Warren Buffet once said that you don’t know who’s swimming naked until the tide goes out. The events of this past week (ably summarized in Friday’s Wall Street Journal) afford an illustration: a sharp contraction in liquidity, transactions withdrawn from the market, major institutions (Bear Stearns, BNP Paribas) reeling from large losses, and so on. We’ve seen it all before. I’m not referring to 2001 (collapse of Enron and bursting of the Internet “bubble”), 1998 (Russian bond default and the collapse of Long Term Capital Management) or 1984 (bursting of the oil boom and collapse of Continental Illinois bank and numerous S&Ls). To see what happens when a tide really goes out, look at 1907.
Sean Carr and I recently completed a book about one of the sharpest financial crises in U.S. history, The Panic of 1907 (to be published by John Wiley & Sons, August 31, 2007). We describe how J.P. Morgan and a small circle of business leaders organized a response to a cascading series of near-death experiences in the financial markets. Morgan’s orchestrated response inspired the founding of the U.S. Federal Reserve System in 1913. The history of the Panic is more than an interesting footnote; it is a cautionary tale about the causes of major crises and tractable responses.
Large and systemic financial crises defy single explanations. They are rooted in buoyant growth that promotes optimism, risk-taking, and demands on liquidity. Leaders trim closer to the wind, taking slack out of their organizations in the pursuit of efficiency. Growth and complexity make it hard for leaders to know what is really going on—this is Warren Buffet’s point: naturally-occurring information asymmetries stymie an understanding of risk exposure. Then a shock of some kind strains the financial system–maybe a speculative collapse or a natural disaster. A panic of investors and depositors ensues. At this point, quelling the panic is a matter of creating transparency, mustering liquidity, and restoring confidence. This calls for a cool head and a keen mind. This general framework applies to disasters in the small as well as in the large—I have seen it in my studies of M&A disasters. And the burgeoning field of operational safety highlights many of the same elements.
To be sure, times have changed since 1907. We have a strong Fed, deposit insurance, and the machinery of bank regulation to help us sleep more soundly. But the world financial system is incredibly more complicated. And major elements of past crises seem to be converging today: innovative financial instruments that cannot be valued very easily (remember Enron); a drop in asset prices (remember oil in 1984); and new financial players whose exposure to risk is not transparent and whose behavior is not predictable (remember LTCM). These factors converged in 1907. We can learn from the events of that fateful year and use them to illuminate the headlines today. Let’s hope that history does not repeat itself.
Posted by Robert Bruner at 08/11/2007 12:45:11 PM