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Visualizing History
Corporate Bond Default Rate (1866-2008)
Representation of how many people feel about Sam Bankman-Fried this week… (original cartoon depicts Robber Baron Jay Gould)
There are some weeks where I sit down to write this newsletter, and there is no “obvious” topic or event requiring historical context. This was not one of those weeks.
Today we are going to discuss the fallout of FTX’s chaotic week that started with cringeworthy threads from Sam Bankman-Fried, and culminated with FTX filing for Chapter 11 bankruptcy on Friday (but also more cringeworthy Twitter threads). So much has been written about the rapid downfall of FTX that I won’t summarize the events here, but this article provides an excellent breakdown for those wishing to get caught up: Bloomberg.
For today’s introduction, I want to provide some historical context (and a fun fact) on aspects of the FTX unraveling:
- The Origins of “Bankruptcy”
- Parallels with 19th Century Railroads
- The Panic of 1907 & Founding of the Fed
Justttt before that, however…
Final reminder for the very exciting conversation I’m hosting with Michael Mauboussin and Kai Wu this Thursday! We will discuss Michael and Kai’s excellent research on intangible assets, and the myriad of ways this “dark matter of finance” impacts markets.
Register for Free
Broken Benches
The Original Finance ‘Platform’: Banking “Benches”
After FTX filed for Chapter 11 on Friday, the word “bankruptcy” is blazoned all over financial media and news outlets.
But have you ever wondered where the term “bankruptcy” comes from?
The answer traces all the way back to 14th century Italy. In this period, Italian bankers conducted business and transactions on benches (see above). However, if a banker became insolvent and could not lend out money or meet payments, their bench was smashed in half to publicly signal their failure and insolvency. So?
Well… the Medieval Italian phrase “banca rupta” meant “broken bench.” Thus, “banca rupta” -> “broken bench” -> “bankruptcy”.
Safe to say that FTX’s crypto bench has been smashed to pieces.
Parallels with 19th Century Railroads: The Panic of 1857
“The crypto community appears to be experiencing the same evolution from “wild west” to regulated entity that traditional financial markets experienced from the 19th to 20th centuries. Of course, crypto and other digital assets are experiencing this transformation at a much more accelerated pace.
However, for those that view crypto and digital assets as nothing but a lawless cesspool of frauds and scams, it is worth remembering that equity markets were no different in the 19th century and early 20th century. The 1800s endured a full century of rampant fraud and market manipulation before finally getting its act together in post-1929 crash.“
Well, if crypto is trying to follow that Wild West to regulated/mature asset class story arc, they are right on track! Why? Because one of the most common features of 19th century / early 20th century “panics” was the collapse of major financial institutions due to speculative loans or bets.
During the 19th century in particular, practically every market panic stemmed from problems in the railroad industry. Like crypto markets today, the 19th century railway industry was utter chaos and plagued by volatility. Consequently, conducting any type of investment or lending activities in this space was inherently risky. However, the heightened levels of volatility, fraud and manipulation did not stop billions of dollars pouring into the railway industry throughout the 1800s.
As we are now witnessing, 19th century financial institutions similarly had recurring problems with risk management and concentrated exposures. Large storied institutions would collapse because they had made significant bets on railroad stocks while also making very risky loans to speculative enterprises. When overall railroad prices fell, then, institutions with concentrated railway industry exposure were punished to the full extent.
That said, it is worth briefly highlighting the panic of 1857.
Panic of 1857
The roots of this panic can be traced back to the California Gold Rush of 1849, which injected the financial system with froth, encouraged western migration, and indirectly fueled the western land and railway booms. In turn, the number of banks and “shadow banks” exploded. The number of banks not only doubled between 1850-1857, but banks also adopted increasingly risky lending practices (higher Liabilities-to-Specie Ratio).
Banks helped produce and (temporarily) sustain the railroad / western land boom, but the banking system was extremely fragile and susceptible to declines in land and railroad stock prices.
The panic of 1857 was exacerbated by two problems still familiar to modern investors.
First, many speculators invested in railroads with loans from banks and/or brokerage firms. This scenario was fine as long as the railway industry continued performing well and attracting more capital. If railroad stock/bond prices tanked, however, speculators that invested with borrowed money would be unlikely to pay back their debts to the bank.
Second, many banks accepted railroad stocks and bonds as collateral from speculator’s seeking additional loans. When the value of this collateral declined alongside the falling prices of railroad securities, borrowers could not obtain new loans to pay off old loans. As a result, the railroad securities that defaulting borrowers had used as collateral were sold on the market at fire-sale prices by banks looking to recoup their losses.
These two problems brought the Ohio Life Insurance & Trust Company to its knees on August 24, 1957.
Ohio Life Insurance & Trust Company
Like many other banks, the financial institution ran into difficulties because of risky loans and investments it had made that eventually turned sour. These issues were exacerbated by the bank’s concentrated exposure to the railway industry in general.
Historians Calomiris and Schweikart note:
“Its [Ohio Life Insurance & Trust Co.] assets consisted mainly of securities and loans to railroads. Gripped by “railroad fever” that swept the state, Ohio Life had a special connection to the Cincinnati, Hamilton, and Dayton Railroad whose dividends were payable at Ohio Life… To facilitate involvement in the securities market, Ohio Life had opened a New York office, under the direction of Edward Ludlow…
Ludlow had loaned an amount equal to the company’s capital – $2 million – to various railroads… of its roughly $4.8 million in assets, the bank invested $3 million in the railroad industry.”(Calomiris & Schweikart, 1991)
This concentrated exposure was a huge issue when railroad stocks began to decline in the summer of 1857. (Calomiris & Schweikart, 1991)
Why did railroad stocks begin to fall? Some historians argue that the answer lies within the Dred Scott decision of 1857, which slowed the flow of settlers into western territories and depressed land/railroad prices:
“the decision put the brakes on westward migration as free-soilers feared the spread of slavery throughout the territories. The South could not provide the numbers of bodies to replace the would-be Northern migrants…
The slowing of the flow of people westward had an impact on land markets, dragging prices downward. In turn, uncertainty about the future profitability of westward expansion affected the value of railroad investments. The downward spiral in stock prices for western railroads led to heightened risk in capital markets and ultimately financial panic.” (Jenny B. Wahl)
As railroad stocks fell, Ohio Life’s portfolio became increasingly shaky, ultimately leading to their decision to suspend specie payments. News of this suspension caused a crisis of confidence nationwide, and Ohio Life’s stock fell off a cliff in just a matter of days:
Sound familiar?
“Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research, setting the stage for the exchange’s implosion, a person familiar with the matter said.
FTX Chief Executive Sam Bankman-Fried said in investor meetings this week that Alameda owes FTX about $10 billion, people familiar with the matter said. FTX extended loans to Alameda using money that customers had deposited on the exchange for trading purposes, a decision that Mr. Bankman-Fried described as a poor judgment call, one of the people said.” (WSJ)
The Panic of 1907 & The Founding of the Federal Reserve
Signing the Federal Reserve Act
The downfall of FTX and the associated fallout in crypto markets has highlighted some drawbacks of operating outside traditional centralized markets. Time will tell, but this collapse may be similar to the Panic of 1907 in that it leads to structural changes from a legislative and regulatory standpoint.
Ironically, earlier this summer Sam Bankman-Fried had been repeatedly compared to John Pierpont Morgan for his role in bailing out other crypto firms that were facing bankruptcy and collapse. During the Panic of 1907, J.P. Morgan famously bailed out other financial institutions in the aftermath of market turmoil. The fact that markets had relied upon a single individual to rescue America’s financial system highlighted the need for a central bank tasked with aiding markets in times of distress. Just a few years later, the Federal Reserve was founded as a result.
Given the scale of FTX’s bankruptcy and collapse, this week may prove to be the moment that drastic action was taken by American regulators and politicians.
Now for today’s links!
The Panic of 1866
Why This is Relevant:
Visualizing History:
Notable Quote:
The Knickerbocker Trust, J.P. Morgan & The Panic of 1907
Why This is Relevant:
The Panic of 1907 proved to be the last straw for American lawmakers. This severe panic highlighted how dire the national financial infrastructure was if markets were reliant upon a single man (J.P. Morgan) for bailing out financial institutions. Thus, after the 1907 Panic, plans for an American Central Bank (i.e., Federal Reserve) were put in motion.
Summary:
“The Panic of 1907 was the first worldwide financial crisis of the twentieth century. It transformed a recession into a contraction surpassed in severity only by the Great Depression. The panic’s impact is still felt today because it spurred the monetary reform movement that led to the establishment of the Federal Reserve System. Moen and Tallman (1999) argued that the experience of the Panic of 1907 changed how New York Clearing House bankers perceived the value of a central bank because the panic took hold mainly among trust companies, institutions outside their membership.”
Visualizing History:
Notable Quote:
Oh, How the Mighty Have Fallen: The Bank Failures and Near Failures That Started America’s Greatest Financial Panics
Why This is Relevant:
A detailed look at how failing financial institutions lead to serious financial panics.
Summary:
“This is my presidential address to the Economic History Association that was delivered in September 2020. It examines the failures or in some cases near-failures, of financial institutions that started the 12 most severe peacetime financial panics in the United States, beginning with the Panic of 1819 and ending with the Panic of 2008. The following generalizations were true in most cases, although not in all. (1) Panics were triggered by a short series of failures or near-failures; (2) many of the failing institutions were what we would now call shadow banks; (3) typically, the source of trouble was an excessive investment in real estate; and (4) typically, they had outstanding reputations for trustworthiness, prudence, and financial acumen—before they failed. It appears that in these respects the Panic of 2008 was an old-school panic.”
Visualizing History:
Notable Quote:
Missed last week’s article? Catch up here!
