"Economic slumps would be associated with financial crises by means of the loss of discipline. Through the boom, banks would overreach and extend loans to riskier clients. The buoyancy of economic booms causes riskier creditors to approach banks for loans - a problem of adverse selection. Some banks succumb to the temptation to make loans to these creditors, perhaps in the belief that luck or a bank clearing house will see them through - this is a problem of moral hazard. Adverse selection and moral hazard ultimately earn their just reward. Decline in asset values causes a decline in the collateral for loans; therefore, banks tighten their lending practices. As the slump worsens, the banks with the riskiest clients turn illiquid and then insolvent."Sound familiar? I was struck by how well this seemed to describe the run up to and unraveling from the sub-prime mortgage situation. What made it doubly impressive was that it was in the closing chapter of the book, The Panic of 1907: Lessons Learned from the Market's Perfect Storm by Robert F. Bruner and Sean D. Carr. Later in the same section, Bruner and Carr cite research that indicates
"financial crises will occur where 'financial markets are opaque, when regulation and supervision are poor, and when lending is based on collateral rather than expected cash flow...' "The parallels between the Panic of 1907 and the credit crunch of 2007 are certainly there if one is looking for them. If one digs into the sub-prime market as it existed in the period leading up to August 2007, one could easily make the case that market was opaque (due to the innovative nature of some of the products), that regulation and supervision were poor (in part because no one was specifically charged with oversight of the mortgage origination industry), and lending was based on collateral (expected housing prices in what had been, up to that point, a rising market) rather than expected cash flow (the income of the buyers).
And while this book did not cover some aspects of the Panic that I had hoped would be covered, it was interesting and a quick read. The structure of short chapters, focused on actual people (J. P. Morgan plays a huge role in the tale), makes it fast-moving and personal instead of a treatise on macroeconomics and finance.
For those of you who teach American History or economics, or who are interested in the monetary history of the United States (the Panic of 1907 led directly to the formation of the Federal Reserve System), you could do worse than pack this in your travel bag as you head out for summer break.
I look forward to other views and comments.