Tuesday, September 30, 2008


With the defeat of the 'Bailout Bill' in Congress yesterday, one can't help but think of the Panic of 1907, which occurred almost 100 years ago.

In 1907, horse-drawn carriages and 'special' trains were state-of-the-art. But while financial markets change, the core elements of a panic remain the same: financial innovation runs ahead of regulation; a short-squeeze; interlocking and connected financial institutions, resulting in a domino-effect of falling institutions; the spread of the contagion; and then, most dangerously, a run on previously-healthy banks.

The 1907 Panic was stemmed on the evening of November 2-3, when JP Morgan famously locked a number of presidents of trust companies (which were the financial innovations of the day, as derivatives and credit-default swaps are today) in his library; they were not 'released' until they all agreed to subscribe to a $25M loan for the Trust Company of America, an otherwise healthy institution that was facing a run. And like in 1907, it is collective action -- individuals acting against their own personal short-term interests for the good of all -- that can stem a panic.

The House vote yesterday was a political version of the 'Prisoner's Dilemma.' The bill would help everyone, but it was in many member's interest to have been able to vote against an unpopular bill. But once it became clear that the House Republicans were not near the 100 votes that Speaker Pelosi wanted, Democrats were not going to pass a bill with little or no GOP support.

The good news, if any, is that the lessons of 1907 still hold; the meeting in Morgan's library was not the first time that "Pierpont" had tried to stem the tide. More than a week earlier, on October 23rd, 1907, Morgan had summoned the trust presidents to his office and urged them to help TCA; but at that time, they were still more concerned about their own cash position, and Morgan had trouble raising $10M. (A week later, it required considerably more money -- $25M -- to stop the run on TCA.)

And as the contagion spread throughout the stock market, Morgan had to inveigh upon then-President Teddy Roosevelt to allow the takeover of Tennessee Coal, Iron & Railroad by US Steel. Roosevelt was known as a 'trust buster', so politically he was contradicting his well-established position. But TR did what was needed to be done, and so avoided (in his words later) "a panic and general industrial smashup at this time."

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