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The Cycles of Speculation (1907)

Sunday Reads

This week I was fortunate to be asked by Real Vision to host a financial history special on market crashes, crises, and more. In a whirlwind of interesting conversations, I recorded interviews with fascinating guests like Jim Chanos, Scott Nations, and Jim Grant. It was in my last conversation with Jim Chanos, however, that prompted the topics for this week’s Sunday Reads. We spent much of our discussion on the ‘Minsky Moment’ concept, named after economist Hyman Minsky.

Minsky Moments

In his work, Minsky identified three types of financing:

  • Hedge Financing (Safest): ‘Firms rely on their future cashflow to repay all their borrowings. For this to work, they need to have very limited borrowings and healthy profits.’
  • Speculative Financing (Riskier): ‘Firms rely on their cashflow to repay the interest on their borrowings but must roll over their debt to repay the principal. This should be manageable as long as the economy functions smoothly, but a downturn could cause distress.’
  • Ponzi Financing (Dangerous):Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.’

This last bullet is the most key, so I will repeat it here: firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.

The easy solution, then, would be to strictly practice ‘hedge financing’, right? Well as Minsky points out, ‘stable economies sow the seeds of their own destruction.’ In other words, stability breeds instability. The Economist provided an excellent summary of this idea:

‘Economies dominated by hedge financing—that is, those with strong cashflows and low debt levels—are the most stable. When speculative and, especially, Ponzi financing come to the fore, financial systems are more vulnerable. If asset values start to fall, either because of monetary tightening or some external shock, the most overstretched firms will be forced to sell their positions. This further undermines asset values, causing pain for even more firms.

They could avoid this trouble by restricting themselves to hedge financing. But over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.’

So what, you may ask, is the ‘Minsky moment’? It is the pin that pricks the ponzi financing bubble, and causes asset values and credit to fall. This is problematic for companies without cashflow to service their debt, and rely on high asset prices to cover their liabilities. If the underlying asset prices fall, trouble (and bankruptcies) ensue.

There are many who believe that we may currently be in the midst of a ‘Minsky moment’, as the coronavirus pandemic unexpectedly halted global economies, and shut down entire industries. As the rating agencies continue lowering their ratings for large swathes of issuers, this is not implausible:

In just the last week, the author of one article questioned Is Private Equity Having Its Minsky Moment?’

‘Private equity is undergoing what the great theorist Hyman Minsky pointed out is the Ponzi stage of the credit cycle in capitalist financial systems. This is the final stage before a blow-up. As Minsky observed, a period of placidity starts with firms borrowing money but being able to cover their borrowing with cash flow. Eventually, there’s more risk-taking until there’s a speculative frenzy, and firms can’t cover their debts with cash flow. They keep rolling over loans, and just hope that their assets keep going up in value so that they can sell assets to cover loans if necessary. To give an analogy, in 2006, when people in Las Vegas were flipping homes with no income, assuming that home values always went up, that was the Ponzi stage.

Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.

I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector.’

Time will tell whether or not the author is right about a ‘Minsky moment’ taking place in private equity, but it is food for thought regardless, and a good excuse to revisit the work of Hyman Minsky.

Kindleberger-Minsky Model

Lastly, before we get into the Sunday links, there is one more concept/model associated with Hyman Minsky that’s worth mentioning. The Kindleberger-Minsky model (Charles Kindleberger and Hyman Minsky) outlines three patterns of speculative bubbles:

The first is that most commonly found in theoretical literature on speculative bubbles and crashes… In this pattern prices rise rapidly, usually at an accelerating rate in most of the theoretical literature, then to drop very sharply back to a presumed fundamental level after reaching the peak.  The general argument is that speculative bubbles are self-fulfilling prophecies.  Price rises because agents expect it to do so, with this ongoing expectation providing the increasing demand that keeps the price rising.  If due to some exogenous shock the price stops rising, this breaks the expectation, and the speculative demand suddenly disappears, sending the price back to its fundamental (or thereabouts) very rapidly where there is no expectation of the price rising…

In the second type the price rises, reaches a peak that may last for awhile, and then declines again, sometimes at about the same rate as it went up.  There is no crash as such, in contrast with other types of bubbles in which there is a period when the price declines much more rapidly than it ever rose, often characterized by panic among agents as described by both Minsky and Kindleberger. In this type of bubble, many agents may be quite unhappy as the price declines, but there is no general panic. Some might argue that such a pattern is not really a bubble in that how one truly identifies a bubble is precisely by the occurrence of a dramatic crash of price…

The third type of bubble is that which exhibits a period of financial distress, a type first identified and labeled by Minsky (1972).  In this the price rises to a peak that is followed initially by a gradual decline for awhile, but then there is a panic and crash.  According to Kindleberger , this is by far the most common type of bubble, with most of the larger and more famous historical ones conforming to its pattern, including among others the Mississippi bubble of 1719, the South Sea bubble of 1720, the US stock market bubble of 1928-29, and the same which crashed in 1987, even as this has been the least studied of bubble types…’

Right, so now that we have a good base understanding of ‘Minsky Moments’ and the ‘Kindleberger-Minsky’ model, we’ll dive into a set of links focusing on examples of these theories in history. Additionally, I’ve included articles on the origins and development of ratings agencies. Again, as we are likely to see a continued period of credit rating downgrades in coming months as earnings are released, and coronavirus continues to keep businesses shut, it is important to understand the historical origins, role and development of these ratings agencies. These organizations’ assessment of risk can be critical to the success of a corporate or sovereign entity.

Now please enjoy this week’s roundup of financial history on:

  • The origins of rating agencies
  • Credit ratings and corporate default risk
  • Subprime plantation mortgages
  • Risks of sudden declines in the assets of Asset Backed Securities

Subprime Plantation Mortgages (On Manias, Ponzi Processes and Illegal Trade)

While this article does cover subprime mortgages, they’re not those subprime mortgages. Instead, rather, this piece focuses on subprime plantation mortgages in the 18th century, which the author argues is a prime example of a Kindleberger-Minsky bubble:

‘When testing different economic theories, we find that the negotiatie system is fits very well in Kindleberger and Minsky’s model of a classic bubble. Rising prices, especially for coffee, together with a form of  financing the new subprime plantation mortgages, provided the ‘displacement’. This seemingly profitable business attracted many a planter, fund director and investor. Once some setback occurred between 1769 and 1771 – drought, declining prices and maroon attacks- the mania started to crumble down. Those with a keen eye, selling their plantations or bonds before the phase of distress began, were winners. Those who held on to their investment were losers. The 1772-3 crisis was not the event that destroyed the negotiatie system, it was just another way of pointing out to the ignorant that the phase of discredit had arrived. This also explains why there was no immediate stop in granting mortgages: there were still people who had not accepted the system defeat. After Ter Borch’s bankruptcy was effectuated in 1774 this became even harder to ignore, so that is why the stream of mortgages almost dried up in the two years afterwards.’

Returning to the three financing types outlined earlier (hedged, speculative, ponzi), this article exhibits the evolution of subprime plantation mortgages into ponzi financing. Remember, this is generally a scenario in which ‘cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabilities. If that fails to happen, they will be left exposed.’

Sure enough, the planters discussed in this article ‘could at best pay the interest on their mortgages, making them speculative borrowers.’ Similarly, ‘they were vulnerable to shocks, such as decreasing product prices and droughts, and this could add to their debt burden…’

With the above observations we have come to the Ponzi aspects of the system. The points is that the negotiatie structure could only continue as long as new money was put into it. A naturally occurring Ponzi process was created as early investors were rewarded with high interest payments and it is likely that their positive stories, next to those of the fund managers, convinced more people to put their money into the system. This was badly needed, for there were few hedge borrowers in the negotiatie structure. Most planters could at best pay the interest on their mortgages, making them speculative borrowers. However, they were vulnerable to shocks, such as decreasing product prices and droughts, and this could add to their debt burden, just like conspicuous consumption did. If this continued, the planters became a Ponzi borrowers and obtaining more credit was then the only way forward. Either a higher prisatie or a new mortgage with another fund would suffice, but this could not go on forever. As the share of Ponzi borrowers in the system increased, it became unstable and was bound to collapse.’

However, the ‘Minsky moment’ could be found in the collapse of coffee prices, which was the crop of choice for many plantations. Suddenly, the ability to make mortgage payments were slim to none as profits were dramatically reduced:

To Err is Human: Rating Agencies and the Interwar Foreign Government Debt Crisis

This paper studies a seminal period in both financial history as a whole, and the credit ratings industry. In the carnage of the Great Depression, a department within the United States Treasury made the crucial decision ‘to use the credit ratings-based formulae to book the value of US national banks’ bond portfolios.’

This was crucial because it meant ‘from that point on, ratings became the main instruments through which regulators supervised banks’ risk exposures – which suggests that they were seen then as part of the solution, not as part of the problem.’ I found the charts below particularly interesting, as it gave a clearer picture of just how accurately rated these sovereign entities were:

This paper is also an interesting read because it offers ‘a useful perspective on what remains one of the most (perhaps the most) violent foreign debt disaster in financial history.’ For context, between 1931 – 1939, over half of the sovereign borrowers that issued in New York between Between 1920 and 1929 defaulted. In this paper:

‘We have gathered and analysed data on ratings and financial markets during the sovereign debt boom-bust cycle of the 1920s and 1930s. Focusing on foreign government securities listed on the New York Stock Exchange, we compare ratings’ reliability among different agencies and between ratings and market yields. We document a large degree of pro-cyclicality of ratings over the period. Perhaps more surprisingly, rating agencies do not appear to have performed particularly well relative to financial markets in forecasting the approaching mess: when we compare the predictive power of agency ratings with that of synthetic ratings based on market yields, we find little that suggests strongly superior performance. Our results leave open the reasons for the emergence of ratings as regulators’ preferred instrument, for superior performance does not appear to have motivated the initial regulatory use of ratings.’

Responding to a Shadow Banking Crisis: The Lessons of 1763

In this article by the Atlanta Fed, the authors cover the Crisis of 1763, which features a similar ‘shock’ or Minsky Moment in the form of a bank failure following the Seven Years’ War, which causes a chain reaction in other areas of the financial sector.

‘In August 1763, northern Europe experienced a financial crisis with numerous parallels to the 2008 Lehman Brothers episode. The 1763 crisis was sparked by the failure of a major provider of acceptance loans, a form of securitized credit resembling modern asset-backed commercial paper. The central bank at the hub of the crisis, the Bank of Amsterdam, responded by broadening the range of acceptable collateral for its repo transactions. Analysis of archival data shows that this emergency source of liquidity helped to contain the effects of the crisis, by preventing the collapse of at least two other major securitizers. While the underlying themes seem to have changed little in 250 years, the modest scope of the 1763 liquidity intervention, together with the lightly regulated nature of the eighteenth century financial landscape, provide some informative contrasts with events of late 2008.’

In conclusion, the authors find:

‘The Panic of 1763 records a distressingly familiar recipe for financial conflagration. Flammable ingredients include a system of securitization with numerous cross exposures (acceptance loans), an aggregate shock to collateral values (the end of the Seven Years’ War), and erratic policy decisions (on the part of the Prussian monetary authorities). The spark is provided by the collapse of a single participant (de Neufville) who is “too interconnected to fail” (in the view of Hamburg petitioners), but who fails nonetheless. Missing from the mix are the too-big-to-fail distortions of modern financial environments, but these seem not to have been necessary in the lightly regulated world of eighteenth-century finance.’

The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815-2007

The role of underwriters today is vastly different than it was in the past. This thought provoking article explores the evolving duties of underwriters and rating agencies over time. Perhaps the best overview is found on page 3:

In the past era (by which we mean the long-run period that began in the early 19th century and ended with the interwar crisis), underwriters provided valuable certification services. They tried to secure prestige by convincing investors that their name was associated with safer products. They did this not for the sake of honesty, altruism, or self-esteem but rather because doing so entailed benefits.

Today is different: underwriters have shed their role as certifiers and have outsourced it to rating agencies. The resulting reduction in liability risk also means that more competitive banks are prepared to issue riskier securities. We suggest that this new situation has given birth to a market for lemons, a market that did not exist in the past. We conclude that the next sovereign debt tsunami will crash on a foreign debt market that is by design more accident prone than its predecessors.”

This stark contrast in the roles of underwriters in each time period has led to what the authors call “the default puzzle”. This puzzle stems from the fact that underwriters used to have a vested interest in how the bonds they underwrote performed, as it could hurt or benefit their corporate brand. This meant that banks acting as underwriters were responsible for carrying out the roles of modern credit rating agencies. If a bank underwrote bonds that ended up defaulting, this would tarnish the bank’s reputation. Investors would ask “How could they fail to see the default risk before deciding to underwrite?”. 

The result was a bond market in which very few ‘junk bonds’ were issued, as underwriters were wary of putting their reputations at stake. The defaults that occurred were generally clustered around the few financial intermediaries that were willing to underwrite the ‘junkier’ bonds, and take on the reputation risk.

BUT! As we all know, credit ratings changed everything.

“The investment banks that became involved in the new market probably welcomed the transformation (they included reincarnations of interwar New York leaders such as JP Morgan or National City Bank).  Fees were now smaller, of course, but liability risk was also reduced. Rating agencies would be the new lightning rod for accusations of financial malpractice. The banks, although undoubtedly informed, would now be able to show to unhappy customers the grades given by (possibly less informed) rating agencies.”

In essence, there’s no longer a need to worry about reputation risk attached to underwriting, because if anything goes wrong, it is the rating agency that is blamed. Consequently, there is now a booming “market for lemons.”

Corporate Bond Default Risk: A 150-Year Perspective

According to Bloomberg News, this week marked the largest weekly outflow from U.S. corporate bond funds in at least a decade. As investors become increasingly pessimistic as markets plummet and coronavirus cases grow, the yields on corporate bonds are ratcheting higher and higher. Companies within the travel space have been particularly hard-hit:

“American Airlines and Viking Cruises Ltd. are among the worst travel industry performers in the high-yield market Friday, with some of their bonds yielding more than 12%

As the impact of coronavirus fears spreads from equities to bonds, it is worth looking at the 150-year history of corporate bond default risk.

“We study corporate bond default rates using an extensive new data set spanning the 1866–2008 period. We find that the corporate bond market has repeatedly suffered clustered default events much worse than those experienced during the Great Depression. For example, during the railroad crisis of 1873–1875, total defaults amounted to 36 percent of the par value of the entire corporate bond market. We examine whether corporate default rates are best forecast by structural, reduced-form, or macroeconomic credit models and find that variables suggested by structural models outperform the others. Default events are only weakly correlated with business downturns. We find that over the long term, credit spreads are roughly twice as large as default losses, resulting in an average credit risk premium of about 80 basis points. We also find that credit spreads do not adjust in response to realized default rates.”

In this article, there is a section on the Panic of 1873 that offers interesting parallels with markets today. The 1870s were highlighted by the exciting and rapid growth of new technology: railroads. With this exciting technology came booming debt markets:

‘The growth in economic activity was accompanied by a rapid expansion in the corporate bond market. For example, the number of bond issuers listed in the Commercial and Financial Chronicle was 158 in 1866, but quickly reached 421 by 1872. The Commercial and Financial Chronicle from this period is often filled with enthusiastic accounts about the promise of new technology:

‘Every well-built railroad if suitably located becomes a productive machine which adds to the wealth of the whole country… Our new railroads increase the value of farms and open new markets for their products. They lessen the time and cost of travel. They give a value to commodities otherwise almost worthless. They concentrate population, stimulate production and raise wages by making labor more efficient. Our existing railroads are computed to create more wealth every year than is absorbed for the construction of new railroads.” (January 11, 1873).’

Yet, eventually, this exuberance must face reality.

‘However, later in the same year there was a major panic which led to a default rate of 14.3 percent in 1873. Contrast the buoyant spirit reflected in the previous quote with that evidenced by the following quote from the Commercial and Financial Chronicle exactly one year later.

“After such a panic as has, the past year, swept over the country, it becomes a kind of melancholy pleasure to look over the field and find that there are not quite so many dead and wounded lying about as was anticipated. It was a fearful storm while it lasted, and although every one of course can say now that he knew it was coming, yet the real truth is, its breaking was terribly sudden and unexpected… There are few people who allow themselves to remember long the lessons experience would teach them. If this were not so, there would be many less failures in the world… Almost all felt they were carrying too much debt; they would henceforth be out of it. There are now, however, very evident signs that these resolutions have been mostly forgotten. Over-trading, as it is called, is an evil that has ever existed, and pretty much the same epitaph can be written above each business prostration—here lies the result of an attempt to do too much with too little capital. Must history necessarily repeat itself?” (January 10, 1874).”‘