Download Do financial crashes have anything in common?

Do financial
crashes have
anything in
common?
Run on the Seamen’s Savings’ Bank during the Panic of 1857
By Steven Albrecht
B
efore 2001, when the words “financial crash”
were mentioned, most investors would think
of 1929, The Great Depression. Few think of
1987, 1907, 1857 or 1825. Now, thoughts of 2008
are more in the forefront of people’s memories. In
each case, investors thought this time was different.
After it was over, they turned to governments to
take steps to prevent the next great crash. I have
been looking at the events that took place prior to
each of these crashes and believe there is a common
thread. Unfortunately, the thread does not identify
a specific quantitative value that once exceeded
triggers a crash. There is also no specific time
interval in which a correction must take place such
as every 10 or 15 years. However, there is a repeated
occurrence that stands out in each of the financial
crashes that I find interesting.
Let’s first move back in time to 1825, to England
where since 1820, British bonds, called gilts, had
been offered as safe investments and had had
correspondingly low yields. They were safe and
boring. In other parts of the world, yields were
much higher, and it was well known that the risks
were higher, as well. These risks were associated
with a lack of good information about the bonds
being offered.
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The 1907 Bankers’ Panic or “Knickerbocker Crisis”
New York’s American Union Bank during a bank run early in 1929
The 2008 Economic Collapse
Understanding Investments Journal
Boring started to dwell on investors, and they wanted
higher returns. Foreign bonds appeared to offer such an
attraction. In 1822, Columbia, Chile, Peru and Mexico
were offering bonds on the London Stock Exchange
that offered higher yields and successfully placed over
21 million Sterling or what would equal $2.8 billion in
current US$. Information on foreign bonds was poor and
limited, but yields were great. Investors were ignoring the
fact these investments were speculative and poured more
money into Russian, Prussian and Danish bonds. Investors
were so desperate to improve yield, that one bond was
sold successfully for a country that did not even exist.
Spain was the first country to start to weaken from slower
economic growth and was on the verge of default in 1823.
With Spain in trouble, fear started to spread through the
foreign bond market. Investors wanted out quickly. After
all, they had planned on seeing this coming and wanted
to get out before everyone else. Unfortunately, “everyone
else” was ready at the selling desk. Peruvian bonds fell 40%
in 1925, as did others. Eventually, the Bank of England had
to step in to avert a major collapse, generated from runs
on deposits at London banks.
The markets were calm for 30 years, and America started
to greatly expand trade with Britain. By 1855, America
was already running a $25 million current account deficit.
In return, Britain was enamored with American company
stock. British holdings of American company stock was
approaching $80 million. Railway companies such as the
Illinois Central and Philadelphia & Reading were popular
investments. They were so popular that several prominent
British investors were serving on American railway
boards.
situation because it had borrowed, thereby leveraging
their investments, in hopes of enhancing the future return.
It didn’t work. Ohio Life failed and the market grew
concerned about bank investments in railway enterprises.
If Ohio Life could fail, maybe the banks could fail as well?
By October 1857, banks were starting to see deposit
redemptions build due to market concerns with the
banks railway investments. As deposits slowed, the banks’
financial strength began to weaken to the point some
banks refused to convert deposits into cash. America’s
financial system started to collapse. This spread to England
because British merchants who traded with American
companies began to suffer from late and failed payments.
A large lender, Overend & Gurney, eventually failed. The
Bank of England refused to step in with a rescue plan.
Panic spread across Europe and eventually hit America.
Again just as in 1825, speculative investments crept into
mainstream investing where earnings should have made a
difference.
Moving forward another 50 years America was enjoying
growth rates in excess of 5%. By 1907, banks had become
very common: the country was populated with 22,000
banks, almost one bank for every 4,000 people. Larger
investors were moving into trust companies where
deposits could be placed into investments of stocks and
bonds. Over the years, even better returns were sought
out by including more speculative investment options
such as underwriting, property, and management of
companies such as railroad enterprises.
Knickerbocker Trust in New York was a favorite amongst
the wealthy in Manhattan. In just ten years, from 1896
There was one problem with the excitement over railway
investments; current earnings did not justify the share
prices. Almost the entire price was based on speculative,
future earnings and the hope to sell in the future at
a higher price. The British were not alone; railway
investments filtered into American corporate portfolios as
well. Ohio Life invested over 63% of their insurer’s assets
in railways. This amounted to over $3 million of a $4.8
million portfolio. Prices were hot, and lack of earnings
were ignored.
Eventually, around 1857 doubts started to creep in as to
whether or not expectations were going to materialize
in the case of the railroads. Costs were constantly eating
up higher revenues, and money was always being used
for expansion and development. Investors were tired of
waiting for tomorrow, and selling pressures started in
the spring of 1857. Ohio Life was caught in a difficult
The Knickerbocker Trust Building, New York Circa 1904
Charter Trust Company
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to 1906, they had grown from $10
million in deposits to $60 million.
The trust company had leveraged
investments to increase returns
even more. Unfortunately, when
the economy started to slow in
1906, management started to
borrow funds from the banks it
managed. Speculation had entered
the investment options offered by
Knickerbocker. Losses became
larger, not smaller, and internal loans
increased. Eventually, depositor
redemptions started. On the first day,
Kinckerbocker redeemed $8 million
in deposits but eventually had to stop
as it ran out of funds.
New technologies were exciting to everyone.
Most americans owned a radio, some were
travling by plane and aluminum was making
things possible that had never before been
contemplated. With these advances, stock
investments started to focus on future
opportunities rather than on dividends and
earnings. New capital was needed to fuel
rapid growth in new technology; otherwise,
investors and enterprises would be left
behind.
Panic spread throughout New York
trust companies leading to depositor
runs, which began at the largest
trust companies such as America
Trust and, eventually, Lincoln Trust.
The financial system of the U.S.
was coming into question, and for
protection depositors’
hoarded cash
at home
removing
it from the
money supply.
Interest rates
started to climb and
eventually reached 125%.
One banker, JP Morgan,
decided to create a pool of
assets to reinforce confidence in
the banking system. It worked for
a while but eventually ended as runs
spread throughout the country, and GDP
fell by 11% in 1908. Speculative investments
again had moved into main stream investing
as investors ignored dangerous positions to gain
returns.
The United States returned to prosperity quickly,
and by 1925 Ford was building affordable cars for
everyone. Banks were back to earlier levels at 25,000
institutions with $60 billion in deposits. Investments were
conservative, placing 60% in loans, 15% in cash reserves,
20% in bonds, most of which were government bonds, and
only 5% in stocks.
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At the same time, established companies
started to weaken because consumer prices
were falling, even while stock prices were
rising. The “new” market was chasing the
future opportunity and reaching new highs,
while the existing market was slowing.
Earnings of established companies eventually
weakened. The Federal Reserve wanted to
slow speculation in the market and in 1928
raised interest rates from 3.5% to 5.0% in an
attempt to slow stock speculation. Shortly
thereafter, in 1929, the DOW reached a
new high of 381.
This increase in
interest rates did
not accomplish what
the Fed so desperately
wanted.
In October of 1929 an
unrelated investment scandal
broke out in London, and the
British stock market began a rapid
decline. Unfortunately, it spread to
the U.S. and the Dow dropped from the
previous high of 381 to 198, just slightly
half of what it had been at its peak. With
falling valuations in their portfolios investors’
turned to the banks to redeem deposits. Bank
failures started to appear in the Midwest as
agriculture-based prices declined. Consumer prices
had been falling, and all levels of businesses were
under pressure on earnings. Loans which needed to
be repaid, were not, and by 1931 bank failures were
common and carried into major markets such as Chicago,
Cleveland, and Philadelphia.
In an unrelated move, Britain dropped the gold standard
in an attempt to gain control of the country’s currency.
It was no surprise, except perhaps to England, that the
Understanding Investments Journal
currency devalued. This created another financial blow
to theU.S. by hitting export-related companies resulting
in further stress on the American banking system. The
Federal Reserve started buying bonds to move money
into the economy. Eventually, panic started to spread and
by February 1933 banks across the country began closing
their doors. Interior banks of the Midwest started calling
on Eastern banks to retrieve their deposits. This stripped
the Eastern banks of reserves and the Eastern banks called
on the Federal Reserve. The Federal Reserve refused to
lend, and 11,000 banks failed.
The Federal Reserve’s decision to not backstop the banks
started a cascading effect of public fear, and the money
supply dropped by 30%, reducing economic activity
and investment. Unemployment, which escalated as
enterprises attempted to wrestle with survival, reached
25%. Again, speculation in new technologies that should
have remained a small portion of investors’ portfolios
crept into the mainstream as people chased returns.
The following events, some directly related, others just
circumstance, caused another financial collapse.
I think it is apparent to most investors that the 2001 “dot.
com” crash was created by investors who were chasing
new technology and forgot about earnings. Remember the
“New Economy”? The same was true in 2008 as investors
chased mortgage derivatives without good knowledge
of credit quality or repayment. Investors were chasing
yield and return. Maybe that was the “New and Improved
Economy.”
On their own, none of these speculative investments
would have caused the financial markets to collapse,
especially on a global basis. What should have been a
limited investment became mainstream. In 2000, no one
cared about GE, but knew everything about a new startup with no revenues and no earnings. If the speculative
investments had remained limited in portfolios, who
knows what the global economy would be today?
Investments in new technology might be more consistent
rather than all-in or all-out, and, yes, they would still carry
risk, but maybe more manageable?
In each case, speculation became a main focus of
investment portfolios, certainly not by everyone, but by
enough investors that it created a potential stress crack
in the overall financial foundation. The stress speculation
creates may not be the only direct cause, but when the
stress is there, sometimes all it takes is one outside event
to create the break.
Charter Trust Company
Steven Albrecht
President & Chief Executive Officer
Charter Trust Company
Mr. Albrecht can be reached at 603-224-1350
or via email at: [email protected]
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