Credit crisis: Meltdown!

In the past 100 years, the rollercoaster ride that is the world of high finance has seen some spectacular lows. Sean O'Grady looks back at four episodes that not only came to define their times but also served as lessons for the future
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The Independent Online

1907: The Bankers' Panic

Sometimes, all that is necessary for a crash to occur is for the lessons of the last one to be forgotten. The Panic of 1907, despite having a strong claim to be the first of the modern era's great financial crises, has been long neglected, although the South Sea Bubble and John Law's Mississippi Scheme, both of which collapsed in 1720, will always have a parable-like quality in their account of unalloyed transcontinental greed.

Bankers and investors in Europe then lost money as a result of more fearless fraudulent ventures thousands of miles away, thus proving that globalisation is not quite as novel as we might think.

And, of course, banks have failed throughout history – although in our own time BCCI (1991) and Barings (1995) have been particularly dramatic and could be treated as one-offs. The reason they did not trigger a wider, "systemic" crisis was because of the system developed after Overend and Guerney went bust in 1866. It was after that that the Bank of England developed its role as the "lender of last resort" for banks in trouble, a safety mechanism to buy time and sooth nerves. So we have been here a few times before.

A century ago, though, the world witnessed the City of London and Wall Street enduring their first serious "stress test". From 1814 to 1914 the United States lived through 13 banking panics, and that of 1907 was the worst. It arose because of the failure of one particular bank, the gloriously named Knickerbocker Trust, run by a man named Charles Barney. Then, as now, an ambitious banker was attracted to "above-average returns" by two speculators who wanted to corner the market in copper, and to use Knickerbocker's funds to do so. Today their operation would probably be termed a hedge fund.

All might have been well, or not turned so disastrously wrong so quickly, if the San Francisco earthquake hadn't put a huge strain on the world's banks and insurers. Lloyd's of London, later to have troubles of its own, was then at the peak of its powers and had insured San Francisco. The payment of claims following the quake and fires produced a large capital outflow, forcing the Bank of England to nearly double interest rates and discriminate against US trade bills. These actions pushed the US into a recession, pushed down the stock market and fatally weakened the Knickerbocker Trust.

In reality, though, the coup de grace was delivered by its own customers, who queued and queued for their cash - $8m of it in two hours one morning in October 1907. Clerks from the bank would address the waiting queues and tell them that the bank was solvent, just as Northern Rock is telling its customers now. Not one left the queue. As The Washington Post reported at the time: "Stacks of green currency, bound into thousand dollar lots, were piled on the counters behind the tellers. One by one these stacks were broached and they dwindled rapidly. Clerks went to the vaults from time to time with arms full of notes, piled up like bundles of kindling wood".

One depositor even took away his money in three wooden boxes of silver quarters. It was too much for the Knickerbocker and it fell, prompting the second stock market crash in a year, with shares down 50 per cent on the year.

As for lessons and effects, the 1907 episode had three. First, the leadership position of the most powerful financier in the world, John Pierpont Morgan, was cemented. With his ally Edward Grenfell in London, Morgan organised lines of credit, purchased shares in sound but distressed companies and engineered banking mergers to protect the system. Morgan's view of commercial credit was that it was above all about "character"– "A man I don't trust could not get money from me on all the bonds in Christendom". We will see how today's J P Morgan company has coped with the sub prime panic when it reports its results next week.

Second, the American public's suspicion of big finance and oligarchic corporations led to the anti-monopoly "trust busting" laws of the next decades. Third, the United States developed the Federal Reserve System in 1913. Prior to that, in the spirit of laissez-faire, it lacked a central bank with a "lender of last resort" mandate. The Fed's most influential chairman was probably Alan Greenspan (1988 to 2006), whose memoirs are out soon, seeking to defend him against the charge that his accommodative policies – cutting interest rates every time the stock market took a tumble and thus encouraging speculation – were disastrous in the long run.

1929: The Wall Street Crash

On 24 October 1929, the panic-selling started on the New York Stock Exchange. Some 12,894,650 shares were traded in a single day, three times any previous record. By 12.30pm, the Chicago and Buffalo exchanges closed down, 11 speculators had killed themselves and the New York Stock Exchange closed the visitors' gallery on the frenzied scenes below.

J P Morgan and Company convened a meeting , and made the following statement that, "there has been a little distress selling on the Stock Exchange... due to a technical condition of the market" and that things were "susceptible to betterment". Not quite right. Despite its infamy, Black Thursday was not quite as grim as Black Monday in October 1987. What was remarkable about 1929 was that, despite rallies and recoveries, the slide in equities didn't actually end until 1932, by which point investors had lost 89 per cent of the value of their shares compared with the peak in 1929. For those who bought at the apex of the speculation, they would not see their money back until late 1954, and, in real terms, until even later. In his classic work The Great Crash: 1929, J K Galbraith put the decline down to the bad distribution of income; the bad corporate structure; the bad banking structure; the dubious state of the foreign balance; and the poor state of economic intelligence. He might have been writing about George W Bush's world rather than that of Herbert Hoover.

Even so the economy was, as the politicians said at the time, "fundamentally sound", but the losses on Wall Street and the banking panic that followed helped to cause the Great Depression. The most notable failure at the time, however, was in Austria. When Credit Anstalt followed many of the German banks into liquidation in 1931 there seemed little hope for the European economies. Governments fell, nations came off the Gold Standard and the Nazis triumphed in 1933. America came off better, with F D Roosevelt and the New Deal, but even though he reassured Americans that "the only thing we have to fear is fear itself" and enacted his bold polices to deal with, among other things, a crisis in the mortgage market, the US only really emerged from its troubles after Pearl Harbour. By 1945, a sprit of "never again" gave the world the Bretton Woods system of international financial support (with the IMF and World Bank at is centre), the widespread adoption of Keynesian demand management polices to defeat unemployment through public spending, and the Welfare State.

1974: The Banking Crisis

A peculiarly British phenomenon, and still not well documented even now. The availability of cheap credit and deregulation of financial institutions resulted in a property boom, which was only brought to an end by the multiple blows of a quadrupling in the oil price, the miners' strike, the three-day week and tensions resulting from the Yom Kippur war. London and County Securities was one such victim. Rumours abounded that the Nat West might also be in trouble and some smaller building societies were taken over by larger more secure brethren. The Bank of England launched a number of "lifeboats" at the time – rescue packages to prevent the "contagion" causing a more generalised panic. It was another debacle to hang around the neck of Edward Heath's Conservative government.

1990: The Housing Crash

Between 1990 and 1993, 247,000 home owners lost their homes as house prices slumped and unemployment rose to record levels. Yet again, easy money was the root cause. The mood in the property market in the late 1980s was even more fevered than today. And while the Great Crash of October 1987 was severe, it was also unusually short-lived – as central bankers throughout the world cut interest rates to bolster confidence and ensure that any institutions in trouble could borrow their way out of trouble. The party that had started after the recession of 1979-81 resumed.

However, the boom did not last, as three factors intervened. First, inflation picked up so that the then chancellor Nigel Lawson and his successors were forced to push interest rates up steeply. Second, the slowdown that followed turned into a recession, with joblessness rising and repossessions relentlessly in the news. Third, the UK joined the ERM, and, to keep sterling at a given exchange rate, the Conservative government kept interest rates at punitively high levels.

John Major, the prime minister, said afterwards that the policy had "killed" inflation. It also killed a lot of households, as people lost their jobs and couldn't afford the huge increases in their mortgage repayments. (Now reforms to bankruptcy laws and Individual Voluntary Arrangements make it much easier for defaulters to run away form their responsibilities – to the worry of the banks).

A new phenomenon emerged – the "negative equity trap" where a homeowner's property had fallen below the value of the mortgage debt outstanding. No one moved house, except if the bailiffs popped over to invite you to relocate. It was a national disaster. It did for Margaret Thatcher and was used by New Labour as a totem of Tory economic incompetence. The 1997-98 series of crises in East Asia and Russia, the collapse of the infamous Long Term Credit Management hedge fund, and the bursting of the dot com bubble in 2000 were all phenomena that affected far fewer households directly. The worrying signs are that Northern Rock's problems look like a symptom of a wider, systemic malaise. One for the history books, perhaps.

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