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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.
Perhaps the most amusing and curious aspect of this entertaining summary of the Mississippi Bubble of 1720, the resulting European debt crisis (the first of many), how bubble frenzies are as old as paper money, the man behind both – convicted murderer and millionaire gambler, John Law, what happens when paper money’s linkage to gold is broken, and how everyone loses their wealth and hyperinflation breaks out, is who the source is. The New York Fed. Perhaps the Fed-employed authors fail to grasp just what their institution does, or have a truly demonic sense of humor. In either case, the following “crisis chronicle” highlighting how banking worked then, how it works now, and how it will always “work”, is a must read by all.
Crisis Chronicles: The Mississippi Bubble of 1720 and the European Debt Crisis
Convicted murderer and millionaire gambler John Law spotted an opportunity to leverage paper money and credit to finance trade. He first proposed the concept in Scotland in 1705, where it was rejected. But by 1716, Law had found a new audience for his ideas in France, where he proposed to the Duke of Orleans his plan to establish a state bank, at his own expense, that would issue paper money redeemable at face value in gold and silver. At the time, Law’s Banque Generale was one of only six such banks to have issued paper money, joining Sweden, England, Holland, Venice, and Genoa. Things didn’t turn out exactly as Law had hoped, and in this edition of Crisis Chronicleswe meet the South Sea’s lesser-known cousin, the Mississippi Bubble.
Who Wants to Be a Millionaire?
John Law was an interesting figure with a colorful past. He was convicted of murder in London but, with the help of friends, escaped to the continent, where he became a millionaire through his skill at gambling. Like South Sea Company Director John Blunt in England, Law believed that a trading company could be leveraged to exchange the monopoly rights of trade for the ability to make low-interest-rate loans to the government. And like Blunt, in 1719 Law formed a trading company—the Mississippi Company—to exploit trade in the Louisiana territory. But unlike Blunt or the South Sea Company, the Mississippi Company made an earnest effort to grow trade with the Louisiana territory.
In 1719, the French government allowed Law to issue 50,000 new shares in the Mississippi Company at 500 livres with just 75 livres down and the rest due in nineteen additional monthly payments of 25 livres each. The share price rose to 1,000 livres before the second installment was even due, and ordinary citizens flocked to Paris to participate. Based on this success, Law offered to pay off the national debt of 1.5 billion livres by issuing an additional 300,000 shares at 500 livres paid in ten monthly installments.
Law also purchased the right to collect taxes for 52 million livres and sought to replace various taxes with a single tax. The tax scheme was a boon to efficiency, and the price of some products fell by a third. The stock price increases and the tax efficiency gains spurred foreigners to Paris to buy stock in the Mississippi Company.
By mid-1719, the Mississippi Company had issued more than 600,000 shares and the par value of the company stood at 300 million livres. That summer, the share price skyrocketed from 1,000 to 5,000 livres and it continued to rise through year-end, ultimately reaching dizzying heights of 15,000 livres per share. The word millionaire was first used, and in January 1720 Law was appointed Controller General.
The Trickle Becomes a Flood
Reminiscent of a handful of florists failing to reinvest in tulip bulbs as we described in a previous post on Tulip Mania, in early 1720 some depositors at Banque Generale began to exchange Mississippi Company shares for gold coin. In response, Law passed edicts in early 1720 to limit the use of coin. Around the same time, to help support the Mississippi Company share price, Law agreed to buy back Mississippi Company stock with banknotes at a premium to market price and, to his surprise, more shareholders than anticipated queued up to do so—a surprise we’ll see repeated at the apex of the Panic of 1907. To support the stock redemptions, Law needed to print more money and broke the link to gold, which quickly led to hyperinflation, as we saw in our post on the Kipper und Wipperzeit.
The spillover to the economy was immediate and most notable in food prices. By May 21, Law was forced to deflate the value of banknotes and cut the stock price. As the public rushed to convert banknotes to coin, Law was forced to close Banque Generale for ten days, then limit the transaction size once the bank reopened. But the queues grew longer, the Mississippi Company stock price continued to fall, and food prices soared by as much as 60 percent.
To make matters worse, there was an outbreak of the plague in September 1720, which further restricted economic activity—in particular, trade with the rest of Europe. By the end of 1720, Law was dismissed as Controller General and he ultimately fled France.
Balancing Dispersed Debt Issuance against Central Monetary Policy
One might argue that Law suffered a self-inflicted loss of control over monetary policy once the link between paper money issuance and the underlying value of gold holdings was broken—a lesson that monetary authorities have learned over time. (ZH: they have? where?) But what if you don’t have direct sovereign authority over banknote issuance or, in more modern times, monetary policy? A challenge that’s perhaps most visible in the Eurozone is how best to balance dispersed, country-specific debt issuance against more centralized authority over monetary policy. In an upcoming post on the Continental Currency Crisis, we’ll see why a united fiscal policy was needed along with the united currency and monetary policies. Could the same be true of Europe? And if so, would a united fiscal policy include Eurozone debt as well as centralized fiscal transfers, or perhaps even collection of taxes? Tell us what you think.
foreward by JS Kim, Managing Director of SmartKnowledgeU
Below is a recent correspondence from our friend Lars Schall, an independent financial journalist, and the German Central Bank, the Deutsche Bundesbank, regarding the exact whereabouts and specifications of Germany’s national gold reserve. From the correspondence below, it appears that the US Central Bank had already leased out Germany’s gold reserves in prior years and no longer has it, as the gold bars the US Central Bankers returned to Germany last year were clearly not the same ones that Germany originally deposited with them. The questions Mr. Schall’s revelations now beg is (1) if the Banque de France and the Bank of England have Germany’s original gold as well; and (2) if the various Central Bankers are deliberately returning Germany’s gold on a painfully slow timeline because they have already leased out Germany’s gold into the open market in prior years, no longer hold it, and must therefore scrape together Germany’s gold from the open market now.
Below is Mr. Schall’s inquiry to the Deutsche Bundesbank:
December 26, 2013
Dear Ladies and Gentlemen:
I am an independent financial journalist.
In connection with the transfer of 37 tons of Bundesbank gold from New York to Germany, I came across the news that the bars were a melted before the transfer. May I kindly ask you for the following information:
Why were the bars melted at all? And why couldn’t that wait until the bars arrived in Frankfurt?
Below is the Bundesbank’s curious reply that is riddled with a lack of transparency:
January 3, 2014
Dear Mr. Schall:
Thank you for your enquiry.
At a press conference on the topic of Germany’s gold reserves on 16 January 2013, Executive Board member Carl-Ludwig Thiele presented the Deutsche Bundesbank’s new storage concept. In addition to the relocation of gold bars, this concept includes, amongst other things, measures to ensure that the specifications of the London Good Delivery (LGD) standard are met. You can find these specifications on Page 17 of the following presentation:
Storage plan (new)
Frankfurt 31% ………… 50%
New York 45% ………… 37%
London 13% ………… 13%
Paris 11% ………… 0%
– Phased relocation of 300 tonnes of gold from New York to Frankfurt.
– Phased relocation of 374 tonnes of gold from Paris to Frankfurt.
– Achieve LGD standard, where this is not already the case.
You can find the specifications for the London Good Delivery (LGD) standard at the following address:
In cases where these specifications were not already met, the Bundesbank had these original gold bars melted down and recast in order to meet this standard. This was achieved without any difficulties. Please understand that in order to ensure the security of the gold transports and our employees, the Bundesbank is unable to provide you with any further information.
60431 Frankfurt am Main
Tel.: +49 69 9566×3511 or 3512
And below are questions raised by Peter Boehringer, president of German Precious Metal Society and co-initiator of the Repatriate our Gold campaign, to the opacity and oddities of the Bundesbank’s response:
Why does the Bundesbank continue to avoid transparency regarding Germany’s gold holdings?
Why not just come up with easy-to-deliver facts instead of repeated rhetoric about an alleged remelting of gold bars in the United States that even people with some knowledge of the gold industry and some common sense fail to understand?
There is no reason why the original gold bars acquired in the 1950s and 1960s (if they ever existed at all, which has never been proven, as by publication of bar lists or photos) had to be melted down and recast into LGD-compliant bars in New York as opposed to Frankfurt. Nor is there reason why all this had to be done in obscurity without any published report of the recasting.
The public is still waiting for answers to crucial questions like these:
– What kind of gold bars were melted? Original material from the 1950s and ’60s?
– How can the Bundesbank hint in its press release that some of the old bars already met the LGD specifications when those specifications were not defined and made a standard for central bank bars until 1979?
– Why has the Bundesbank not published a bar number list of the old bars? How can there be security concerns about bars that no longer exist? Why has the Bundesbank not published a bar number list of the newly cast bars?
– Who exactly melted the bars? Where exactly was this melting performed? Is there a smelter at the Federal Reserve Bank of New York?
– Who witnessed the melting and recasting of the bars?
– Are there any reports on this in writing with a valid signature? By whom?
– And especially: Why was it deemed necessary to perform this action in the United States as opposed to Frankfurt or nearby Hanau, where there are some of the best facilities in the world for metal probing, melting, and recasting? Had these actions been performed in Germany in a fully transparent manner, it would have been so easy for the Bundesbank to dismiss all questions from “paranoid gold conspiracy theorists.”
The Bundesbank is just the custodian of Germany’s national gold, which is worth more than $125 billion. The Bundesbank owes the public full transparency in all these gold matters. That is, physical audits, independently verified storage reports, and a publication of the full bar lists of all its gold in all national or international vaults. Despite having now had the excellent opportunity of this partial repatriation, the Bundesbank has again failed to produce any proof or indication that at least 37 tonnes (out of 1,500 tonnes of German gold at the New York Fed) still existed through 2013 in their original 1950s-’60s bar form. Instead, Germany is now owner of almost 3,000 LGD-compliant standard bars, which proves nothing and dismisses no allegations of decade-long manipulation of the gold price.
It is still possible and even probable that the old German bars were lent into the market long ago or that they have multiple owners or are backing multiple gold exchange-traded fund derivatives. Of course the same holds for our remaining 120,000 bars at the New York Fed. The “repatriation” of a mere 1.5 percent of Germany’s foreign gold holdings and the supposed melting and recasting of the original gold bars do not prove the continued existence of Germany’s remaining gold holdings supposedly vaulted at the New York Fed. The Bundesbank has missed a great opportunity to bring transparency to Germany’s gold reserves. What a pity. And at its current speed the Bundesbank will require 60 years to accomplish the repatriation mission forced upon it by an impatient public. What a shame.
The initiators of the Repatriate Our Gold campaign are considering legal action based on freedom-of-information law against the Bundesbank and possibly also against its auditors, who have certified the Bundesbank’s balance sheet without having adequately considered the risks associated with a non-transparent gold hoard, which is the only asset of substance on the Bundesbank’s books. (Ninety percent of those assets are mere paper claims, many of dubious quality, like “Target 2? claims.)
Our objective remains to achieve the publication of all gold bar lists and full transparency involving Germany’s gold. The German people are entitled to have all information about their golden property. And the American people have a right to know as well. After all, it is the U.S. Federal Reserve System and the U.S. Treasury Department that have been obscuring their gold holdings and foreign gold holdings since the last proper audit in 1953.