October 21, 2007
One World, Taking Risks Together
HUGE financial losses in the United States spark fears in Europe. A credit crisis ensues. Soon the fear spreads to Wall Street, where the biggest banks fight off rumors of insolvency amid a broader economic panic, and Washington is forced to step in. The market swoons. If this sounds familiar, it should. Except we’re not talking about the subprime mortgage crisis, or the deal brokered by the Treasury Department last week with three American banking giants to cough up $75 billion for a fund aimed at stabilizing the global credit market, or Friday’s 366-point drop in the stock market.
In fact, it’s a brief history of the Panic of 1907, which culminated exactly 100 years ago today.
Back then, losses stemming from the San Francisco earthquake the year before hammered British insurers and eventually forced government officials on this side of the Atlantic and none other than J. P. Morgan himself to come to the rescue. On the night of Oct. 21, 1907, the legendary tycoon summoned the country’s leading financiers to his Murray Hill mansion to help finance a bailout.
“This is where the trouble stops,” Mr. Morgan famously declared. He succeeded. By early 1908, the panic had passed.
Today, it’s J. P. Morgan again — the firm, not the man — along with Citigroup and Bank of America that are trying to fix things, with prodding from Henry M. Paulson Jr., the secretary of the Treasury, and, as the former head of Goldman Sachs, something of a latter-day tycoon.
Given the historical echo — as well as the 20th anniversary of the crash of Oct. 19, 1987 — it’s appropriate that the plan to ease the credit crunch is high on the agenda this weekend as the finance ministers of the Group of 7 leading industrial countries confer in Washington.
But this time around, it may take much longer to repair the damage and restore confidence than it did a century ago. It’s not only that the sums are larger now: even adjusting for a century of inflation, losses from the San Francisco earthquake totaled only about $18 billion in today’s dollars, according to Marc Weidenmier, an associate professor of economics at Claremont McKenna College, compared with the likely loss of hundreds of billions dollars related to subprime mortgages.
It’s also that the breadth and complexity of today’s global markets create risks so great that no group of business leaders — or even a single country — can control them.
When it comes to the valuing of the mortgage-backed securities that are at the heart of the subprime meltdown, no less an expert that Benjamin S. Bernanke, the chairman of the Federal Reserve, admits he’s at a loss. “I’d like to know what those damn things are worth,” Mr. Bernanke said during the question-and-answer period after a speech in New York Monday night.
So would many ordinary homeowners who normally don’t concern themselves with the inner workings of the Fed. Unlike past panics, or even the crash of 1987, the current credit turmoil has affected ordinary consumers who merely want to secure a mortgage or refinance a loan. Rates have spiked for even the best-qualified borrowers, and home buyers with less than stellar credit histories now find themselves locked out.
This phenomenon goes both ways. Not only are people without a dime in stocks affected by market gyrations, but in an era when United States mortgage defaults can move markets from London to Mumbai to Shanghai, it seems as if bad decisions by a lender in Cleveland or a borrower in Miami can have worldwide implications.
On a trip last week to New Zealand to meet with investors, Byron R. Wien, chief investment strategist of Pequot Capital and a 40-year Wall Street veteran, noted, “every place I go they ask about subprime and climate change — those are the two big issues.”
It wasn’t supposed to work this way. Interconnected global markets should make the world economy more stable, according to traditional economic theory, with risk spread more widely and strength in one region offsetting weakness in another.
“In practice, we’re not seeing that happening,” says Richard Bookstaber, a veteran hedge fund manager and author of a new book, “A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.”
Although international financial links are nothing new, as the Panic of 1907 shows, what’s different now is how closely international markets are correlated with one another. “Everybody tends to invest in the same assets and employ the same strategies,” Mr. Bookstaber says, noting how just as Citigroup and Merrill Lynch suffered billions in losses from subprime loans, so did banks in France, Germany and Britain.
Indeed, Northern Rock, a British bank, suffered a run by depositors last month before the Bank of England effectively bailed it out.
The trend extends into stock exchanges in Asia, where shares in India and China are experiencing a parabolic rise. “You have speculative American money invested in India, just as you have speculative Indian money invested in India,” he says. “As markets become more linked, diversification doesn’t work as well.”
As a result, Mr. Bookstaber argues that today’s global financial markets may actually be more risky than in the past. That’s because the same types of investors are taking on the risky bets and then simultaneously heading for the exits when trouble comes, even if they’re on opposite sides of the world.
“If they’re more speculatively oriented, at the very time you have a problem they’re going to dump because they have so much leverage,” he says.
Historically, adds Mr. Bookstaber, there are two characteristics that precipitate financial crises: complexity and leverage. And the current subprime mess, in which risky mortgages were bundled together by Wall Street and then sold to investors who borrowed heavily to buy them and who may not have understood exactly what they were getting, pretty much fits this pattern.
This, too, has implications for ordinary consumers as well as the Masters of the Universe. Homeowners having trouble coming up with their mortgage payment can no longer call their local bank to renegotiate because their mortgage is being held by an investor thousands of miles away.
At the same time, foreigners seem to be emulating the American appetite for risk-taking and speculation, rather than learning from its dangers.
“We’re still the big spenders, but there’s evidence that’s starting to change,” says Mr. Weidenmier, citing China as one example. Not only is consumer spending there booming, but local investors have bid up shares on the Shanghai Stock Exchange by 432 percent over the last two years — many going into debt to get a piece of the action.
Now, just as problems in the United States have caused ripples in Europe, there are fears that a bursting of the Asian bubble could soon be felt in New York. A brief sell-off in Shanghai prompted a 400-point decline in the Dow last February, but both markets quickly bounced back. A prolonged plunge now in Chinese stocks might not be so easy to shake off, especially given the turmoil in credit markets in the United States and Europe, says David Malpass, chief economist at Bear Stearns. Of course, taking risks, even speculative ones, has always been a driving force behind economic growth and the dynamism of the capitalist system. John Maynard Keynes called these urges “animal spirits,” and experts like Mr. Wien disagree with the notion that globalization has made things more risky.
He argues that the newly rich in places like the Middle East can actually smooth things out by having the money to buy when everyone else is selling. That’s one reason his next stop after leaving New Zealand was Dubai.
Regardless of who’s right, Mr. Weidenmier argues that financial crises ultimately make the entire system stronger. Indeed, the Panic of 1907 led to the creation of the Federal Reserve, which has set monetary policy for the United States ever since. “Sometimes financial crises are actually good,” he says, “because they cleanse the system.”