The Fed’s Liberty Street Economics blog had a thought provoking post the other day, “Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market“ by James Narron and David Skeie. Is this history teaching us an important lesson or a reach?
So what is the history lesson? From the post:
“…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…”
Bills of exchange circulated as a near-riskless instrument, with each seller jointly liable for the repayment. The guarantee feature created inter-connectedness between the financial houses.
“…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…”
The fall in the price of wheat by 75% (after a speculative trade gone bad) triggered other asset prices to fall. This, in turn, spooked lenders and created a liquidity crunch.
“…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 spread from Amsterdam to Hamburg.
“…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…”
And the solution was to freeze payments for a time.
“…Berlin was able to mitigate the effects of the crisis when Crown Prince Frederick imposed a payments standstill for several firms…”
The analogy to the funding crisis triggered by a loss of confidence in asset-backed CP and securitized sub-prime mortgages kind of smacks you in the face here. We are less sure about the tri-party and fire sale connection. The fall in the price of wheat was an unwind of a speculative bubble and the trigger of the liquidity crisis. OK. Where exactly is the fire sale in this scenario?
The credit crisis in the mid-1700s was exacerbated by, “…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…” Perhaps the post missed an opportunity to focus on how lender of last resort facilities can be responsibly used in today’s world?
Is the author (not so subtly) hinting that Crown Prince Frederick’s solution (of a payments standstill) should be adopted in today’s securities financing world? It seems like one more swipe at the safe harbor provisions of the bankruptcy laws allowing non-defaulting parties to immediately liquidate collateral.
We do agree that when asset prices fall dramatically, there is a contagion effect. Fed governor Dudley’s arguments about externalities and fire sales makes a lot of sense. But the Fed has said they are focused on mitigating fire sales on only the most liquid assets. We have suggested before this is where they needn’t worry so much (even if that is the lions share of tri-party). Perhaps the Fed should be thinking more about the less liquid assets financed in tri-party and how to prevent fire sales there? We never heard about anyone having problems selling US Treasuries in the financial crisis. But RMBS, well that is another matter.