Roger Lowenstein wrote the first in-depth biography of Buffett in 1995 called The Making of an American Capitalist, an outstanding account that spans from Buffett’s early days in his partnership to the prime years of Berkshire’s growth. Lowenstein also wrote a book I like even better – one of my all-time favorite business books: When Genius Failed, which was the story of the LTCM collapse. There are lots of great lessons for investors to take away from that story, and in my opinion, that book should be required reading for all money managers.
There are also great learning lessons to be gleaned from his latest book, America’s Bank: The Epic Struggle To Create the Federal Reserve.
I read this book earlier this year, and wanted to write a review, because it was one of the most interesting books I’ve read in awhile.
I love studying past financial crises. It has become somewhat of a hobby to read about what led to events such as the 2008 Financial Crisis, the Great Depression, the Panic of 1907, and even some of the crashes and panics of the late 19th century (some of which are hardly known today, but were nearly as severe as the Depression of the 1930’s).
Observing how people behave during the time leading up to the crisis, during the crisis, and then how they try to react after the crisis is very interesting. While we’ve learned different things from each crisis, I think it’s helpful as an investor to understand how people behave during times of panic. It’s also interesting to read first hand accounts of how fearful people were. It’s easy to look back now, after eight years of a bull market, to say that 2008 was a buying opportunity. It’s much different to say (and do) that during the midst of the panic. I remember Buffett being laughed at as stocks continued falling for six months after he wrote his “Buy America” op-ed in October of 2008. Now it seems that every pundit claims a) they knew that subprime was a bubble in 2006 and b) they were buying stocks in 2008-2009.
The panic and run on the banking system in 1907 that led to the establishment of “America’s Bank” had a lot in common with the most recent crisis. Each crisis has certain common denominators, and I think reading about history helps you gain a perspective that can help you make good decisions during panics that will inevitably occur in the future.
Human nature doesn’t change.
We know how people behave during panics, but it’s also interesting to observe what happens just after it passes. After every major crisis, people get upset, investors point fingers at others for their own misfortune, politicians look for scapegoats, and the government drags business leaders in front of special congressional committees to demand answers.
Usually, some type of regulatory reform is the result of these crises – and while finger pointing typically is a waste of time, sometimes the regulations are much needed and beneficial. This is debatable of course, and I won’t discuss the merits of specific regulatory policies, but I will say the same thing happens each time. 2008 gave us Dodd-Frank and the Consumer Financial Protection Bureau (CFPB). The Crash of 1929 and the Great Depression that followed gave us a slew of new regulations and legislation including Glass-Steagall, the FDIC, the SEC, and Social Security, among many others. And in the case that this book highlights, the Panic of 1907 (which is fascinating to study in its own right) was the crisis that led to banking reform, and the founding of the Federal Reserve.
A Banking System in Need of a Fix
There were four problems facing America’s banking system around the turn of the 20th century:
- There were 15,000 banks, each with their own reserves—collectively, the US banking system had a sizable amount of reserves, but each bank acted in its own best interest, and this meant the banks hoarded cash and stopped making loans when things got panicky, causing cash to evaporate from the system when it was most needed. The fragmented system was like a town without a fire department that instead gave each house a bucket of water in case a fire broke out. A more efficient use of reserves (whether it’s water or capital) would be to allow the flexibility of those reserves to flow freely to where they are needed most at any given time. Absent that flexibility, fires would be hard to put out.
- Fragmented currency—banks issued their own bank notes for currency, which were pieces of paper that were backed by that specific bank’s gold reserves. So each note had a different market value based on the credit strength of the bank that issued the note. This made doing business more complicated, as merchants were not always accepting of currency from banks across state lines that they weren’t familiar with.
- Inelastic currency backed by gold – this reduced flexibility in times of panic, reducing liquidity. It also kept a lid on the money supply, creating scarcity in tough times where currency was hoarded, which led to devastating bouts of deflation. Farmers, who typically took on debt to buy seeds and equipment in the spring, received less for their produce at harvest time, making the debt (which now had a higher real value) harder to manage. We are conditioned to think in terms of steady inflation, where the value of a dollar slowly erodes (and prices steadily rise for goods priced in those dollars), but incredibly, during a brutal 3 decade period from 1867 to 1897, prices for consumer goods fell by a whopping 50% (this makes Japan’s more recent battle with deflationary conditions look like a walk in the park).
- No Secondary Market – banks would make commercial loans (“bills of trade”) but kept them on their balance sheet, thus tying up that capital. If banks could have sold their loans to a central bank or into a vibrant secondary market (investors), they would have had more capital to make new loans, as opposed to an illiquid asset. All loans have to live somewhere, but a more fungible credit system allows for more loans to be originated, more capital investments to be made, and more commerce to be done.
The economy of the late 1800’s and very early 1900’s was largely divided between the country farmers on one side of the economy and the emerging industrial economy of the large cities on the other side. Each group had their own economic interests and motives. For example, one big issue was tariffs: the farmers didn’t like tariffs because their input costs (seeds, fuel, equipment, etc…) were mostly impacted by commodity prices, which could be propped up if imports declined and prices rose. Industrial companies in the cities, on the other hand, favored the tariffs because the products they sold like steel and machinery benefited from lower foreign competition. Farmers bought the products impacted by the tariffs; industrial producers sold them.
Fragmented Banking System
The banking system was also a class system of sorts, divided into three main classes:
- The country banks (the smallest banks in rural towns all over America)
- The city banks (the larger banks in larger metropolitan areas)
- The “reserve banks” (the select few large banks in major cities like New York, Chicago, and St. Louis)
Banks had to keep a certain amount of its capital as reserves to be deposited with other banks (for example, country banks were required to deposit 25% of its capital in city banks, which were required to deposit 25% of its capital with reserve banks).
The problem with the banking system was that anytime there was a credit problem with farmers, it quickly spread to cities and thus the economy as a whole. If farmers had a bad crop season, they pulled money from banks to cover losses and to pay the bills. This drained the capital of the country banks, who then were forced to pull reserves from the city banks. This in turn forced city banks to draw from the reserve banks, who in turn suffered their own liquidity problems.
Inefficient Equity Capital
So the US banking system at the turn of the 20th century collectively had a large amount of reserves. But because of the fragmented structure of the industry that lacked an omnipotent lender of last resort, the reserves were not used efficiently. Each bank first and foremost looked out for its own solvency. This is understandable, but it meant that reserves were hoarded when fear spiked. Some banks in the midwest held a whopping 60% of their deposits in cash. This ensured the stability of that particular bank, but that surplus (along with the surplus at other banks that hoarded cash in panics) in aggregate represented the wasted reserves of the banking system. Some banks were far over capitalized, while other banks became insolvent because panicked depositors pulled out their cash. On balance, the system had plenty of reserves that could have helped prevent many of these failures while also moderating the violent boom/bust swings, but without a central bank to provide liquidity when no one else would, the engine of the country’s banking system was not firing on all cylinders.
Also, because there was no central bank that could inject capital into the system when fear was soaking it up, the banking system suffered from routine and frequent panics—the classic “run on the banks”.
The Panic of 1907 was started by one of these runs, and it’s a fascinating story on its own. Basically, the failure of a single small bank led to a widespread crisis where everyone feared that their deposits weren’t safe. When people got scared, they went to the bank to get their money back. They hoarded cash. People weren’t the only ones to hoard cash. Banks did also. As described above, country banks pulled their cash that they held at city banks, and city banks were in turn forced to pull their cash from reserve banks in New York and Chicago to cover their own withdrawals.
This drained the reserves from the entire banking system, which seized up commerce. Since there was no central bank (“lender of last resort”), there was no way to neutralize this liquidity crisis, and businesses that needed access to cash to pay its bills and its employees had to close their doors. This led to a significant economic downturn that could have been mitigated (if not prevented) if one bank was there to provide cash when no one else would.
Lowenstein is a great story-teller, and this book is a great read, especially if you’re interested in financial crises and banking history.
Have a great week!
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.