Does this sound familiar? “A major New York financial institution was in serious trouble. The government authorities were trying to get other, sounder institutions to rescue it and prevent a failure that might have far wider repercussions. But no one would step forward, and the institution failed.
Does this describe Lehman Brothers in 2008? No, this history was written by John Steele Gordon about the Bank of United States in 1930. In the December 13, 2008 of Barron’s magazine, Mr. Gordon goes on to describe just why it failed.
“It was the biggest bank failure in American history up to that time, and it made headlines around the world. Its loan portfolio was heavily in mortgages, often second and third mortgages. Worse, its investment arm, the Bankus Corp., engaged in manipulating the bank's stock and using those shares as collateral for loans.”
The storyline is eerily familiar to today. Excessive leverage in real estate and stock manipulation like the fraud we now know some hedge funds perpetrated this past decade.
Following the news that the Bank of United States was closing its doors the stock market plunged. Many European investors mistakenly assumed it was a government institution and bank withdrawals accelerated as everyone doubted their own banks' solvency.
There are many reasons why the financial crisis that began the spring of 1929 escalated into the Great Depression, but the failure to prevent a run on the banking system like that which started with the Bank of United States was a large contributor.
Is it different this time? Yes. In 2008 a major New York financial institution (Lehman) was allowed to fail, but actions by the Federal Reserve, the U.S. Treasury, and the Federal Deposit Insurance Corporation have gone far to prevent anywhere near a banking system panic.
Why then are investors acting has if the next Great Depression is upon us? Why are capital market prices reflecting a steep drop in economic activity? A good candidate to explain all this is regulatory pessimism.
The bond market shows an unprecedented level of risk aversion or expectation of deflation. As of December 26, yields on very short-term U.S. Treasury debt is near zero and the yield spread (the difference between 2-year and 10-year U.S. Treasury notes) is only 1.2 percent.
Stock market prices are such that the current dividend yield on the Standard and Poor’s 500 Index is more than 1 percent higher than 10-year U.S. Treasury notes. Such a difference reflects a strong expectation that dividends will be cut as profits at U.S. corporations drop dramatically.
Clearly, expectations are negative, but the actions are different. The financial crisis of 2008 did not spark a bank-run like that of 1929 and 1930. This year we have a run to U.S. Treasuries. That is, people did not pull their cash from the financial markets, just moved it around.
If not in financial institutions themselves, the pessimism of 2008 must be with the response to failing institutions.
Following the Great Depression there was large scale regulatory reform. The Securities Exchange Commission was formed and banks were hit with far more oversight. Today, more institutions are willing to accept oversight, and policy makers are more than happy to provide it.
Goldman Sachs and other investment banks earlier agreed to become bank holding companies and come under the scrutiny of the Federal Reserve and others. This week, General Motors Acceptance Corporation (GMAC), the former auto lending arm of GM, also agreed to join the banking ranks, and in doing, accept government funds.
While the managers of these firms see more regulation as a necessary evil, the market disagrees. All of these regulatory changes have done nothing to encourage more risky investments.
Investors remain pessimistic – keeping their funds in Treasuries and avoiding the stock market. The government has already prevented a run on the financial institutions - there is no 2008 ‘run on the banks’. What the market wants now is market clearing. The bad financial institutions can be allowed close.