Is This The Turn - Road to the Middle Class

ON THURSDAY September 18, the Dow Industrials staged a robust recovery, soaring 5.4 percent from an intraday low of 10459.77 on news that the Feds intended to create a new Resolution Trust Corporation. The new RTC, similar to the agency that cleaned up the assets of the failed Savings and Loans back in 1989-1992, would “address the illiquid assets on bank balance sheets that are at the underlying source of the current stresses in our financial institutions and markets,” according to TheStreet.com. In 1989-1992 the original Resolution Trust Corporation probably saved the US from a serious recession, something that really would have been “the worst economy in the last 50 years” that Candidate Clinton claimed on the campaign trail.

Is this then the market bottom?

It could be. A century ago in in the Panic of 1907, the US experienced a similar crisis of confidence in its financial institutions. Back then the weak links in the chain were the so-called trust companies, most notoriously the Knickerbocker Trust, hot items offering better interest rates to depositors and more impressive facades than the regular banks. But in the credit crunch of 1907 it turned out that their assets weren’t of the best quality, and several of them failed. J.P. Morgan tried to get the presidents of the trust companies together to assist each other, but failed. Apparently the trust company CEOs figured that if they all hung together they would all hang.

But the turning point of the Panic of 1907 came on a swap of assets, according to Robert F. Bruner and Sean D. Carr in The Panic of 1907. On the weekend of November 3-4, 1907, it was feared that a stockbroker, Moore & Schley, would fail on Monday because the assets on which its working capital was secured, common stock in Tennessee Coal & Iron, was of questionable value. In other words, nobody knew if Moore & Schley was underwater or not.

Morgan and his associates devised a plan. They talked to the CEO of United States Steel, Elbert H. Gary, to get him buy a majority share in TC&I by exchanging stock in TC&I with a similar value in United States Steel 5 percent gold bonds. The takeover would bolster the stock of TC&I and save broker Moore & Schley. It took a bit of juggling, and an overnight trip on a private sleeper to Washington DC to get the approval of trustbuster President Theodore Roosevelt. But the deal was done before the market opened on Monday November 5, 1907. Stocks soared on the opening, and the crisis was over.

The same thing seems to have occurred with the RTC announcement on Thursday, September 18. If the Feds were willing to take the underwater loans off the market then the traders on Wall Street need no longer fear the underwater “dark matter” that might hole them under the water line. So stocks soared in the hope that the crisis was over.

The simple lesson to learn out of the credit crunch is that when people start to doubt the solvency of other market participants then the system starts to seize up. Obviously, the most vulnerable market participants are people who are highly leveraged. That would be Wall Stree investment firms with a reported 60 to 1 leverage ratio—ships sailing with roughly two percent freeboard above water. Or it would include homeowner with a 90 percent mortgage in a down market. Any decline in asset values puts these marginal players underwater and the system at risk.

But business is about more than proper collateral and sensible debt-to-equity ratios.

Congress failed to understand this when it investigated the banking business in the Pujo hearings in 1912. Here is J.P. Morgan testifying to a lawyer on character.

Mr. UNTERMYER. Is not commercial credit based primarily upon money or property?
Mr. MORGAN. No, sir; the first thing is character.
Mr. UNTERMYER. Before money or property?
Mr. MORGAN. Before money or anything else. Money cannot buy it.

And so on. Samuel Untermyer could not understand that, for Morgan, the question of collateralizing a loan was far less important that the character of the man to whom he was loaning the money. A man who is leveraged up to the eyeballs is a man saying: heads I win big, and tails you are all sunk. He is not a man you can trust.

J.P. Morgan solved the credit crunch in the Panic of 1907. The Resolution Trust Corporation solved the S&L crisis nearly 20 years ago. And we all hope that today’s J.P. Morgan, Treasury Secretary Henry Paulson, has got the current crisis in hand.

So we’ll probably muddle through this one.

But there’s a bigger issue to consider. It is the question addressed by Laurence Gonzales in Deep Survival. Accidents happen. “Large accidents, while rare, are normal.” Efforts to prevent accidents and make systems safer often “make the systems more complex and therefore more prone to accidents.” Tightly coupled systems, like financial markets, in which everyone is connected to everyone else, are especially prone to systemic error.

Maybe the economy needs less complexity and more character.

Christopher Chantrill blogs at www.roadtothemiddleclass.com. His Road to the Middle Class is forthcoming.

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