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StrategyDriven Podcast Series

StrategyDriven Editorial Perspective – Good Intentions, Bad Results: Learning from the Panic of 1826

Good Intentions, Bad Results: Learning from the Panic of 1826They say the road to hell is paved with good intentions. In 1825, to deal with the “Indian Problem,” the US Congress formed a region known as “Indian Country,” lands West of the Mississippi (today Oklahoma). Their intentions were good.

“The removal of the tribes from the territory which they now inhabit would not only shield them from impending ruin, but promote their welfare and happiness,” President James Monroe told Congress on January 27. He went so far as to say that without a defined Indian country “their degradation and extermination will be inevitable.”

It’s heartening to know that at least some of the President’s contemporaries could see through his good intentions. New York County District Attorney Hugh Maxwell and twelve other prominent New Yorkers wrote in a pamphlet published in1825 that “the American Indians, now living upon lands derived from their ancestors and never alienated or surrendered, have a perfect right to the continued and undisturbed possession of these lands,” and the “removal of any nation of Indians from their country by force would be an instance of gross and cruel oppression.”

History was not on Mr. Maxwell’s side, nor with his attempts to reform the financial industry a few years later. His prosecution of the Life & Fire Insurance Company, whose owners Jacob Barker, et al perpetuated a fraud that led to the Panic of 1826, resulted in a hung jury. (Eventually, Mr. Maxwell’s efforts did lead to comprehensive reform, including: financial reporting requirements, accounting standards, and defined roles & responsibilities for directors, according to Professor Eric Hilt in a paper about the Panic of 1826.)

Mr. Maxwell’s rationality was no match for his era’s good intentions. For what lead Life & Fire’s directors to commit fraud in the first place was in part driven by a desire (so they claimed) to extend credit to high-risk borrowers being ignored by traditional banks. When those borrowers started to default en masse, fraud appeared to be the only way to repay their investors, but unfortunately, even that didn’t work.

Why was an insurance company doing a bank’s work? In the 19th century, banking was the most profitably industry in America, and incumbent banks fought hard to protect their profits. To open a new one involved special-act charters and bitter legislative battles. Would-be owners required both political and financial capital, which few had in equal measure.

Enterprising merchants like Mr. Barker started circumventing these laws by forming insurance companies whose charter empowered them to lend their capital. In so doing, they created a new financial product called a post note. A typical post note transaction went as follows: a borrower approached an insurance company and requested a six-month IOU of $1000, minus a discount of say 3%. The borrower would then sell the discounted $970 post note on the money market, also paying a discount to the post note purchaser of say $30, receiving $940 in cash.

After six months, the borrower would repay the insurance company’s IOU of $1000. The insurance company would repay the money market investor’s post note of $970, yielding a $30 profit for both the insurance company and the investor.

While rates and terms varied, it was not unusual for post notes to trade at yields of 2 percent per month or more, compared to banks that were lending at yields of five percent per year, Professor Hilt’s research found. Needless to say, these products were very profitable as long as default rates were low.

But higher yield meant higher risk, since borrowers who sought out post notes did so because they did not qualify for the less expensive credit from traditional banks. Despite their dubious quality, the corporate guaranty by the insurance company created a sense that the investments were safe. This combination of high yield and seemingly low risk sparked a credit boom.

“The judge the lawyer the doctor the clergy the widow the trustee of orphans all fell into the common vortex of investing in these bonds,” Life and Fire Insurance Company director Jacob Barker wrote in a letter in 1827.

Like post notes, what made sub-prime mortgage-backed securities (MBS) so attractive to investors during the boom years was their high yield and perceived low risk. Unlike 1826, where the secondary market was created by the private sector, our government in many ways created the secondary market that gave sub-prime loans both the cash and perceived safety they needed to expand.

This was all done with good intentions. Looking to increase the homeownership rate and “foster affordable housing,” the Housing and Urban Development (HUD) department issued regulations that required 55% of all government sponsored entities (GSEs) to purchase “affordable” loans from banks, either directly or through packaged MBS.

Most of these “affordable” loans were in fact sub-prime, “for persons with blemished or limited credit histories,” and “carry a higher rate of interest than prime loans to compensate for increased credit risk,” according to HUD.gov. In 2009, forty percent of mortgages were sub-prime according to Forbes.com.

By 2007, Fannie Mae and Freddie Max held $227 billion (one in six loans) in nonprime (aka subprime) pools, and approximately $1.6 trillion in low-quality loans altogether, according to Forbes.com and the Congressional Budget Office (CBO).

“That was a huge, huge mistake,” said Patricia McCoy, who teaches securities law at the University of Connecticut. “That just pumped more capital into a very unregulated market that has turned out to be a disaster.”

Nonetheless, when the crisis hit in the Fall 2008, the financial world seemed to be blind-sided. “It’s a new financial world on the verge of a complete reorganization,” said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey.

But was it a new financial world? In many ways, looking back to the Panic of 1826, we see ourselves looking back at us. Both were defined by financial innovations that seemed to defy the natural law of risk and reward, by promising a high yield and low risk. Both crises fooled investors into believing that transferring risk is the same thing as removing it. Both crises were made worse by the good intention that lending money to people who can’t pay it back is good for society. Both crises proved it’s not.

In our time, the implosion of the subprime lending market “has left a scar on the finances of black Americans,” the Washington Post reported in 2012, “that not only wiped out a generation of economic progress but could leave them at a financial disadvantage for decades.” (HUD.gov studies reveal that African-Americans are one-and-a-half times more likely to have a subprime loan than persons in white neighborhoods.)

Like the comprehensive financial reforms made after the 1826 panic, we can be reasonably sure that the numerous reforms issued after our own will fail to avert another crisis. This is because financial regulation cannot address the cause of financial crises that lives in our mirror. As long as there are borrowers who can’t see through good intentions, and take on more debt then they can repay, there will be financial crises.

Real financial reform means living within our means, and abiding by the natural law of risk and reward. With the rising default rate on student loans, the increasing popularity of sub-prime auto loans, I fear that we have not yet learned our lesson. I’m confident we will eventually, but like our predecessors, it may have to be the hard way.


About the Author

Cara WickCara Wick writes about American financial and political history at www.bankersnotes.com. She holds a BA from Williams College and an MBA from the University of Iowa. Cara can be reached at [email protected].

StrategyDriven Podcast Series

Inside Job – Unveiling Economists’ Ties to the Financial Sector

America and the world are still recovering from the global economic crisis of 2008. And with unemployment rates above 9 percent, many wonder if the market turmoil will ever end.

PBS NewsHour Economics Correspondent Paul Solman talks to Charles Ferguson, director of Academy Award winning documentary, Inside Job, a film that raises red flags about the world of finance. Paul examines how the film – which raises concerns about conflicts of interest for economists in academics – is influencing some leading economic thinkers.

The Alfred P. Sloan Foundation provided funding for this project.

StrategyDriven Podcast Series

Economists’ Ties to the Financial Sector

The Financial Crisis of 2008 shook the very foundations of the global economy. In this PBS Newshour video, Business and Economics Correspondent Paul Solman talks to Charles Ferguson, director of the Academy Award winning documentary, Inside Job, a film that raises concerns about conflicts of interest for economists in academics and their work within the financial sector. Solman goes on to explore how this film is influencing some leading economic thinkers today.

Click here to access a full transcript and mp3 audio file of this video.

StrategyDriven Podcast Series

Business Complexity has Grown Significantly Since the Financial Crisis

New research confirms the financial crisis has significantly exacerbated business complexity. A recently released survey reveals that 86 percent of firms face increasing complexity in their operating environment or organizational structure over the past three years.

In the survey for the report titled, The Complexity Challenge: How businesses are bearing up, only 22 percent of senior executives think their organizations are well prepared to confront complexity in the future. More than one in four of them describe their firm as ‘complex and chaotic.’ The most prominent reason for the spiraling complexity is the greater expectations of customers. Complexity stemming from globalization or technology rank much lower in the list of causes.

The report also explains the wide range of measures companies are adopting to tackle the complexity; from cutting down management layers to simplifying product portfolios and processes. “It is clear from the research that complexity has become a constraint and a risk for firms,” says Abhik Sen, editor of the report. “Our study shows that some of the most successful companies today are the ones that are tackling this challenge head on by simplifying their organizations or business practices.”

Other key findings in the report include:

  • The single biggest cause of complexity is greater expectations on the part of customers. Increasing customer demands for more choice in the quality and range of products and services are providing the biggest impetus to complexity. The second most cited cause of complexity in the survey is regulation.
  • Complexity is exposing firms to new and more dangerous risks. Complexity has significantly increased the risk exposure of nearly one in five firms. The majority of survey respondents say complexity is affecting the ability of their firms to change business processes and is hindering the introduction of new products and services.
  • Businesses are focusing on technological solutions to tackle complexity. Simplifying information technology systems seems to be the most popular way to tackle complexity in business, along with efforts to simplify or consolidate product and service portfolios. As a source of complexity, though, technology comes in only at seventh place in the survey.
  • A majority of firms have an organizational structure that is adding to complexity. Nearly three in five survey respondents say that the organizational structure of their firms is exacerbating complexity. Almost half (47%) say it is difficult to work out who is responsible for what at their companies and 39 percent say that, as a result of the lack of transparency, there is considerable duplication of effort.

Click here to get your copy of The Complexity Challenge.


About the Research

The complexity challenge: how businesses are bearing up is an Economist Intelligence Unit (EIU) report commissioned by the Royal Bank of Scotland. The research is based on a worldwide survey conducted by the EIU in October-November 2010 of 300 senior executives from a wide range of industries. Approximately half the respondents represent firms with $500M USD or more in annual global revenue. Over half the respondents are C-level or equivalent and the others are directors or senior managers. A minimum of 125 respondents are from the finance function and a minimum of 125 represent functions other than finance. The Economist Intelligence Unit bears sole responsibility for the content of the report.

About the Economist Intelligence Unit

The Economist Intelligence Unit is the world’s leading resource for economic and business research, forecasting and analysis. It provides accurate and impartial intelligence for companies, government agencies, financial institutions and academic organisations around the globe, inspiring business leaders to act with confidence since 1946. EIU products include its flagship Country Reports service, providing political and economic analysis for 195 countries, and a portfolio of subscription-based data and forecasting services. The company also undertakes bespoke research and analysis projects on individual markets and business sectors. More information is available at www.eiu.com.