History repeats itself – GFC’s, and how the banks and government regulation have impacted financial crashes in the past

This week we continue with where we left off last week’s episode – is it the Banks, or Government Regulation and interference, that causes financial crashes.

Let’s take a look back on America and their financial crashes through history

1. 1873 – 1907 – Financial panic was common
   • 1983 a bank panic triggered worst depression US had seen – Stabilised after J.P. Morgan stepped in –
     • P. Morgan – The monopoly man, founder of J.P. Morgan Bank
     • Speculation that J.P. Morgan caused this through spreading rumours
   • 1907 – Speculation on wall street ended in failure – bank panic
     • History: speculation that went awry – “stock operators” borrowed huge sums of money to finance an effort to manipulate a stock price
     • In October 1907 – Mercantile National Bank attempted to corner the market of a copper mining stock. The operation failed, and the stock, which reached a price of 60 during the attempted corner, almost immediately collapsed to 10.
2. Mercantile National Bank, was feared by the public to be bankrupt.
   • The bank was still solvent, but in banking, perception can become reality, and as depositors pulled their money out, Mercantile needed an emergency loan to stay alive.
3. The prospect of a small bank failure shouldn’t have been more than a blip on the economic radar.
4. But, there was no central bank to act as a lender of last resort, and no deposit insurance, which would have calmed the nervous savings account holders
5. The next victim: failure of the Knickerbocker Trust company in New York
6. Drained cash reserves from the financial system and created a shortage of liquidity all over the city and, eventually, in the broader economy.
7. Businesses couldn’t use credit to pay for inventory, cash wasn’t available to pay workers, farmers couldn’t sell their crops, and the economy entered a recession.

The Cabal – A group of bankers, led by J.P. Morgan himself,

1. They went over the Knickerbocker’s books to determine whether or not it should be saved or not. In the end, the bankers, who were essentially acting as a central bank of sorts, decided to let the Knickerbocker go down (technically, the trust didn’t fail, it just closed its doors for six months and locked out depositors; but practically speaking, it was bankrupt).
2. This failure sparked massive fear all around New York
   • Morgan and his cohorts quickly reversed course by extending a lifeline to The Trust Company of America and a few other major financial institutions in the city.

But just like in 2008, the bailouts didn’t stop the crisis from spreading. Depositors continued to ask for their cash back, and the banking reserves of the entire financial system rapidly evaporated.

1. 48% of the deposits left New York trusts and found safety in mattresses and dresser drawers.
2. It meant that businesses didn’t have enough cash to finance their operations or pay their workers, and many had to close their doors and halt production lines. The share market plummeted 40%.

The Panic of 1907 and the crisis that occurred 101 years later in 2008 were remarkably similar.

1. Mercantile National Bank failure was like Bear Stearns – it was the first domino, but on its own it should have been manageable.
2. But the Knickerbocker – just like Lehman in September 2008 – was the catalyst that accelerated the crisis and nearly brought down the financial system.
3. In both instances, the men in charge (Morgan and his syndicate in 1907; Bernanke and Paulson in 2008) decided against saving what turned out to be a systemically important bank.
4. And in both cases, this decision led to panic, crashing stock prices, and additional bank runs.
5. Everyone wanted their cash in hand. Both bank failures also caused the decision makers in each case to reverse course and save other teetering institutions – in 1907, Morgan saved the Trust Company of America, and in 2008, the US government saved AIG

The practical takeaway – asset prices can be impacted by sheer emotion and herd behaviour

1. The greatest investors are usually the ones who capitalize on such panic
2. Morgan was making loans and buying banks for cheap when no one else was in 1907
3. Buffett (and JP Morgan Bank) were providing capital and buying stocks 2008

The factors that are the same in financial crisis

1. Fear and panic
   • Depositors around New York City wondered if their own deposits were safe
   • It was a classic run on the bank – fear begets fear, and everyone wanted their cash back at once
   • Run on the bank created further panic, people demanded cash above any other asset, liquidity dried up, causing businesses that relied on credit to suffer
2. Liquidity
   • Banks have 30% of funding from short term liquidity
   • 60% from Deposits

The Aftermath – The More Things Change, The More They Stay The Same…

1. The general result of every crisis is always the same: finger pointing…but then…
   • The remedy is new legislation and increased regulation – all designed to prevent the next crisis.
   • The merits of this is debated, but the common denominators are in human behaviours
   • Given the fact that human nature doesn’t change, the next crisis is inevitable.
     • Greed and fear are two constants in financial markets, and they will be the two key ingredients that will lead to the next great crisis.
     • The cause will be different and unexpected, but the human behaviour before, during and after the panic will look very similar.
   • One difference is that the 1907 recession was very deep, but the recovery was swift, unlike the aftermath of 2008
     • The panics of 1873 to 1907 – lead to a big change in the way the banking system works
     • Meant to cure this problem, but it is still going on – Why can’t they avoid collapses?
       • After 2008 – To stimulate the economy and further lower borrowing costs, the Federal Reserve turned to policy tools.
       • It purchased $300 billion in longer-term Treasury securities,
2. Support the housing market, the Federal Reserve purchased $1.25 trillion in mortgage-backed securities guaranteed by agencies such as Freddie Mac and Fannie Mae and about $175 billion of mortgage agency longer-term debt.
3. These Federal Reserve purchases have reduced mortgage interest rates, making home purchases more affordable.

You can’t regulate human behaviours of greed and fear

1. How much safety does the guarantee provide to the public?
   • How bailouts are funded through ‘Quantitative Easing’ as it was called in the US, but it is printing money by any other name
   • What allows for these bail outs, where the money comes from, and the flow on effects of cash advancing your unlimited credit card, but at the government level it is ‘Quantitative Easing’
2. The burden is now on the public – Regulations and deregulations lead to the monopoly of present day – creating banks being too big to fail, meaning that they are insured, which leads to their failing due to risky behaviour – but they can fail so step in the Reserve Bank!
3. We will look at this in the next episode…

Thanks for listening!