voluntary disclosure”, in the sense of refining existing guidance to investors, rather than an obligatory announcement triggered by market rules requiring profits warnings when circumstances showed “material differences” compared with previously available information.

Full results for the second quarter will be published on August 12.