Feb 18, 2014

Lessons from the 19th century crises

In the 19th century, an unexpected failure of just one or a few firms was usually enough to ignite a panic. That was because in the era without a lender of last resort, company reputation was more important than actual financial soundness. In such a setting, a collapse of one or two prominent financial institutions typically resulted in widespread distrust of other financial companies and in an immediate withdrawal of deposits from banks and investments from the stock market.

Panic of 1819
State and private banks oversupplied mortgages to Western farmers seeking to acquire land from the federal government. When land speculation ended, farmers could no longer pay back to the banks. The bankruptcy of banks ignited the panic.

Panic of 1837
A simultaneous failure of J. L. & S. Josephs & Co., a New York bill broker, and Hermann, Briggs & Co., a client of Josephs & Co. and a major cotton manufacturer, precipitated the start of the panic.

Panic of 1839
The Bank of the United States of Pennsylvania failed due to a classic maturity mismatch. The bank funded itself with short-term liabilities called post notes while making long-term investments in government bonds that had been issued for construction of canals and railroads in the West. When the expected returns on canals and railroads did not materialize, the Bank of the United States was forced to close up shop, commencing a panic.

Panic of 1854
The collapse of Knickerbocker Saving Bank sparked a run on other banks in New York City. To meet depositor withdrawals, banks sharply reduced cash provision to the call loan market and sold some of their own securities, in effect further depressing prices on the stock market.

Panic of 1857
The origin of the panic stemmed from the uncertain political environment over the issue of whether the states of Kansas and Nebraska would end up becoming slave states. The political ambiguity negatively impacted Western railroads that build railway lines between Western and Eastern states. Financial troubles at railroad companies in turn led to a collapse of the Ohio Life and Trust Company, a bank that had substantially lent to railroads. The bank's failure marked the beginning of the stock market panic.

Panic of 1873
The panic was triggered by the collapse of Jay Cooke and Company, an investment bank established by a famous financier named Jay Cooke, who had played a crucial role in obtaining financing for the Civil War. Cooke & Co. had concentrated its investments in bonds issued by railroad companies. When railroad companies defaulted on their bonds, so did Cooke & Co., spreading a panic across the financial system.

Panic of 1884
The fiasco of Grant & Ward, a famous brokerage firm, started the panic. The firm was managed by the ex-president and the commander of Union armies during the Civil War, Ulysses Grant, and by one of the "young Napoleons of Wall Street" (Sobel, 1999, p.219), Ferdinand Ward. Grant & Ward failed due to large investments in railroad stocks.

The failure of Grant & Ward was followed by a temporary but acute suspension of payments by the Metropolitan National Bank, which had also made speculative bets on railroad stocks. A widespread panic ensued.

Panic of 1890
The collapse of two brokerage firms, Decker Howell & Company and Charles Whitney, both of which had placed large bets on railroad securities, triggered the panic.

Panic of 1893
Several national banks, most famously the Chemical National Bank of Chicago, failed after having made bad loans. This was followed by a failure of big-name private banks, including Herman Schaffner & Company and Wisconsin Marine and Fire Insurance Company Bank, both of which had made unsound investments in real estate and mining. A credit crunch and a financial panic followed.

Conclusion
As a very LT investor can observe, in all major panics of the 19th century, financial institutions failed because they had overly concentrated their investments in rapidly-growing and speculative sectors of the economy, such as real estate, railroads, or mining. At the epicenter of each of these panics were shadow banks: either totally unregulated brokerage houses and investment banks, or lightly regulated state banks that nevertheless fall under the definition of shadow banking.


Sources

Cormac, G. & White, E. (2002). Who Panics During Panics? Evidence from a Nineteenth Century Savings Bank (NBER Working Paper No. 8856). Cambridge, MA: National Bureau of Economic Research.

Rockoff, H. (2013). The Failures that Ignited America’s Financial Panics: A Clinical Survey (Rutgers University Paper). New Brunswick, NJ.

Sobel, R. (1999). Panic on Wall Street: A history of America’s financial disasters. Washington, D.C.: Beard Books.

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