Affordable Housing Institute : US

The last few weeks have revealed gaping fissures in our financial liquidity system. 

 

What do you mean, we outran our boundaries?

 

Will they lead to meaningful reforms, such as the sweeping reforms proposed by Treasury Secretary Paulson?

 

As treasury Secretary, I pray they do

 

It’s evident to me they should be – with any luck I’ll write the long editorial explaining why – but in the meantime, will they?  To answer that, you have to answer this question: is the current catastrophe big enough?

 

Do you feel lucky, blogger?

 

In a democracy, painful governmental reform is deferred long as wishful thinking is remotely plausible.  It normally takes an actual catastrophe – not a bullet dodged – to compel fundamental reform of an inadequate system. 

 

The system let us down

 

In my twenty or so years of banging my head against the edifice of policy complacency I’ve had occasion to say this multiple time; two years ago, in the context of France’s urban riots (which have, thankfully, quieted down), I even posted about it, but it was only recently, reading the Federal Reserve Bank of New York’s remarkable Congressional testimony about the Saint Patrick’s Day Weekend financial coup (about which a post is coming, never fear), that I realized how much of what we now take for granted in the American financial system is a byproduct of recovery from previous financial catastrophes averted or experienced.  Here’s a roll call:

 

Shay’s 1787 Rebellion and the Constitution.  The states that won their freedom at Yorktown and the Treaty of Paris were anything but United. 

 

 

As Shelby Foote has noted, until the Civil War people said “the United States are” (collective noun) and only after it did we say “the United States is” (singular noun).  The central government’s articles of confederation represented little more than a club to which the states belonged as members, a club that had no power to levy dues, or to raise armies, which proved a problem:

 

The rebellion started on August 29, 1786. A militia that had been raised as a private army defeated an attack on the federal Springfield Armory by the main Shaysite force on February 3, 1787.

 

Protecting the armory, 1787

 

Like many such crises, this one was precipitated by a credit crunch and an asset-value mismatch:

 

Daniel Shays, a former Continental Army officer, led an uprising of distressed farmers from western Massachusetts groaning under the load of heavy taxes assessed to pay the interest and principal (at face value in specie) of the state’s wartime debt.  During an economic depression, with farm prices low and foreign markets closed, the state government was taxing the farmers (payable in hard money only) to pay wealthy eastern creditors who had lent depreciated paper (accepted at full face value) to the state government for bonds during the war.

 

The crisis revealed a weakness in government: raising a domestic army was voluntary by the states, and many states refused Massachusetts‘ call.

 

Some of the nation’s leaders had long been frustrated by the weakness of the Articles of Confederation. James Madison, for example, initiated several efforts to amend them.  was frightened by the events in Massachusetts. By January 1787, George Washington, who had long been cool to the idea of strong centralized government, decided to come out of retirement and to attend the Constitutional Convention being called for the coming May in Philadelphia.

 

Closer to our time and more directly related to finance, we have these catastrophes to thank for spawning new institutions:

 

The Panic of 1907 and the Federal Reserve Bank.  Does any of the following sound like 2007?

 

We want our money, and we want it now!

 

Also known as the Bankers’ Panic, this was a financial crisis in the United States. The stock market fell nearly 50% from its peak in 06, the economy was in recession, and there were numerous runs on banks and trust companies.

 

The run on Northern Rock, UK, 2007

 

Its primary cause was a retraction of loans by some banks that began in New York and soon spread across the nation, leading to the closings of banks and businesses.

 

In March 07, over-expansion and poor speculation led to a stock market crash.  Money became extremely tight.  A second crash occurred in October 07.  To bring relief to the situation, the Treasury earmarked $35 [billion] of Federal money to quell the storm.  Complete ruin of the national economy was averted when J.P. Morgan stepped in to meet the crisis.  

 

Protect the bank, and the bank will protect the currency

 

Morgan organized a team of bank and trust executives that team redirected money between banks, secured further international lines of credit, and bought plummeting stocks of healthy corporations.  Within a few weeks the panic passed, with only minimal effects on the country.

 

It all happened a hundred years ago, in the Panic of 1907 – which lead directly to the creation of out Federal Reserve Banks, as testified by New York Fed CEO Tim Geithner to Congress on April 3, 2008:

 

Fortunately for us, Geithner read his financial history

 

Congress created the Federal Reserve after the Panic of 1907 with broad authority and a range of instrument … in recognition of the need for a public institution to perform the role of lender of last resort.  When the Federal Reserve was founded, there was no deposit insurance, so the willingness of individuals and businesses to hold deposits at a particular bank depended wholly on their degree of trust that the bank would be able to promptly furnish them with the money they had deposited—whenever they might request it.

 

Landmark legislation enacted in the Wilson Administration

 

From a bank’s perspective, a deposit is a short-term loan made to the bank by the depositor. 

 

But—as Congress understood—the business of banking involves making loans as well as taking deposits.

 

Pre-Federal Reserve Banks borrowed short (funding their operations with low-interest-rate deposits) and lent long.  In this they turbocharged their balance sheets, albeit unwittingly.

 

Because banks, in order to make money, needed to extend long-term credit to customers for things like the purchases of homes or investments in business equipment, not all of the money taken in by banks could be readily available to be paid out if depositors were to request it. In fact, only a small fraction of a typical bank’s assets were kept in liquid enough form to be immediately paid to depositors upon demand.

 

That’s still true today.

 

This fundamental fact of bank operation left banks—and the banking system—open to liquidity shocks that, nearly a century later, have their echoes in recent market developments.

 

The financial crises around the turn of the century were the historic catalyst for the Federal Reserve’s creation by Congress. It is panic or fear that drives depositors en masse to the door of the banking house to demand their money back.

 

You’re interested in the 4% only if you’re confident the principal is safe

 

In such a case, even an institution that is fundamentally solvent—i.e., whose assets (mostly longer-term loans) are worth more than its liabilities—may find that it does not have enough cash on hand—that is, enough liquidity—to satisfy its customers.

 

Eerie echoes of Bear Stearns, isn’t it?  Here’s what I said when it happened:

 

Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades.  Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do. 

 

These tickets are valuable

 

It’s no irony that an institution created after the Panic of 1907 played a critical role in what will prove to be the turning point in the Panic of 2007-08. 

  

1929’s Black Tuesday and the Securities and Exchange Commission.  Everybody knows that the Roaring Twenties came to an end with a mighty crash as populist panic overwhelmed plutocratic prudence:

 

When you can’t get your money, mill about!

 

With the bankers’ financial resources behind him, Richard Whitney, vice president of the Exchange, placed a bid to purchase a large block of shares in U.S. Steel at a price well above the current market. As amazed traders watched, Whitney then placed similar bids on other “blue chip” stocks.

 

Like bacteria that evolve immunities to previous vaccines, new crises prove immune to the previous panic’s treatment:

 

This tactic was similar to a tactic that ended the Panic of 1907, and succeeded in halting the slide that day. In this case, however, the respite was only temporary.

 

Over the weekend, the events were covered by the newspapers across the United States.

 

 

Note the appearance of mass media, and their impact on shaping public opinion.

 

On Monday, October 28, more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 13%. The next day, “Black Tuesday”, October 29, 1929, 16.4 million shares were traded, a number that broke the record set five days earlier and that was not exceeded until 1969.  The market lost $14 billion in value that day, bringing the loss for the week to $30 billion, ten times more than the annual budget of the federal government, far more than the U.S. had spent in all of World War I.

 

More money lost in one day than the US spent in World War I

 

Black Tuesday in 1929 led to the Securities and Exchange Commission.  As I wrote 2½ years ago:

 

The stock market crash of Black Tuesday (October 29, 1929) begat securities laws (1933) and the SEC (1934).

 

 That one took only four years of severe depression and a new president.

 

Today it’s unthinkable that we could have publicly traded securities without full and accountable disclosure – for that, credit the Depression. 

 

Something good’s gotta come of this

 

The Depression wrought massive changes in the American housing ecosystem as well: it birthed the Farmers Home Administration (FmHA, now known as Rural Housing Services); the Federal Housing Administration (FHA, now part of HUD); and the Federal public housing system.

 

Does it take a Depression to create an administration?

 

So the system remained for roughly thirty years, while intervened global trauma of a different kind – World War II.  The resulting postwar boom – demographic and financial – carried the US economy and our housing infrastructure steadily upward for thirty years, until the late Sixties.

 

[Continued tomorrow in Part 2.]

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