The Panic of 1873

They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default.

Answer: nothing.

A key theme of Honestly Lay Bare is that we seek out historical case studies to illuminate the appropriateness of responses to modern day scenarios.

The current credit crisis has led many to draw comparisons to the Great Depression of 1929.

Such comparisons are 56 years from the real great depression and the classic case study of a market meltdown when there was a misunderstanding of risk.

Welcome to the Panic of September 1873.

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The problems had emerged around 1870, starting in Europe.

In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris.

Mortgages were easier to obtain than before, and a building boom commenced.

Land values seemed to climb and climb; borrowers assumed more and more credit, using unbuilt or half-built houses as collateral.

But the economic fundamentals were shaky.

Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them.

The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export trainloads of wheat to abroad.

Britain, the biggest importer of wheat, shifted to the cheap wheat quite suddenly around 1871.

By 1872 kerosene and manufactured food were rocketing out of America's heartland, undermining rapeseed, flour, and beef prices.

The crash came in Central Europe in May 1873, as it became clear that the region's assumptions about continual economic growth were too optimistic.

Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis.

The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates.

This banking crisis hit the United States in the fall of 1873.

Railroad companies tumbled first.

They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. Answer: nothing.

The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track.

Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble.

When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years.

The panic continued for more than four years in the United States and for nearly six years in Europe.

The long-term effects of the Panic of 1873 were perverse.

For the largest manufacturing companies in the United States — those with guaranteed contracts and the ability to make rebate deals with the railroads — the Panic years were golden. Andrew Carnegie, Cyrus McCormick, and John D. Rockefeller had enough capital reserves to finance their own continuing growth.

For smaller industrial firms that relied on seasonal demand and outside capital, the situation was dire. As capital reserves dried up, so did their industries. Carnegie and Rockefeller bought out their competitors at fire-sale prices.

As the panic deepened, ordinary Americans suffered terribly.

Between 1873 and 1877, as many smaller factories and workshops shuttered their doors, tens of thousands of workers — many former Civil War soldiers — became transients. The terms "tramp" and "bum," both indirect references to former soldiers, became commonplace American terms. Relief rolls exploded in major cities, with 25-percent unemployment (100,000 workers) in New York City alone.

Unemployed workers demonstrated in Boston, Chicago, and New York in the winter of 1873-74 demanding public work. In New York's Tompkins Square in 1874, police entered the crowd with clubs and beat up thousands of men and women. The most violent strikes in American history followed the panic.

A nationwide railroad strike followed in 1877, in which mobs destroyed railway hubs in Pittsburgh, Chicago, and Cumberland, Md.

In Central and Eastern Europe, times were even harder. Many political analysts blamed the crisis on a combination of foreign banks and Jews. Nationalistic political leaders (or agents of the Russian czar) embraced a new, sophisticated brand of anti-Semitism that proved appealing to thousands who had lost their livelihoods in the panic. Anti-Jewish pogroms followed in the 1880s, particularly in Russia and Ukraine.

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Compare this period of uncertainty with today and you start seeing the ghosts of the residential mortgage market.

Loans after about 2001 were issued to first-time homebuyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times.

Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing.

Those debts were wrapped in complex securities that mortgage companies and other entrepreneurial banks then sold to other banks; concerned about the stability of those securities, banks then bought a kind of insurance policy called a credit-derivative swap, which risk managers imagined would protect their investments. More than two million foreclosure filings — default notices, auction-sale notices, and bank repossessions — were reported in 2007.

By then trillions of dollars were already invested in this credit-derivative market.

Were those new financial instruments resilient enough to cover all the risk? (Answer: no.)

The protracted reconstruction of banks in the United States and Europe created widespread unemployment.

Unions (previously illegal in much of the world) flourished but were then destroyed by corporate institutions that learned to operate on the edge of the law. In Europe, politicians found their scapegoats in Jews, on the fringes of the economy.

Americans, on the other hand, mostly blamed themselves; many began to embrace what would later be called fundamentalist religion.

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135 years later it appears that we have failed to learn the lessons of the Panic of 1873.

Why is that?

Is it that each generation needs to learn a new.

Does society’s understanding of risk blind itself to thinking that lessons can be learnt from examples of human endeavor.

Does society think that human nature changes over time such that we cannot see in ourselves the actions of a forebears.

If there is one lesson from the Panic of 1873 it is that all the investment in current risk management frameworks and models may be no more beneficial than having on your payroll a knowledgeable and articulate business historian.

Could the Chief Historian be about to replace the Chief Risk Officer?

(Post based in part on The Real Great Depression By Scott Reynolds Nelson The Chronicle of Higher Education October 17, 2008 Issue)