THE PANIC OF 1907 THE FINANCIAL CRISIS OF 2007

PANDEMONIUM IN THE MARKETS

DEVASTATION SAN FRANCISCO EARTHQUAKE

Shortly after 5 a.m. on April 18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute.

EVENTS IN 1906

UNCONTROLLABLE BLAZE 80% OF THE CITY DESTROYED

Though the damage from the quake was severe, the subsequent fires from broken gas lines caused the vast majority of the destruction.

SAN FRANCISCO EARTHQUAKE 1906

3000 people died500 shot as looters

The Fires Raged for Four Days

REMEMBERING THE SAN FRANCISCO EARTHQUAKE OF 1906

DIFFICULT BALANCING ACT INFLEXIBLE CURRENCY

Between 1870 and 1914 many countries adhered to a gold standard.

This strictly tied national money supplies to gold stocks.

Currency was redeemed for gold at a fixed exchange rate.

THE GOLD STANDARD

THE WORLD’S FINANCIAL SYSTEM HAD BECOME COMPLEX & INTERRELATED

At the end of 1905, nearly 50 percent of the fire insurance in San Francisco was underwritten by British firms. The earthquake gave rise to a massive outflow of funds -- of gold -- from London, both immediately after the earthquake and again in the autumn of 1906.

The magnitude of the resulting capital outflows in late summer and early autumn 1906 forced the Bank of England to undertake defensive measures to maintain their desired level of reserves. The central bank responded by raising its discount rate 250 basis points between September and November 1906.

Actions by the Bank of England attracted gold imports and sharply reduced the flow of gold to the United States. By May 1907, the United States had fallen into one of the shortest, but most severe recessions in American history.

GREAT ECONOMIC PROMISE

At the beginning of the century, the nation was brimming with a great amount of optimism.

Here is a list of

very familiar companies all founded between 1900 and 1905.

Eastman KodakFirestone TireFord MotorsHarley-DavidsonHersheyU.S. SteelJ.C. PenneyPepsi-ColaTexacoSylvania Electric

EVENTS IN 1907

In October 1907 two brothers, Otto and F. Augustus Heinz, teamed up with Wall Street banker Charles W. Morse in an attempt to manipulate the stock of a copper company.

They planned to corner the market in the copper company's shares by buying aggressively in hopes they could later force short sellers to buy them at high prices.

The plan was undercapitalized and failed.

PANIC IN THE STREETS

News of a cabal involving prominent New York banks in the failed scheme began a crisis of confidence among depositors.

As additional institutions were implicated, queues formed outside numerous banks as people desperately sought their savings.

FURTHER COMPLICATING MATTERS

Trust companies were a financial innovation beginning in the 1890s. They had many functions similar to state and national banks but were far less regulated.

GREATER RISKS WERE TAKEN

They were able to hold a wide array of assets and were not required to hold reserves against deposits.

They could earn a higher rate of return on investments and pay out higher rates, but do this while highly leveraged.

They could take more risks than traditional banks.

A NEW YORK CITY BANK RUN IN NOVEMBER OF 1907

The runs on deposits that sparked the Panic of 1907 were at two of the largest New York City Trust Companies: Knickerbocker Trust and Trust Company of America.

THE IMPACT

The crash and panic of 1907 had a dramatic effect on the health of the American economy as well as those world-wide. In the United States:

Commodity prices fell 21% Industrial production fell more than in any other crisis in American

history to that point.The dollar volume of bankruptcies declared in November was up

47% from the previous year.The value of all listed stocks in the U.S. sunk 37% In October and November of 1907 25 banks and 17 trust

companies failed. Thousands of depositors lost their life savings.

THE IMPACT

Gross earnings by railroads fell by 6% in December and production fell 11%

Wholesale prices fell 5%.Imports shrank 26%In a few short months, unemployment rose from

2.8% to 8%.Immigration reached a peak of 1.2 million in 1907

but fell to around 750,000 by 1909.

THE “BIG CHIEF” J.P. MORGAN

HE WASN’T ELECTED OR APPOINTED, HE JUST FELT IT WAS HIS TIME TO

ACT

In the absence of a strong federal regulatory structure or any safety nets, the response to this crisis had to be delivered by a private citizen, J.P. Morgan the world’s most powerful banker.

He used all of his influence to convince fellow titans of industry to pool their resources and salvage the nation.

The “Panic” subsided after six weeks.

WHAT WAS DONE?

Speculation in off-street markets Bucket Shop in 1907

LESSONS FROM THE PANIC OF 1907

The bucket shop, similar to a betting parlor, was outlawed in 1909 blamed for fueling the speculation surrounding the Panic of 1907. They provided people with a venue to place side bets on the direction they felt stock prices were going, without the inconvenience of owning the security. New York was first to ban them and then other states followed. In 2000, the Commodity Futures Modernization Act revived the bucket shop bet.

The world made a huge bet on the U.S. housing market ……….and lost!!

By ignoring risk, remaining irrationally optimistic, and forgoing transparency through a wild array of fantastically complicated investment vehicles, the world’s financial markets were managed like an unsuccessful casino.

The underlying assumptions at the foundation were that housing prices never fall and homeowners almost always pay back their mortgages.

THE FINANCIAL CRISIS OF 2007

During and after the mild recession of 2001, the Fed lowers interest

ratesFormer Fed Chairman Alan

Greenspan

THE ORIGINS OF THE CRISIS

Former President George Bush

Strongly promotes home- ownership.

“We can put light where there’s darkness, and hope where there’s despondency in this country. And part of it is working together as a nation to encourage folks to own their own home” –President Bush, October 15, 2002.

THE ORIGINS OF THE CRISIS

Highly complex forms of financing

This was too tempting for the financial institutions

The momentum behind the expansion of homeownership led the government to reduce regulations and capital requirements for making loans.

This led to a dizzying amount of innovative ways to get less qualified borrowers a mortgage and deflect the loan originator from the weight of the risk.

Mortgages could be bundled and sold around the world as securities.

CAUSES OF THE CRISIS

The agencies trusted to warn investors failed Risk rating agencies

The MBS were multi-layered securities constructed of mortgages of differing quality levels.

The obligations of solid borrowers were mixed with the sub-prime variety in a manner that made it very difficult for experts to calculate risk.

The assumption that U.S. housing was a sure bet led agencies to rate these as AAA lowering investor’s guard.

CAUSES OF THE CRISIS

What were we thinking? “The Perfect Storm” Homeownership peaks in early 2005

at 70% of households The Fed raises interest rates Home prices fall ARMs adjust higher increasing

payments for sub-prime borrowers Borrowers default in waves Dozens of sub-prime lenders file for

bankruptcy The substantial holdings of MBS

world-wide tank and some of the biggest institutions gasp for air.

Fannie and Freddie seized by the federal government.

EFFECTS OF THE CRISIS

“FINANCIAL WEAPONS OF

MASS DESTRUCTION”

Financial institutions were allowed to book bets on whether people would default on their mortgages. CDS are private insurance contracts that paid off if the investment went bad, but you didn’t actually have to own the investment to collect on the insurance. These bets were unregulated and the big investment houses didn’t have to set aside any money to cover their bets.

THE GREAT RECESSION

Bank Failures: 183 (2%) 12/07-2/10 (No deposits lost)

Unemployment Rate: 10.2% (10/09)

Economic Decline: -3.8% (2Q 2008-2Q 2009)

Biggest Drop in DJIA: -53.8% (10/9/07-3/9/09)

Change in Prices: +0.5% (12/07–3/09)

Emergency Spending Programs: 2.5% of GDP for two years

Increase in Money Supply by the Fed: 125% (9/08-12/09)

THE GREAT RECESSION

6.7 million jobs lost between 1/08 and 1/10

Capital investment levels lowest in 50 years

Domestic demand declines 11 consecutive quarters

Industrial production down world-wide: Japan 31%, Korea 26%, Russia 16%, Brazil 15%, Italy 14%, Germany 12%

The federal government unleashed a tsunami of remedies in an attempt to contain and destroy the contagion.

Massive sums of money were created to capture toxic assets and bailout key elements.

In the process, the taxpayers took over several familiar companies and had to accept the consequences of greed.

This time the government bails the country out and businessmen and bankers are labeled pariah.

BAILOUT TRACKER

PROGRAM AMOUNTTARP $700 BILLION

FED RESCUE EFFORTS $6.4 TRILLION

FEDERAL STIMULUS PROGRAMS $1.2 TRILLION

AIG BAILOUT $182 BILLION

FDIC BANK TAKEOVERS $45.4 BILLION

OTHER FINANCIAL SECTOR INITIATIVES

$1.7 TRILLION

HOUSING MARKET INITIATIVES

TOTAL

$745 BILLION

$11 TRILLION

Sources: Federal Reserve, Treasury, FDIC, CBO, White House (as of 11/16/2009)

FISCAL IRRESPONSIBILITY?

GDP in 2010: $14.6 trillionNational Debt in 2010: $13.8 trillionDebt to GDP ratio in 2007: 57%, 2010: 94%Highest debt to GDP ratio: 122% in 1945Estimated debt to GDP ratio in 2040: 240%Portion of the federal revenues used to service

the debt in 2010: 13%

FISCAL IRRESPONSIBILITY?

Fiscal 2009 federal budget deficit: $1.42 trillionEstimated 2010 federal budget deficit: $1.7

trillionUnfunded promises to Medicare, Medicaid, and

Social Security: $53 trillion, $175,000 per American

Amount of federal debt held by foreign countries in 2009: 44.5%, $800 billion by China and $750 billion by Japan

(Source: The Peter G. Peter Foundation)

1907 2007 Highly complex and linked financial

system Strong growth in the economy

starting in 1900 Many people and institutions highly

leveraged Innovative form of finance: Trust

Companies Stock market setting all-time highs A limited role for government Markets swing from great optimism

to great pessimism

Global interdependent financial system

Vibrant economic recovery after recession in 2001

Lenders willing to take more risk in making loans

Unregulated financial institutions: Hedge Funds

Companies reporting record earnings

Absence of many safety buffers Dow 14,164 to 6500 in 16

months

SIMILARITIES

1907 2007 J.P. Morgan, a private citizen,

orchestrates the bailout. The Panic lasted for six weeks,

though the economy didn’t return to pre-Panic levels until 1909

Many banks were closed and depositors lost their savings

The nation was on the gold standard and the supply of money was fixed

The San Francisco earthquake was a catalyst for the Panic

The climate toward business was hostile in advance

The Federal Reserve and Treasury Department organize the reaction

The event has been unfurling for over two years

Many banks have closed but have been folded into healthier banks and depositors have yet to lose any of their savings

The nation uses Federal Reserve notes creating a very flexible money supply

Hurricane Katrina was generally benign as a catalyst

The climate toward business was friendly in advance

DIFFERENCES

ADVANTAGES DISADVANTAGES

Money backed by a fixed asset. Provides a stabilizing and self-

regulating effect on the economy. Discourages inflation because the

government can only print as much money as the country has gold.

Discourages government budget deficits and debts.

Discourages trade deficits. The gold standard has spurred

exploration. Forces the economy to be fiscally

disciplined, balancing the budget, and limiting government intervention.

Size and health of the economy depends upon a country’s supply of gold, not the resourcefulness of its people.

Countries without gold are at a competitive disadvantage.

Keeping gold becomes an obsession rather than improving the business climate

These actions can cause large fluctuations in the economy and lead to recessions or depressions.

Constricts the government’s ability to respond to a crisis.

Creates an inflexible money supply.

THE GOLD STANDARD

ADVANTAGES DISADVANTAGES

Allows a government to rapidly expand funds in response to economic growth

Governments can respond to a national crisis with flexibility and mitigate panics and disasters

Through fractional-reserve banking and taxation, the quantity of money can be easily multiplied to counter a contraction in the economy

By following simple monetary rules, it is possible to keep the amount of money in circulation stable

The system is not self limiting which can make a nation vulnerable to hyperinflation

A nation has to trust its politicians to make wise economic decisions in the management of the money supply

The system allows for postponement of obligations and the transfer of debt upon future generations

The system promotes moral hazard providing short term solutions with long term consequences.

FIAT MONEY SYSTEM