From an abundance of easy credit invariably followed all manner of financial abuses, fraud, and speculation. One writer later described the abuses during this time as “the worst kind of commercial gambling,” Borough Bank of Liverpool was among “the most notorious of the reckless re-discounters” (rediscounting was the selling of loans to another lender). The bank rediscounted bills having “no negotiable validity” beyond its own endorsement and without any attempt to evaluate their quality.47 These practices created a mountain of debt with almost no solid financial ground beneath it.
London discounters found it difficult to turn away potential customers. Financial journalist David M. Evans later described London’s financial atmosphere: “In the lenders there was utter recklessness in making advances; in the borrowers unparalleled avidity in profiting by the occasion; and thus an unwieldy edifice of borrowed capital was erected ready to topple down on the first shock given to that confidence which was, in fact, its sole foundation.”48 That shock would arrive soon enough. Much of Britain’s lending was in short-term “call loans”: in the event of a bank run, that bank would have to call (demand immediate repayment) loans, the immediate calling in of loans would ripple quickly through the economy.49
In March 1857, railroad cost overruns and overcapacity in the United States had accumulated to the extent that U.S. railroads were teetering financially.50 Then two events further destabilized them. The 1850 Swamp Land Act had provided states the opportunity to reclaim any land deemed swampland that had been granted by the federal government to railroads. An 1857 amendment strengthened the states’ claims. Historian Scott Reynolds Nelson sees the 1857 amendment as a direct threat, not only to railroad expansion but to the credit standing of bonds railroads had issued that were backed by property.51 Note that Abraham Lincoln’s burgeoning law practice included the defense of railroads in Swamp Act matters.52 Second, the Dred Scott court decision deepened America’s slave-state quagmire and called into question westward economic expansion.
As an aside, Nelson reports that it was railroad interests that helped finance the “free soil” side of the conflict known as “Bloody Kansas,” that stemmed from 1854’s momentous Kansas-Nebraska Act. Bostonians John Murray Forbes and Nathaniel Thayer had investments in the area threatened by the Swamp Act, which gave them the incentive to defend federal over state rights and was at least part of their motive to come up with the term “free soil,” support abolitionist activity, and form the New England Emigrant Aid Society that would help send New Englanders to Kansas. They were also leaders within the new Republican Party, and it would be their preferred candidate and railroad industry lawyer Abraham Lincoln who would get their party’s presidential nomination in 1860.53
One historian noted that “by June 1857, the amount of indebtedness incurred by railways, manufactures, and promoters of all kinds to the banks of the country and to each other had . . . overreached the saturation point.” Catastrophe was imminent.54
Farmers now came under duress too. Wheat prices peaked in 1855 and collapsed after the Crimean War ended in February 1856, then kept falling through 1858.55
Back in New York, on August 24, 1857, the Ohio Life Insurance and Trust Company failed. This came as “a clap of thunder in a clear sky” and was the event that ignited the 1857 Panic.56 Despite its name, Ohio Life never dealt in insurance, nor did it issue its own currency in the form of banknotes. It had a home office in Cincinnati, but most of its large-scale financial and investment activity took place in its large branch in New York City, which served as a vital link between flush eastern investors and the rapidly expanding but cash-poor economy of western states, such as Ohio, Indiana, Illinois, Wisconsin, and Michigan.57
Ohio Life’s investment portfolio was weighted heavily toward securities issued by western railroads, which had generally performed poorly since 1854. It needed to find a way to overcome this problem, so it began making large amounts of call loans to major Ohio railroad companies. Of the roughly $1 million worth of railroad bonds in Ohio Life’s portfolio at the time of its failure, some $800,000 in bonds were issued by the three railroads with which company management had personal ties. Credit problems with those bonds helped bring about Ohio Life’s failure.58
After Ohio Life failed, railroad shares plummeted. “Accompanying the unwelcome reports of falling stock prices were the melancholy announcements of bankrupt companies,” wrote James L. Huston.59 Michael A. Ross writes that “farm prices crashed,” and in Keokuk, Iowa, “lots that brought $1,000 before the crash now could not be sold for $10.” The chaos unleashed crime on the streets.60
The La Crosse & Milwaukee and Milwaukee & Mississippi Railroads failed later in the summer, the effects reverberating through the financial networks, starting with New York banks that had invested in them. The impact then expanded outward until it reached those unfortunate Wisconsin farmers who had taken out loans collateralized by their farms to buy La Crosse stock at the urging of its agents, and now suddenly found themselves with neither a farm, because it would now be repossessed by the lender, nor railroad stock, since it was worth no more than a few pennies on the dollar.61
Recent research has demonstrated that a majority of securitized railroad farm mortgages had loan-to-value ratios well in excess of accepted norms and thus were especially risky.62 It was ultimately Ohio Life’s overexposure to railroad investments rather than individual malfeasance that proved to be its undoing.63
The repercussions of Ohio Life’s collapse were felt far and wide. To meet escalating withdrawals, by mid-September the New York bankers reduced their outstanding loans by roughly $10 million by demanding early payment from other customers, thereby adding to the mounting financial turmoil. When the Clearing House Association decided in mid-September to conduct its daily settlements in specie only, it forced the smaller and less powerful New York banks to call in loans from their own brokers and dealers, which in turn forced many of them into failure and insolvency.64
To add to the distress, on September 18, the steamship Central America sank en route to New York, with 425 passengers and almost $2 million worth of California gold that might have provided a much-needed boost.65 On September 25, the presidents of all Philadelphia’s banks met and unanimously agreed to suspend payment. With the suspension in Philadelphia, one historian later wrote, “all hope disappeared.” Failures and suspensions rippled across the country.66
By late October the New York banks alone had reduced their loans a total of 20 percent since early August and announced they would suspend specie payment indefinitely.67 Between five thousand and six thousand individual American businesses failed during 1857, with total liabilities in the neighborhood of $280 million to $290 million.68 A newspaper moralized, “If our own word is to be taken for our national character in October 1857, we are the most blundering, headlong, silly and incompetent generation of speculators, not to say swindlers, that ever trifled with magnificent materials, and threw away golden opportunities.”69
This was to unfold as our first global financial crisis, however, and not just a calamity for guileless Wisconsin farmers, because banks and investors from overseas had invested in U.S. railroads as well. British firms had been extending extraordinary amounts of credit to the United States for years. This included credit for highly speculative ventures, such as the extension of railroads beyond the frontier and into the mostly unsettled Great Plains.70 On September 7, the news of the Ohio Life failure reached Liverpool and quickly ricocheted through the streets of London, accompanied by news that discount rates in New York had climbed as high as 12 percent.71 It became clear that Britain’s extensive financial exposure to the United States meant that a crisis at home was inevitable. On October 27, these fears seemed to be confirmed when the Liverpool Borough Bank suspended payment.72 The iron industry, from the United States to Wales, Scotland, and England, all but shut down owing to a lack of demand largely caused by an abrupt halt to railroad construction.73
Table 5.4. France Crisis Matrix:
1850s
aFor 1857.
*Limited data points.
In the five years leading up to 1857, France’s wheat production doubled, and railroad expenditures increased tenfold, while miles built more than doubled before plummeting. Crédit Mobilier loans increased fifteenfold.
In France, the speculative rail story was the same, albeit less extreme. Crédit Mobilier and Crédit Foncier had been established in France during the early 1850s, announcing a new era in lending.74 Crédit Mobilier’s directors borrowed and speculated on a grand scale, and for a while the company paid remarkable dividends on paid-up capital—47 percent in 1855 and 24 percent the following year.75 But by 1857, it was holding large amounts of dubious paper and had incurred debt on speculative ventures that weren’t performing well. In the understated words of one contemporary British critic, the firm was forced to admit that “these Railways, these Gas Companies and Omnibus Companies, these lines of Postal Communication, these Steam Packets, these obligations in Switzerland, Spain, Austria, and Russia—had not turned out quite so successful as was expected.”76
Of all the European cities and nations affected by the 1857 crisis, Hamburg—one of the key ports of northern Europe77—probably suffered the most. The liabilities of Hamburg merchants doubled during the four years before the crisis, from 1853 to 1857.78 Between November 1857 and May 1858 more than two hundred Hamburg businesses suspended payment—a quarter of which were later declared bankrupt.79
In a postmortem of its crisis, New York’s Mercantile Agency found fault on both sides of the transatlantic trade, especially pointing to American mercantile firms that imported foreign goods far in excess of demand simply because “European letters of credit have been so easily obtained.”80 Finally, the report cited the cycle of indebtedness that seemed to be developing as a normal feature of the financial landscape, in which retailers were constantly indebted to jobbers, who were indebted to wholesalers, who always owed money to importers, and so on, through the whole chain of commerce.81
In America, the crisis brought financial pain that contributed to the dark national mood that would soon lead to its Civil War.82
“The distress . . . was caused by an enemy more formidable than hostile armies; by a pestilence more deadly than fever or plague. I believe that it was caused by a mountain load of DEBT,” concluded the American statesman Edward Everett, the multihyphenate statesman (senator, congressman, governor, Harvard University president), writing in The Mount Vernon Papers. The Albany Argus editorialized, “The dangerous facility of debt has tempted us into speculations beyond our depth.”83
In London, a New York Daily Tribune journalist watched the economic carnage toppling markets and wrote, “It happens that, among all modern industrial nations, people are caught, as it were, by a periodical fit of parting with their property upon the most transparent delusions. . . . What are the social circumstances reproducing, almost regularly, these seasons of general self-delusion, of over-speculation and fictitious credit? If they were once traced out, we should arrive at a very plain alternative. Either they may be controlled by society, or they are inherent in the present system of production.” Two years before, he had observed that crises came from the “industrial system which leads to over-production.”84
His name was Karl Marx.
The Crisis of 1866
The 1860s saw the last great railroad expansion period in the United Kingdom, with miles of new railroad track laid all but doubling between 1860 and 1863. Trouble once again followed along the tracks of railroads, in the financial crisis of 1866. In May of that year, Overend, Gurney & Company, the oldest and most successful discount (lending) house in London, was forced to close its doors for good, which triggered the crisis.85
Overend had transformed itself into a newly authorized86 type of company, the limited liability company, which as the title suggests, limited the liability of shareholders to the amount of their investment. This was a key new protection for stock investors.87 Overend issued new company shares in this new form in the fall of 1865, and by October they had risen 100 percent. It had grown rapidly, in part through railway loans.88 Nonetheless, to anyone paying attention, the Bank of England’s actions during that same period indicated that it foresaw trouble: it increased its gold reserves, while also raising the discount rate from 3 percent to 7 percent, with three percentage points added within one nine-day span.89
Stories had been circulating since 1860 that some discounting companies had been recklessly extending credit by discounting worthless bills. Bankers’ Magazine had noted that some “minor discount establishments” had “adventured out of their depth in paper they should not have touched.”90 Concerns about the creditworthiness, stability, and profitability of the new limited liability firms were revived in 1865. Discount houses were suspected of loaning money at high interest rates to other limited liability companies and taking low-quality securities as collateral. The worst offenders may have been a type of lender known as a finance company, since finance companies’ whole business model was “to deal in securities which were beyond the legitimate scope of the banks and the discount market.”91
Table 5.5. U.K. Crisis Matrix: 1860s
*Limited data points.
From 1861 to 1866, U.K. railroad miles grew briskly, and limited commercial bill data suggest private debt grew briskly as well.
The first cracks began to appear in January 1866, with the collapse of a smaller firm named the Joint Stock Discount Company. Then rumors began to spread that partners of Overend in its former structure were hurriedly cashing in their shares and that current partners were selling off their personal estates to try to raise money.92 A few weeks later, public disclosures during the liquidation of Joint Stock Discount revealed a “rottenness” pervading its financials as well as those of its partners. Nervous individual account holders began to withdraw their money. The apprehension spread. Within two months, deposits at Overend fell by roughly £2.5 million, with another £2 million withdrawn by May.93
In April, Spanish merchant firm Pinto, Perez & Company failed, and everyone knew that a substantial amount of its liabilities was owed to Overend. The revelation a few weeks later that the company’s officials were guilty of serious fraud hurt the situation. On May 9, a court ruled that Overend did not have the legal power to collect substantial debts owed to it by the Mid-Wales Railway.94 “Bears,” those pessimistic about markets at the London Stock Exchange, soon picked up the scent of failure and began shorting Overend shares, beating down the already sagging price. Most everyone knew Overend’s end was near.95
It finally arrived on Thursday, May 10, with a short notice posted on the main entrance to Overend: severe runs had compelled them to stop payment.96 Bank of England governor Henry Holland sent a small committee to investigate Overend’s books, and committee member Robert Bevan reported that “the firm was so rotten” it effectively sealed its own fate.97 The company had liabilities over £5 million, though it was difficult to be certain since its books were in such disarray.98
Holland raised the Bank of England’s rate to 10 percent.99 Three London banks were among the casualties. Scores of bill brokers, discount houses, and finance companies that had thrived in the shadows of the legitimate banking world were similarly wiped out. By August 10, 1866, more than 180 companies had entered bankruptcy proceedings—casualties from the Overend collapse.100
Runs on banks continued and rumors swirled, and Holland and the Bank of England acted vigorously to provide short-term funding to banks deemed sound enough for support. Holland sent a letter to Chancellor of the Exchequer William Gladstone, assuring him that things were essentially under control on “Threadneedle Street”—the Bank of England. He explained that the bank had advanced over £4 million to “Bankers, Bill Brokers and Merchants in London—an unprecedented sum to lend in one day and which, therefore, we suppose would be sufficient to meet all their requirements.” He told Gladstone, “We have not refused any legitimate application for assistance.�
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Despite the lingering fallout, the Bank of England was able to maintain gold reserves at a relatively constant level throughout the crisis.102 This was due partly to the 10 percent bank rate, of course, but also to shipments of gold arriving regularly from Australian mines. The reserves were more than enough to cover any drains, and the bank never did need to invoke an indemnity guarantee.103
The 1866 British crisis was seen by many as a validation of Economist editor Walter Bagehot’s newly articulated rules for what he termed the “Lender of Last Resort,” a duty he expected of the Bank of England: lend freely but only to those institutions solid enough to weather the crisis, and only then at an interest rate that could be considered punitive.104
After a doubling of railroad miles built, France saw economic turmoil and a spate of failures in the same year, though not at the magnitude of Britain’s crisis. Crédit Mobilier and Société Immobilière reached the brink of failure and had to seek assistance from the Bank of France, though only limited assistance was forthcoming. Mobilier had to be dissolved, and Société de Crédit Mobilier Français formed in its place.105
Conventional wisdom among many economists holds that after 1866, the United Kingdom experienced fewer financial crises because of the good stewardship of the Bank of England, especially in its “lender of last resort” duties. This stewardship contrasted dramatically, they argue, with the absence of any such central bank in the United States during the period.106
Yet the difference in number of financial crises is not primarily attributable to the presence or absence of a central bank since they do not exercise their “lender of last resort” powers until after the lending misbehavior has occurred. Thus they do not prevent the crisis by using these powers but instead ameliorate the resulting damage. The smaller number of crises in Britain after 1866 is attributable to the basic fact that by that year, the majority of Britain’s railroad track had already been laid. Hence, the speculative outbursts of construction sufficient to provoke a crisis had largely ended. At that same moment in the United States, only a small portion of the track that would ultimately be built had yet been laid, and there were many massive railroad construction bursts yet to come. In England, new railroad mileage built between 1870 and 1900 was less than that built before 1870. In contrast, the United States built triple the miles between 1870 and 1900 than it did before that time—and it did so in these enormous bursts.
A Brief History of Doom Page 16