Saturday, June 27, 2020

BIS: "The first sub-prime mortgage crisis and its aftermath" (1857)

"Emerging market speculation tends to appear at a juncture in the economic cycle when 
declining yields on domestic bonds combine with an excess of capital to make 
foreign investments particularly attractive."
-Edward Chancellor
Chapter 4, Fool's Gold: The Emerging Markets of the 1820's

That was a Climateer Quote of the Day back in 2010.

Keynote speech at the joint BIS/Monetary Authority of Singapore "Property markets and financial stability" workshop, 5 Sept 2011 released March 2012 via the Bank for International Settlements:

Financial markets in the years and months leading up to the financial crisis of 2007–08 were characterised by growth in the shadow banking sector, pyramiding and hidden leverage in the consumer and financial sectors, off-balance sheet financing by systemically important firms, and mortgage securitisation and other “creative” financing schemes that some say resembled games of “hot potato” and “hide the sausage”. The failure of a prominent financial institution triggered an eventual full collapse in stock prices, resulting in, among other things, a foreclosure crisis with long-lasting negative spillovers into the real economy.

Many believe the recent crisis to be unprecedented, where, for example, Hyun Song Shin (2010) wrote: “The global financial crisis that erupted in the summer of 2007 has the distinction of being the first post-securitisation crisis in which banking and capital market developments have been clearly intertwined.” In this speech I will present research I am conducting on the US panic of 1857 that contradicts Professor Shin’s observation, where the 1857 panic bore eerie similarities to the more recent panic.
The older panic, which occurred almost exactly 150 years prior to the more recent panic, had, in addition to the factors noted above, global capital flows emanating primarily from England and the Continent with clearly intertwined banking and capital markets. And, although sub-prime mortgage lending and securitisation were perhaps not as widespread as they were in the current crisis, they played a very central role in propagating the panic from a few strategically placed firms located near the frontier of the Old Northwest back east to New York City and Europe.

It is said that every crisis is similar and that every crisis is different. Identification of the relevant similarities and differences requires memory and retained knowledge, where this knowledge can be gained and retained in different guises. The broader objective of this speech is to argue that historical perspective, and more generally inductive methods to research, provides a strong complement to more traditional deductive research methods such as large-sample econometric analysis.

This speech is organised in three acts. The first act sketches the background of the US economy in the years and months leading up to the crisis of 1857 (which occurred in late August and lasted through October of that year). The second act analyses the sub-prime mortgages and their securities that existed at the time, which were known as the railroad farm mortgage (RRFM) and the RRFM-backed security. The third and final act considers the failure of the prominent financial institution that triggered the panic, and the panic’s aftermath as it specifically related to the RRFMs and their securities.

Act I: The years and months leading up to the panic of (late August through October) 1857
Some historical background on the 20 years leading up to the panic of 1857 is necessary to appreciate the panic’s many contributing factors. At a very basic and very real level, the panic of 1857 was the natural culmination of events that started with the even more severe panic of 1837.

For my story, there are two essential direct consequences of the earlier panic that are relevant. First, as a result of state-level funding of transportation infrastructure development (canals and the relatively new invention of the railroad), a number of states defaulted on their bonds after the panic of 1837. This experience caused many states to restrict any public funding of transportation projects. These restrictions shifted the burden of financing public goods to cities and more often individuals, resulting in a number of distorting effects. Second, bank failures in the 1837 panic were related to “money-run” as opposed to “deposit-run” problems, as deposit-based banking was in its infancy in the United States. Thus, the free banking era was born after 1837, with most of the regulatory focus on the quality of money printed by individual banks. Deposit-based banks consequently operated at the fringes of banking and bank regulation at the time, and were in effect shadow banks. By the time of the 1857 panic, other non-money issuing firms such as railroads also operated as shadow banks by intermediating between direct capital suppliers and indirect investors.

In addition to state-level funding of infrastructure projects, significant amounts of the capital channelled into investment prior to the 1837 panic came from England and the Continent. After that crash, foreign investors said, “Never again!” Time and a yearning for easy riches erode many things, however. One key event that prompted a change in attitude among foreign investors was the California gold strike and gold rush of 1848 and 1849. That event significantly added to the gold stock of the United States and the world, resulting in, among other things, increased credit availability, growth in world trade, industrial construction and railroad building (Van Vleck (1943, pp. 38–39)).

Shortly after the gold rush, a railroad boom indeed began in earnest, as newfound wealth and an influx of foreign capital made its way into the hands of railroads and their promoters. Figure 1 shows the extent of the boom, with the amount of investment and added railways from 1850 to 1856. It is estimated that in excess of 25 per cent of the US GDP derived from the railroads during the mid-1850s. As noted in Panel B of the figure, Ohio, Indiana, Illinois, Michigan, Wisconsin and Iowa were considered western states at the time, at or near the frontier of the country and of railroad development. Figure 2 provides a visual depiction of  railroad investment/construction activity during the 1850s.

Largely because of the huge capital appetite of the railroads as a result of their stupendous growth during the 1850s, Wall Street began taking on its more modern character as an investment banker in addition to providing stock brokerage services and other methods of sourcing capital and making markets for securities. These developments helped lay the foundation for new creative ways to package securities for sale to investors....MORE (12 page PDF)
First posted March 2012.

In the earlier post "Is our money about to spout memories?" the writers quote "Hyun Shin, of the Bank for International Settlements" and I thought "Why do I know that name?"
And there he is back in 2012 before he went on to work for the very same BIS that put on the workshop. For what it's worth the author of this speech, Timothy J Riddiough, does not work for the BIS, instead he has an endowed chair at the University of Wisconsin.

See also
Charles Dickens on Finance and Financial Crises
To honor the bicentenary of Dickens birth I had planned to put together a post on Dickens and the commercial crisis of 1857-58 including the failure of the Strahan, Paul & Bates bank. Then I found that someone much, much sharper than I had done it back in 2008....