Panic and Profits
Americans seem to be carelessly floating away on the housing bubble…Chris Mayer gives us a closer look at the history of financial cycles and shows us that this boom has nowhere to go – but down…
‘To be ignorant of what happened before you were born is to be ever a child.’ -Cicero
George Peabody may not be a name familiar to you, but surely, you have heard of J.P. Morgan. Well, there may never have been a Morgan if not for George Peabody. What follows is a bit of his story, a small study in the creation of wealth in 19th-century America. The opportunity for Peabody emerged in the aftermath of the Panic of 1837.
The Panic of 1837 itself is a great tale, not only because of its useful parallels with today’s markets, but also because it gives us an example of the great truth about financial crises – they are midwives of opportunity.
Generally, the study of the bubbles and busts of the past should be a staple in every investor’s diet, because speculative manias and panics are bound to be a part of every investor’s experience. There is much to be learned in mining these old experiences. The more we know (so we hope), the better prepared and less surprised we will be when things start to break.
Panics always have their beginnings in the boom that precedes them. Just as all hurricanes first develop over warm waters from pre-existing conditions, financial storms are spawned by surging growth in money, debt and speculation – the tres hombres of financial upheaval, if you will.
Erie Canal: A Lure for European Capital
From the perspective of European investors, 1830s America was a booming emerging market full of promise and potential, a lure for hungry European capital.
The cotton industry was thriving, as the United States was a major global exporter of cotton. Cotton prices were probably as important as the price of oil is today for Middle Eastern countries like Saudi Arabia.
In addition to the cotton industry, there was a great surge in canal construction. The Erie Canal was completed in 1824 and made a big impact on trade. As Marc Faber reports in his excellent book Tomorrow’s Gold, the Erie cut travel expenses by 90% on some routes. New canals linking the St. Lawrence River to the Great Lakes allowed for easier transportation of Midwestern grains to New York.
The canal was like any of our recent technological marvels, in that it cut costs and improved productivity. This should concern those investors who are banking on productivity and breakthrough technologies to make them rich, because the canal boom and bust is another in a long line of examples (including airlines and automobiles) in which investors lost boatloads of money betting on life-changing technologies.
In any event, the success of New York’s canals helped make the state the financial and commercial center of the young republic. It also inspired numerous imitators, as other towns and cities sought to copy its successes. New bubbles need a crowd of support to wreak havoc, just as politicians need votes to get started.
The canal mania also stimulated rampant speculation in land as speculators tried to position themselves to profit from the growing canal boom. Land prices soared, and properties were flipped like Internet stocks.
Much of this expansion – the cotton boom, the canal construction and the speculation in land – was financed on credit. The banking business, too, was a growth industry. The number of banks in the United States rose from 330 in 1830 to 788 in 1837 – a 139% increase.
The Second Bank of the United States (an embryonic Federal Reserve, which was disbanded in 1836 after Andrew Jackson vetoed the bill to renew its charter) and its coterie of state banks fueled a credit binge that would have made Greenspan proud.
Erie Canal: Malinvesting
Total bank loans and money supply more than doubled in the six years running up to 1836. In short, there was a huge amount of money chasing cotton plantations, canal projects and speculating on land.
Austrian business cycle theory, as crafted by economists Ludwig von Mises and Murray Rothbard, dictates that any bank credit inflation leads to the boom-bust cycle. All that money and debt creation leads to malinvestments. Malinvestments are investments that later prove to be unprofitable. The word is perfect to express what happens in a boom – malinvestments multiply. The 1830s boom would be no exception.
The immediate causes of the bust were numerous, and all happened in 1837, precipitating a period of tighter money in which the house of cards began to collapse on itself.
But the immediate causes of the Panic are not important. What is important to remember is that massive borrowing and speculation put the economy on the inevitable path of all bubbles. It also important to note that as prosperous as America was to become, it was plagued in its early stages with regular economic crises – in 1819, 1837, 1857, 1873, 1884 and 1893. Emerging market investors of today take note (because as promising as China looks today, it will not have a smooth ride, if history is any guide. In fact, I think 19th-century America is probably a good metaphor for China).
During the ensuing depression, cotton prices would fall 70%, bankrupting a number of speculators and plantation owners who had paid inflated prices for their land. U.S. banks, facing the withdrawal of foreign credit, began to shut their doors, unable to meet the redemption demands of their depositors. U.S. bank shares fell to small fractions of their previous highs.
Many of the investments made in canal construction were based on unrealistic high-growth assumptions and caused great losses for investors. Many projects, starved for capital after the Panic, were never finished and became worthless.
It was in this maelstrom that George Peabody would build the fortune that founded the House of Morgan. A Baltimore merchant, he opened a merchant house in London in 1838, trading in dry goods and trade finance. American securities had become a specialty of Peabody’s, and he sold many U.S. bonds to British investors. State governments had become big debtors in the infrastructure boom – spending money on canals and public works projects.
Peabody actually saw what was coming, and in anticipation, he began to curtail some of his operations, collecting debts he was due, selling stock and getting into cash-building a kitty that would see his business through the Panic and give Peabody some dry powder to take advantage of inevitable new opportunities once the air finally came out of the balloon.
Erie Canal: Cheats, Rascals, and Ingrates
Like contemporary Russia or Brazil, the United States was the emerging market crisis of that time. The state governments were the deadbeat debtors of the day. As author Ron Chernow notes, ‘British investors cursed America as a land of cheats, rascals and ingrates.’
The stain of default also tainted the federal government’s credit standing. When the United States sent Treasury representatives to meet with the august James de Rothschild, he reportedly answered, ‘Tell them you have seen the man who is at the head of the finances of Europe and that he had told you that they cannot borrow a dollar. Not a dollar.’
Because of U.S. debt troubles, Peabody became persona non grata around London (after all, he had sold the Brits much of that debt). But that did not deter him. He bought the depreciated state bonds when they were trading for pennies on the dollar. When these bonds paid interest again, in the late 1840s, Peabody reaped a fortune. By 1848, American securities had come to be seen as something of a safe haven as Europe was engulfed in the flames of revolution. The American railroad boom was going strong too, and gold was soon discovered in California.
The promise of America once again won the hearts (and investment dollars) of Europe’s moneyed elite. Proof once again that investors of all times and places have short memories.
Peabody’s reputation was restored, as America once again became the place to invest. By the 1850s, he had amassed a fortune of some $20 million and had an annual income exceeding $300,000. He was financing everything from Chinese silk to iron rail exports to America.
Peabody, though, was careful with his money. ‘My capital is ample,’ he wrote, ‘but I have passed too many money panics not to have seen how often large capitals are swept away and that even with my own I must use caution.’
Junius Spencer Morgan, J.P. Morgan’s father, was invited to become Peabody’s partner in 1854. Fortunately for Morgan, Peabody had no heirs or a spouse – not even a nephew to whom he could pass on his vast fortune and thriving business. Not only that, he was determined to find an American of good standing and talent to take the reins. As Chernow writes, ‘This placed the Morgans in the exceedingly nice position of inheriting somebody else’s empire on a platter.’
It was to Morgan that such a fortune would fall when Peabody retired, although Peabody broke their agreement by refusing to allow Morgan to use the Peabody name (or perhaps the House of Morgan would have become the House of Peabody). In September of 1864, George Peabody & Co. became J.S. Morgan & Co.
Erie Canal: Long-Term Patience
The Morgan family would prove to be good stewards of Peabody’s empire. The senior Morgan, whether you view him as villain or hero, was a shrewd investor. Morgan and his partners were patient, taking a long view of their investments and allowing their companies to develop without panicking at short-term setbacks.
Long-term patience like that is not a hallmark of today’s institutional money. A whole culture of meeting quarterly earnings estimates seems to have vastly shortened investment horizons – to the detriment of today’s shareholders.
Taking the lesson of past crashes and heeding the warnings about rampant debt creation and widespread speculation, let’s look at today’s market for areas that might be potential panic spots for 2005 and beyond.
It is hard to look at today’s market and not see housing as a potential panic spot. It is like looking at a normal-sized man with elephant ears: It’s hard not to notice. The housing market has all the makings of a bubble – lots of debt (mortgages), artificial government stimulation, incredible price increases and a belief that housing is always a good investment. As Grant’s Interest Rate Observer notes, ‘Since the stock market peaked, Americans have shifted their hopes for capital appreciation to the roofs over their heads, net of the mortgages on their backs.’
The United States has not seen such a long bull market in housing since at least the 1950s.
In some parts of the country, the gains have been staggering. Since 2000, in the Washington, D.C., area market, where I live, prices have gained 70%. Housing prices do decline, lest we forget. According to research by HSBC, ‘Declines occurred in 1975, 1979-82 and 1989-94, using the OFHEO House Price Index. In the past 116 quarters that we have data for (1975Q2-2004Q1), real prices rose 73 times and fell 41 times and were flat twice. In other words, real prices declined 35% of the time.’ This time, the run-up in prices was unprecedented. Will we soon be able to add housing to the long list of great bubbles in American history – along with canals, railroads and all the rest?
In short, the housing bubble is stretching itself awfully thin. Take this story to heart and become more knowledgeable about risks, and learn to appreciate the timeless qualities of financial cycles. Like Peabody, let’s heed the warnings and keep our capital safe.
for The Daily Reckoning
October 21, 2004
The dollar hit a seven-month low against the euro yesterday.
The greenback hit a low in January…rose in the spring…and barely budged in the summer.
‘Look at this,’ said colleague Dan Denning yesterday. He pointed to MoneyWeek’s Chart of the Week, clearly showing that though the dollar rose in 2004, it never actually left its downward channel. Now, it’s dropping again.
We don’t know where it will end up. Nor do we know what is ahead for stocks or residential real estate. We can neither predict the future nor control the present in this great big world of ours. But in our tiny little sphere, at least, we still have some influence. Whatever the answer the future gives, we don’t want to be holding dollars, stocks or leveraged houses when we get it.
If consumers were earning more money, we might expect them to buy more from American companies. The sales should increase profits and make stocks worth more. But consumers aren’t earning more. What they spend comes from borrowing, not earning. And even the credit seems to be running out.
‘BOGO.’ That’s the new offer from GM dealerships in Kansas City. Buy one, get one free. They’re giving away a new Chevy Aveo when you pay full price for an SUV. Not a great way to make money. And GM doesn’t. It loses money on every car it sells…and makes it up by being in ‘finance’ – offering more credit to consumers.
Yesterday, too, Countrywide Financial Corp. stock dropped 12%. The company finances houses. It said the volume of refinance deals has fallen…and its margins have been squeezed. Of course, this is what happens to ‘finance’ companies when credit begins to contract. Not that we know for sure we’ve reached the end of the credit boom. But when it comes, you won’t find our names on lists of ‘finance’ company shareholders.
The worldwide property boom began in London in the mid-’90s. Here in London, it seems to be over. The Halifax House Price Index fell to its lowest level in nine years yesterday.
Houses go up in price when more people have more money to spend on them. But by many measures, American families have never had so little spending power. They owe more than ever before. Good-paying new jobs are scarce. During the boom years, new houses were put up on practically every empty plot of land and abandoned factory lot. What would make them go up – except more credit?
And the dollar itself? What would make it go up is exactly what America hasn’t got – a positive and improving trade balance. If U.S. industries were selling more things overseas, the foreigners would want dollars to buy them. Instead, it is the foreigners who sell…and it is the foreigners who end up with billions of U.S. dollars on their hands, and wonder what to do with them. For the present, they turn them into their central banks…who recycle them into U.S. assets. That they will not always do so is written in the stars and on the walls. When they will not do so is an open question…but the day surely approaches. And when it arrives would not be a good day to be holding too many dollars.
More news from New York City :
Eric Fry, reporting from Manhattan…
How exactly is the United States comparable to a ‘foolish virgin’? Apparently, the answers lie within a biblical parable.
Bill Bonner, back in London:
*** ‘Oh, I can’t stay,’ said a friend with whom we had a drink last night. ‘I’ve got to get back to my hotel room. The BBC has a great documentary on tonight. It shows how the neocons fabricated this war on terror…’
We went home too and turned on the ‘telly.’ What we discovered was that the BBC has gone on the attack against America’s neoconservatives. We were glad to see it; we despise the neoconservatives too…though not necessarily for the same reasons. All the media is biased – and generally biased in the neoconservatives’ direction. As we’ve pointed out many times, the neoconservatives are not conservatives at all, but the worst kind of liberals. They favor government programs of all kinds – especially those that that get people killed. They’ve even stirred up the Bible-thumpers to back an absurd and anti-Christian crusade against Islam. Neos talk about faith, freedom and democracy, but what they really seem to want is what all meddlers want…to tell other people what to do.
*** ‘Oh Dad, you won’t believe it.’
Maria, in her first year of theater school in London, described what goes on:
‘We all form a circle. And you’re supposed to go into the circle and say something personal. I mean, you’re supposed to make some sort of confession or something. It is amazing. It does seem to do something strange. I am in tears each time. Some of the kids tell us the most remarkable things…about how their parents didn’t like them…or how awful other people were to them. I really don’t have anything like that to say. I didn’t know what to say…so I just cried. And then I had to apologize for crying. I don’t know what makes me cry. But they seem to accept it. Others cry too. And I feel so sorry for them. But I really don’t want to say anything too personal…anything that I will regret later. Besides, I don’t really have any deep emotional scars. And I find it a little weird. The way people open up.
‘But I think we’re getting a little tired of it. It was interesting at first. But now, we’ve all made fools of ourselves. So yesterday…people went into the circle and said that they liked being at school…and that everything was basically all right. And then one boy went in, and he told us how upset he was that we were all so complacent and so…well, happy…I don’t know really what was bothering him. He seemed most bothered by the fact that the rest of us weren’t bothered.
‘And then a girl went into the circle to answer him. I mean, you hear the most amazing things. She said that if he had a problem, it was his own fault…
‘At the beginning of these sessions, we were told that we could say anything we wanted…that we should be open…and we could be as critical as we wanted. We were supposed to say exactly what we think. But that does not seem like a good idea to me. I mean…if we all did that, the world wouldn’t be fit to live in…Would it?’