A Walk-Thru The First Shadow Bank Run… 250 Year Ago

Plain vanilla bank runs are as old as fractional reserve banking itself, and usually happen just before or during an economic and financial collapse, when all trust (i.e. credit) in counterparties disappears and it is every man, woman and child, and what meager savings they may have, for themselves. However, when it comes to shadow bank runs, which take place when institutions are so mismatched in interest, credit and/or maturity exposure that something just snaps as it did in the hours after the Lehman collapse, that due to the sheer size of their funding exposure that they promptly grind the system to a halt even before conventional banks can open their doors to the general public, the conventional wisdom is that this is a novel development (and one which is largely misunderstood). It isn’t.

As the NY Fed’s blog (whose historical narratives are far more informative and accurate than its attempts to “explain away” the labor force participation collapse) recounts, the first tremor in the shadow banking system took place not in 2008 but some 250 years ago… during the Commercial Credit crisis of 1763, whose analog today is the all too shaky and largely unregulated core shadow banking system component: Tri-Party Repo.

From the NY Fed blog, by James Narron and David Skeie:

Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market

During the economic boom and credit expansion that followed the Seven Years’ War (1756-63), Berlin was the equivalent of an emerging market, Amsterdam’s merchant bankers were the primary sources of credit, and the Hamburg banking houses served as intermediaries between the two. But some Amsterdam merchant bankers were leveraged far beyond their capacity. When a speculative grain deal went bad, the banks discovered that there were limits to how much risk could be effectively hedged. In this issue of Crisis Chronicles, we review how “fire sales” drove systemic risk in funding markets some 250 years ago and explain why this could still happen in today’s tri-party repo market.

Early Credit Wrappers

One of the primary financial credit instruments of the 1760s was the bill of exchange—essentially a written order to pay a fixed sum of money at a future date. Early forms of bills of exchange date back to eighth-century China; the instrument was later adopted by Arab merchants to facilitate trade, and then spread throughout Europe. Bills of exchange were originally designed as short-term contracts but gradually became heavily used for long-term borrowing. They were typically rolled over and became de facto short-term loans to finance longer-term projects, creating a classic balance sheet maturity mismatch. At that time, bills of exchange could be re-sold, with each seller serving as a signatory to the bill and, by implication, insuring the buyer of the bill against default. This practice prevented the circulation of low-credit-quality bills among market participants and created a kind of “credit wrapper”—a guarantee for the specific loan—by making all signatories jointly liable for a particular bill. In addition, low acceptance fees—the fees paid to market participants for taking on the obligation to pay the bill of exchange—implied a perceived negligible risk. But the practice also resulted in binding market participants together through their balance sheets: one bank might have a receivable asset and a payable liability for the same bill of exchange, even when no goods were traded. By the end of the Seven Years’ War in 1763, high leverage and balance sheet interconnectedness left merchant bankers highly vulnerable to any slowdown in credit availability.

Tight Credit Markets Lead to Distressed Sales

Merchant bankers believed that their balance sheet growth and leverage were hedged through offsetting claims and liabilities. And while some of the more conservative Dutch bankers were cautious in growing their wartime business, others expanded quickly. One of the faster growing merchant banks belonged to the de Neufville brothers, who speculated in depreciating currencies and endorsed a large number of bills of exchange. Noting their success (if only in the short term), other merchant bankers followed suit. The crisis was triggered when the brothers entered into a speculative deal to buy grain from the Russian army as it left Poland. But with the war’s end, previously elevated grain prices collapsed by more than 75 percent, and the price decline began to depress other prices. As asset prices fell, it became increasingly difficult to get new loans to roll over existing debt. Tight credit markets led to distressed sales and further price declines. As credit markets dried up, merchant bankers began to suffer direct losses when their counterparties went bankrupt.

The crisis came to a head in Amsterdam in late July 1763 when the banking houses of Aron Joseph & Co and de Neufville failed, despite a collective action to save them. Their failure caused the de Neufville house’s creditors around Amsterdam to default. Two weeks later, Hamburg saw a wave of bank collapses, which in turn led to a new wave of failures in Amsterdam and pressure in Berlin. In all, there were more than 100 bank failures, mostly in Hamburg.

An Early Crisis-Driven Bailout

The commercial crisis in Berlin was severe, with the manufacturer, merchant, and banker Johann Ernst Gotzkowsky at the center. Gotzkowsky’s liabilities were almost all in bills of exchange, while almost all his assets were in fixed capital divided among his silk works and porcelain factory. Berlin was able to mitigate the effects of the crisis when Crown Prince Frederick imposed a payments standstill for several firms. To prevent contagion, the prince also organized some of the first financial-crisis-driven bailouts after he examined the books of Gotzkowsky’s diverse operations. Ultimately, about half of Gotzkowsky’s creditors accepted 50 cents on the dollar for outstanding debts.

Meanwhile, banks in Hamburg and the Exchange Bank of Amsterdam tried to extend securitized loans to deflect the crisis. But existing lending provisions restricted the ratio of bank money to gold and silver such that the banks had no real power to expand credit. These healthy banks were legally limited in their ability to support the credit-constrained banks. To preserve cash on hand, Hamburg and Amsterdam banks were slow to honor bills of exchange, eventually honoring them only after pressure from Berlin. The fact that Amsterdam and Hamburg banks re-opened within the year—and some even within weeks—provides evidence that the crisis was one of liquidity and not fundamental insolvency.

The crisis led to a period of falling industrial production and credit stagnation in northern Europe, with the recession being both deep and long-lasting in Prussia. These developments prompted a second wave of bankruptcies in 1766.

Distressed Fire Sales and the Tri-Party Repo Market

From this crisis we learn that it is difficult for firms to hedge losses when market risk and credit risk are highly correlated and aggregate risk remains. In this case, as asset prices fell during a time of distressed “fire sales,” asset prices became more correlated, further exacerbating downward price movement. When one firm moved to shore up its balance sheet by selling distressed assets, that put downward pressure on other, interconnected balance sheets. The liquidity risk was heightened further because most firms were highly leveraged. Those that had liquidity guarded it, creating a self-fulfilling flight to liquidity.

As we saw during the recent financial crisis, the tri-party repo market was overly reliant on massive extensions of intraday credit, driven by the timing between the daily unwind and renewal of repo transactions. Estimates suggest that by 2007, the repo market had grown to $10 trillion—the same order of magnitude as the total assets in the U.S. commercial banking sector—and intraday credit to any particular broker/dealer might approach $100 billion. And as in the commercial crisis of 1763, risk was underpriced with low repo “haircuts”—a haircut being a demand by a depositor for collateral valued higher than the value of the deposit.

Much of the work to address intraday credit risk in the repo market will be complete by year-end 2014, when intraday credit will have been reduced from 100 percent to about 10 percent. But as New York Fed President William C. Dudley noted in his recent introductory remarks at the conference “Fire Sales” as a Driver of Systemic Risk, “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales.” For example, in a time of market stress, when margin calls and mark-to-market losses constrain liquidity, firms are forced to deleverage. As recently pointed out by our New York Fed colleagues, deleveraging could impact other market participants and market sectors in current times, just as it did in 1763.

Crown Prince Frederick provided a short-term solution in 1763, but as we’ll see in upcoming posts, credit crises persisted. As we look toward a tri-party repo market structure that is more resilient to “destabilizing asset fire sales” and that prices risk more accurately, we ask, can industry provide the leadership needed to ensure that credit crises don’t persist? Or will regulators need to step in and play a firmer role to discipline dealers that borrow short-term from money market fund lenders and draw on the intraday credit provided by clearing banks? Tell us what you think.

* * *

Fast forward to today when we find that the total collateral value in the Tri-Party repo system as of December amounts to $1.6 trillion.

… or 10% of US GDP. What can possibly go wrong.


    



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Consumers Max Out Their Credit Cards In Month When Personal Savings Tumble

One week ago we remarked that in the month of December, in order to fund their purchases of Holiday gifts and year-end trinkets, Americans burned through a whopping $46 billion in personal savings, in the process taking the US saving rate down to a one year low of 3.9% and dropping.

 

Today, we got the credit side of the ledger with the December consumer credit report, in which we learned that in addition to the now traditional draw of Car and Student loans, which came out to $13.8 billion, or exactly in line with the 12 month average draw, sending the total notional to a record $2.24 trillion, it was revolving credit, i.e., credit cards, which saw a substantial $5 billion increase in outstandings – the most since May 2013 – bringing total revolving credit to $862 billion if still far below the nearly $1.1 trillion in student loans outstanding.

So just as the US consumer was tapped out, and saw their personal income remain unchanged from November and real disposable income cratered, as a result having to draw down on their savings, the remainder of all purchases was funded through the use of credit cards, which may or may not be repaid in 2014. There is always hope that this time will be different and incomes finally pick up.


    



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Elizabeth Phillips Wiley, 82, of Fayetteville

Elizabeth Phillips Wiley, 82, of Fayetteville, passed away February 5, 2014.

She was preceded in death by her husband William Lloyd Wiley and son Jerry Mauldin.

She is survived by her daughter Teresa (Russell) Joiner; grand-daughters Elizabeth (Benjamin) Urban, Amy (Matthew) Rouse, and Kimberley (Bradley) Hale; great-grandchildren Carter Hale, Ansley Hale, Catie Rouse and Jack Rouse; brother William B. (Eris) Phillips; sister Birdie Hall; and many nieces and nephews.

read more

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John Leonard, age 85

We celebrated the life of John Leonard on Friday, February 7th at 10:30 at  Holy Trinity Catholic Church in Peachtree City.

John passed away on February 3rd after a brief illness. He was 85 years old.

He is survived by his wife of 60 years – Madeline, 5 children – John, Helen, Katherine, Michael and Peter, and 5 grandchildren – Anthony, Lisa, Christina, Andrew and James.

read more

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William Henry Newman III, age 74, of Peachtree City

William “Bill” Henry Newman III, age 74, of Peachtree City, Ga. passed away on February 4, 2014.

He was born in Atlanta, Ga. on February 8, 1939 to the late Bill and Mable Newman. He was raised in the Ben Hill area. He graduated from Brown High School. He was a US Army Veteran.

He spent his entire life defending and protecting animals. He was the Director of the Fayette County Animal Shelter where he retired after 24 years of service. His beloved dog, BJ retired with him.

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Philly DA: We’ve Been “Vigorously Investigating” Police Brutality Claim of Teen with Ruptured Testicle, Now Combining Efforts With Police Investigators

there but for good grades go a lot of cases the da doesn't investigatePhiladelphia’s district
attorney says he doesn’t usually confirm ongoing investigations,
but when he does it’s because he wants the city to know that his
office is doing something about something. In this case, the DA has
confirmed an investigation into an
incident
where a female officer allegedly frisked a teenager so
violently she ruptured one of his testicles. But in coupling the
announcement that his office has been investigating for several
weeks with an announcement that the DA and police would combine
their efforts sends a pretty mixed message.
Via the Philadelphia Tribune
:

“We don’t normally confirm ongoing investigations,”
Williams said. “But given the nature of this case, we felt it was
important to let the public know that we have been vigorously
investigating this case since it occurred. Both the police
commissioner and I have worked extensively to combat the perception
that justice is not dispensed equally in Philadelphia, and that is
why we are joined together today. We are using all the tools
available at our disposal to bring this to a fair and just
conclusion. And as has been the case since I took office in 2010,
we will continue to investigate and prosecute every person in this
city who has committed a crime, no matter who they are.”

When asked if a grand jury was being convened to pursue the
investigation, Williams didn’t say yes or no to that
possibility.

“What I stated was that we would be using every means we have at
our legal discretion to find out what happened. That is the maximum
I can say to answer that question,” Williams said. ”We’re going to
do everything that we can. We’re getting the Internal Affairs
division and the Special Investigations unit of the District
Attorney’s Office to gather as much evidence as possible; medical
records, documents, video tapes, everything that we can to get the
truth about what happened that day and report back to the
public.”

The whole thing doesn’t sound too inspiring, a generic comment
about going after “every person” who commits a crime in the city
ends with a promise to “report back” what his office finds out
about an incident that started with a questionable police encounter
and ended with a teenager’s testicle ruptured. That teenager,
Darrin Manning, incidentally, was already charged by cops on
multiple misdemeanor counts, including one for resisting arrest.
The officer who allegedly ruptured his testicle is as yet unnamed,
and presumably uncharged.

The Huffington Post, which does not mention in its story that
the DA and police department are combining their efforts,
talked
to the Manning family’s attorney, who explained that he
recommended Manning not to investigators from Internal Affairs
because that was not an “appropriate party.” When the
incident
was first reported in the media, the police
commissioner, Charles Ramsey, like the DA now, wanted Philadelphia
residents to know he really wanted to get to be bottom of what
happened, but lamented why the teen, who had been charged by cops,
wasn’t willing to come to them with his complaints. No wonder
Ramsey gets the
big bucks
.

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Small town courage

A few mornings ago, a traffic stop was executed on I-85 South near mile marker 35. The car was clocked at doing 101 miles per hour in a 70.

The driver, age 22, did not have a driver’s license and was arrested for speeding, reckless driving, and driving without a license. After the man was booked into the Coweta County jail, the police learned that the Saturn the man was driving was stolen. He was also wanted for the kidnapping and stabbing of a 23-year-old woman.

read more

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Who’s Trying to Destroy Ride-Sharing Services This Week?

Mustaches, not medallionsApparently not regulating
ride-sharing services like Uber and Lyft as harshly as Chicago does
taxi services is a violation of the rights of tax drivers. That
“interesting” argument, pretending the expensive regulatory
protection schemes of taxi services is something being forced on
them and not something the industry itself wants to limit
competition, is the basis of a lawsuit filed in Chicago to try to
fight ride-sharing companies.

The lawsuit though, is actually quite blunt about protecting the
taxi industry’s assets, not reducing oppressive regulation. Via

Bloomberg
:

Chicago-area taxi operators claim in a lawsuit that the city is
violating their rights by allowing the unregulated ride-share
services run by Uber Technologies Inc. and Lyft Inc. to operate on
its streets.

The failure to apply taxi and limousine rules to the two San
Francisco-based companies threatens to devalue the more-than 6,800
operating permits issued by the city, which have a total market
value of $2.38 billion, according to a complaint filed today by the
cabbies and their trade association in federal court in
Chicago.

That puts the value of each operating permit at $350,000.
Furthermore, Bloomberg notes, “Not enforcing the taxi rules against
the companies violates federal constitutional guarantees of equal
protection under the law and breaches the taxi operators’ contracts
with the city, according to the complaint. It also enables
unregulated drivers to discriminate against the elderly or poor who
may not be able to use a smartphone to summon one of their cars.”
Hey, those elderly and poor folks might be able to afford a
smartphone if they didn’t have to pay so much for taxi services,
thanks to the city-taxi permit racket.

A spokesman for the city of Chicago’s law department said the
lawsuit has no merit, while Uber shot back, “After years of
neglecting Chicago drivers and passengers alike, the taxi industry
has resorted to name-calling and frivolous lawsuits.”
Unfortunately, Uber’s also working with Mayor Rahm Emanuel to
create a new regulatory system, so we’ll just see if just end up
with a second form of protectionist rules to ultimately make it
harder for newcomers to compete with Uber and Lyft.

Meanwhile, a group of lawmakers in Georgia have introduced a
bill to increase regulations on taxi services in order to control
the services. Peach Pundit
analyzed
the legislation:

The bill, filed yesterday, would add a host of statutes related
to “transportation referral service provider[s]” (ie. Uber, Lyft).
It would allow the Department of Public Safety to license
individual drivers, charging them up to $100 annually, and adds a
number of other compliance regulations, including a requirement
that they obtain “either a certificate of public necessity and
convenience or medallion.”

“Certificates of public necessity” make up the system by which
existing businesses and service providers are given veto authority
by the government to prevent competition. The Pacific Legal
Foundation just recently
won a lawsuit
to block this system from being used to prevent
the creation of new
moving companies
in Kentucky.

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Russia Bans Bitcoin

Don’t try to do Winter Olympic business in the currency of
tomorrow, today!, Bitcoin.

Why not? Russia’s Prosecutor General announced today, reports
Fox News
:

“Bitcoin is a money substitute and cannot be used by citizens
and legal entities,” the agency’s press release reads.

The Russian law enforcement agency cited an existing 2002 law
signed by Russian President Vladimir Putin that reads, “the
official currency of the Russian Federation is the ruble.
Introduction of other monetary units and money substitutes is
prohibited.”

Has this Russian maneuver destroyed market desire for the
digital currency? Not quite:

The price of bitcoin on Coinbase.com, the largest
American site for buying and selling bitcoins, fell from about $780
before the Russian announcement to $700, before rising back to $750
by mid-day Friday. The price may also have been affected
by financial
problems
 at the Japanese bitcoin exchange MtGox.

I wrote last year about how governments can and will try to
hobble, but are
unlikely to be able to destroy
, Bitcoin.

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Is Wellesley's Underwear-Clad Statue Too Scary for Free Speech?

While the students of some
universities fight their administrators to
protect
the right to free speech, the pupils of Wellesley
College in Massachusetts are taking a contrary approach to sticking
it to the man. In response to a recently unveiled piece of art that
portrays a nearly-naked individual, some students of the all-female
liberal-arts college want to censor it because certain
interpretations may lead to mental and emotional distress.

On Wednesday, along a main thoroughfare the university installed
“Sleepwalker,” a hyper-realistic sculpture of a man stumbling in
his underwear. In a press release from the school’s Davis
Museum, one art historian explains,
“Art has the ability to invite the kinds of conversation that are
not easily available anywhere else but in the art world.
Sleepwalker can even do some of the work in sparking the kinds of
dialogue that we want to have on campus.”

Although the artwork would not likely be legally considered
indecent, let alone obscene,
student Zoe Magid is less interested in talking about it and more
interested in removing it. She believes that, “while it may appear
humorous, or thought provoking to some,” such qualities are
invalidated by others’ readings of it. Magid asserts
that the inanimate object is “a source of apprehension, fear, and
triggering thoughts regarding sexual assault for some members of
our campus community.” So, she started a petition demanding the
university stick Sleepwalker inside the museum, away from the
public eye. 722 people, about one-third the school’s student
population, have signed.

Alumna Magdalena Zebracka put her John Hancock on the petition
because she believes the sculpture is mentally oppressing the
women. “What does this statue do if not remind us of the fact of
male privilege every single time we pass it, every single time we
think about it, every single time we are forced to acknowledge its
presence,” she
asks
.

Zoe Kraus, another student, voiced a similar sentiment, assuring
that she is not “pro-censorship,” but wants
the sculpture, as well as the entire exhibit, to be removed in
favor of the work of an artist who isn’t a “well-established,
middle-aged white man.”

Amanda Marcotte of Slate
points out
that, “notably, no self-identified rape survivors
piped in to say that the statue reminded them of their own
experiences, but that didn’t hold back the tide of speculation that
it might traumatize them.”

Charlotte Alter of Time criticizes
the students for advocating “Soviet-level censorship” and “a
weirdly puritan strain of liberalism.” She touches on the dangers
of censorship and a culture that has “the expectation that once
offended – or, in most cases, once a hypothetical offensiveness has
been identified – the world must immediately act to make the ‘bad
thing’ disappear. There’s something spoiled about our knee-jerk
reaction to abolish anything that could be considered even remotely
insensitive.”

Although Wellesley doesn’t
have a stellar
record
on promoting free speech, the administration will let
Sleepwalker remain. Davis Museum Director Lisa Fischman
responded
to the petition, offering a different interpretation,
and defending the installation. “He appears vulnerable and
unaware against the snowy backdrop of the space around him… He is
profoundly passive. He is inert, as sculpture,” she writes.

Tony Matelli, the artist, was shocked by the negative response
and says
he hoped the students would feel empathy for the vulnerability of
man being portrayed.

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