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Financial crisis: History repeats

Mar 24, 2008

"If you're really good at what you do, you probably have a lot of choices when it comes to taking the next step in (or starting) your career. But if you can tackle complex challenges with creative solutions, and want to be able to make your mark quickly regardless of title or tenure, we think your only real choice is pretty clear."

These are the welcome words on the career section of the website of Bear Stearns, the investment bank, which got sold off for 'peanuts' to JP Morgan Chase. And this is what has been the undoing for the bank, which indulged in complex challenges (read, derivative products), wanting to make a mark clearly regardless of any risks to its business, and existence. Will other investment banks in the US draw lessons from this death of a competitor? If we go by historical evidence, maybe not!

A century later, it's JP Morgan again!

Even before the US central bank, Federal Reserve came into existence, a gentleman called J. Pierpont Morgan, during the panic of 1907, played a key role in preventing a potential disaster for financial markets. He rallied his fellow bankers to help faltering banks and trust companies, which had been shaken by poorly timed investments. He convinced rivals that they had to band together or else risk a market collapse that could destroy them all. Ultimately, the bailout helped avert a financial crisis in the US banking system.

Incidentally, almost 100 years later, JP Morgan - the firm, not the man - has been asked to rescue the American financial system by way of taking over Bear Stearns. It is though duly helped this time by a Fed in existence. Ironically, it is this very Fed that sowed the seeds of this crisis by way of keeping money cheap, and for long. Now, to stave of the dangers lurking for the financial system and the real economy, the central bank policymakers are cutting rates left right and centre (or what could explain 6 rate cuts in a span of 6 months, including 4 in 2 months?).

Of course, this is not the first time the Fed has joined hands with Wall Street to orchestrate a bailout. The most recent case was its role in saving Long Term Capital Management (LTCM). The hedge fund, run by some of the best and brightest from Wall Street and academia, was undone by leverage during the credit shakeout in the late 1990s.

Similarly, investment banks and hedge funds in the latest credit crisis have also been burned by the use of leverage. Several institutions have already been overwhelmed by margin calls triggered by plunging values in mortgages and other bond assets.

There are also some parallels to the financial panic in 1907, which was triggered by an unwillingness of some New York banks to make loans - unwillingness that spread across the country. Stock investors were anxious over market declines, the economy was in the grips of a recession, and lending was tight.

But this time around, it may take much longer to repair the damage and restore confidence than it did a century ago. It is not only that the sums are larger now. Even adjusting for a century of inflation, losses from 1907 crisis totaled only about US$ 18 bn in today's dollars (as per a report from the International Herald Tribune) compared with the likely loss of hundreds of billions dollars related to subprime mortgages.

Some economic researchers argue that financial crises ultimately make the entire system stronger. Indeed, the panic of 1907 led to the creation of the Federal Reserve (in 1913), which has set monetary policy for the US ever since. Sometimes financial crises are actually good because they cleanse the system. We hope this one does as well. Amen!

References:

  • Federal Reserve website

  • Federal Reserve Bank of Boston website

  • The International Herald Tribune


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