PANDEMONIUM IN THE MARKETS. THE PANIC OF 1907. THE FINANCIAL CRISIS OF 2007. EVENTS IN 1906. DEVASTATION. SAN FRANCISCO EARTHQUAKE. Shortly after 5 a.m. on April 18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute. SAN FRANCISCO EARTHQUAKE 1906.
THE PANIC OF 1907
THE FINANCIAL CRISIS OF 2007
SAN FRANCISCO EARTHQUAKE
Shortly after 5 a.m. on April 18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute.
80% OF THE CITY DESTROYED
Though the damage from the quake was severe, the subsequent fires from broken gas lines caused the vast majority of the destruction.
3000 people died
500 shot as looters
The Fires Raged for Four Days
DIFFICULT BALANCING ACT
Between 1870 and 1914, many countries adhered to a gold standard, strictly tying national money supplies to gold stocks and standing ready to redeem currency for gold at a fixed exchange rate.
At the end of 1905, nearly 50 percent of the fire insurance in the city of San Francisco was underwritten by British firms. The San Francisco earthquake gave rise to a massive outflow of funds -- of gold -- from London, both immediately after the earthquake and again in the autumn of 1906.
The magnitude of the resulting capital outflows in late summer and early autumn 1906 forced the Bank of England to undertake defensive measures to maintain their desired level of reserves. The central bank responded by raising its discount rate two hundred-fifty basis points between September and November 1906.
Actions by the Bank of England attracted gold imports and sharply reduced the flow of gold to the United States. By May 1907, the United States had fallen into one of the shortest, but most severe recessions in American history.
At the beginning of the century, the nation was brimming with a great amount of optimism. At the right is a list of very familiar companies all founded between 1900 and 1905.
In October 1907 two brothers, Otto and F. Augustus Heinz, teamed up with Wall Street banker Charles W. Morse in an attempt to manipulate the stock of a copper company. They planned to corner the market in the copper company's shares by buying aggressively in hopes they could later force short sellers to buy them at high prices. The plan was undercapitalized and failed.
News of a cabal involving prominent New York banks in the failed scheme began a crisis of confidence among depositors. As additional institutions were implicated, queues formed outside numerous banks as people desperately sought their savings.
KNICKERBOCKER TRUST COMPANY
Trust companies were a financial innovation beginning in the 1890s. They had many functions similar to state and national banks but were far less regulated.
Illustration from Harper's Weekly December 20, 1913 by Walter J. Enright
They were able to hold a wide array of assets and were not required to hold reserves against deposits. They could earn a higher rate of return on investments and pay out higher rates, but do this while highly leveraged. They could take more risks than traditional banks.
The crash and panic of 1907 had a dramatic effect on the health of the American economy as well as those world-wide. In the United States:
THE “BIG CHIEF”
HE WASN’T ELECTED OR APPOINTED, HE JUST FELT IT WAS HIS TIME TO ACT
In the absence of a strong federal regulatory structure or any safety nets, the response to this crisis had to be delivered by a private citizen, J.P. Morgan the world’s most powerful banker. He used all of his influence to convince fellow titans of industry to pool their resources and salvage the nation. The “Panic” subsided after six weeks.
Speculation in off-street markets
Bucket Shop in 1907
The bucket shop, similar to a betting parlor, was outlawed in 1909 blamed for fueling the speculation surrounding the Panic of 1907. They provided people with a venue to place side bets on the direction they felt stock prices were going, without the inconvenience of owning the security. New York was first to ban them and then other states followed. In 2000, the Commodity Futures Modernization Act revived the bucket shop bet.
The world made a huge bet on the U.S. housing market
By ignoring risk, remaining irrationally optimistic, and forgoing transparency through a wild array of fantastically complicated investment vehicles, the world’s financial markets were managed like an unsuccessful casino. The underlying assumptions at the foundation were that housing prices never fall and homeowners almost always pay back their mortgages.
During and after the mild recession of 2001, the Fed lowers interest rates
Former Fed Chairman Alan Greenspan
Former President George Bush
Strongly promotes home- ownership.
In 2002, the Bush administration made a very public promotion of the importance of homeownership. “We can put light where there’s darkness, and hope where there’s despondency in this country. And part of it is working together as a nation to encourage folks to own their own home” –President Bush, October 15, 2002.
Highly complex forms of financing
By June of 2007, financial firms and hedge funds owned more than $2 trillion of securitized debt from sub-prime loans.
The momentum behind the expansion of homeownership led the government to reduce regulations and capital requirements for making loans. This led to a dizzying amount of innovative ways to get less qualified borrowers a mortgage and deflect the loan originator from the weight of the risk. Mortgages could be bundled and sold around the world as securities.
The agencies trusted to warn investors failed
Risk rating agencies
The MBS were multi-layered securities constructed of mortgages of differing quality levels. The obligations of solid borrowers were mixed with the sub-prime variety in a manner that made it very difficult for experts to calculate risk. The assumption that U.S. housing was a sure bet led agencies to rate these as AAA lowering investor’s guard.
What were we thinking?
“The Perfect Storm”
Homeownership peaks in early 2005 at 70% of households
The Fed raises interest rates
Home prices fall
ARMs adjust higher increasing payments for sub-prime borrowers
Borrowers default in waves
Dozens of sub-prime lenders file for bankruptcy
The substantial holdings of MBS world-wide tank and some of the biggest institutions gasp for air.
Fannie and Freddie seized by the federal government.
Financial institutions were allowed to book bets on whether people would default on their mortgages. CDS are private insurance contracts that paid off if the investment went bad, but you didn’t actually have to own the investment to collect on the insurance. These bets were unregulated and the big investment houses didn’t have to set aside any money to cover their bets.
Bank Failures: 183 (2%) 12/07-2/10 (No deposits lost)
Unemployment Rate: 10.2% (10/09)
Economic Decline: -3.8% (2Q 2008-2Q 2009)
Biggest Drop in DJIA: -53.8% (10/9/07-3/9/09)
Change in Prices: +0.5% (12/07–3/09)
Emergency Spending Programs: 2.5% of GDP for two years
Increase in Money Supply by the Fed: 125% (9/08-12/09)
With a great deal of uncertainty, the federal government unleashed a tsunami of remedies in an attempt to contain and destroy the contagion. Showing little regard for the burdens being placed on future generations, massive sums of money were created to capture toxic assets and bailout key elements. In the process, the taxpayers took over several familiar companies and had to accept the consequences of greed.
This time the government bails the country out and businessmen and bankers are labeled pariah.
Sources: Federal Reserve, Treasury, FDIC, CBO, White House (as of 11/16/2009)
Highly complex and linked financial system
Strong growth in the economy starting in 1900
Many people and institutions highly leveraged
Innovative form of finance: Trust Companies
Stock market setting all-time highs
A limited role for government
Markets swing from great optimism to great pessimism
Global interdependent financial system
Vibrant economic recovery after recession in 2001
Lenders willing to take more risk in making loans
Unregulated financial institutions: Hedge Funds
Companies reporting record earnings
Absence of many safety buffers
Dow 14,164 to 6500 in 16 months
J.P. Morgan, a private citizen, orchestrates the bailout.
The Panic lasted for six weeks, though the economy didn’t return to pre-Panic levels until 1909
Many banks were closed and depositors lost their savings
The nation was on the gold standard and the supply of money was fixed
The San Francisco earthquake was a catalyst for the Panic
The climate toward business was hostile in advance
The Federal Reserve and Treasury Department organize the reaction
The event has been unfurling for over two years
Many banks have closed but have been folded into healthier banks and depositors have yet to lose any of their savings
The nation uses Federal Reserve notes which are apparently in limitless supply
Hurricane Katrina was generally benign as a catalyst
The climate toward business was friendly in advance