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Jeff Saut: Modern Echoes of The Bankers' Panic


...the seeds for the 1907 panic were likely "planted" in 1906 with the government's anti-trust intervention.

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

Early in the 20th century, most banks were prohibited from forming and administering trust accounts.

Therefore, trust companies were created to deal or invest in businesses, stocks and bonds, commodities, etc. By definition, a trust account is an account established under a trust agreement containing funds administered by a trustee for the benefit of another person or persons (if that sounds a lot like our modern day hedge fund business, it should).

Initially, these early century trusts were conservative in nature, but over time they morphed into highly speculative vehicles using leverage (read: margin accounts) to become heavily invested in the various markets. Unsurprisingly, as their popularity and profitability grew, trust companies became intertwined with the banks via bank board members, directors, wealthy clients, etc. who could indeed own trust companies. Consequently, by 1906 the web of interconnectivity between large or rich market speculators, trust companies, and banks had become almost invisible.

The increasingly speculative investment binge being driven by the burgeoning "trusts," and amplified further by the "new era" mindset ushered in with the Wright Brothers' historic flight in 1903, lifted the "Industrials" (now called the D-J Industrials) from their low of 42 in 1903 to their high of 97 in the fall of 1906. Similarly, the "Rails" (now called the D-J Transports), which was the major index back then, rose from its 1903 low of 88 to a high of 138 over the same time frame. And then it happened: the U.S. government began anti-trust suits against Standard Oil of New Jersey and American Tobacco.

While these are clearly not the investment "trusts" to which I have been referring, the government's intervention and regulation seemed to "prick" the market's speculative bubble as stocks traded sideways into year-end and then started to decline in January 1907. The decline accelerated over the course of the year and turned into a full-blown panic in the fall of 1907.

At the center of the panic was Montana's "copper king," F. Augustus Heinze, who had sold most of his mining shares for the tidy sum of $12 mln in 1906, moved to New York City, bought a bank, and had become involved in banking and trusts.

It was already a sluggish time on the "Street of Dreams" with the economy muddling, credit contracting, stocks stalled, new bond issuance almost non-existent, and everyone reluctant to loan money. Amid that environment Mr. Heinze attempted to "corner" (read: gain control) the shares of United Copper. His attempt failed and with United Copper's share price down 76% in two days the headlines read, "Copper Breaks Heinze." Since Heinze controlled a chain of banks, it was rumored those banks were involved in the attempt, causing frightened depositors to withdraw their funds. Those fears were contagious, since Heinze's failed scheme revealed a web of interlocking directorships between banks, brokerage houses, and trust companies, and the "run" on New York City's banks and trusts grew.

With the stock market in full retreat, "margin calls" proliferated and the "dash for cash" spread across the nation, sending "call money" interest rates from 6% to over 100%. Because the banks were in direct competition with the trust companies, the bankers had no vested interest in attempting to bail-out the "trust" and when Knickerbocker Trust Company failed the financial fires roared out of control. While not the worst financial crisis the U.S. had seen, it was one of the most important, for it led to the creation of the Federal Reserve System in 1913.

I revisit the "Bankers' Panic" this morning not because I am predicting similar events, but because, even after 100 years, the parallels are interesting. As stated, I think the seeds for the 1907 panic were "planted" in 1906 with the government's anti-trust intervention. Coincidentally, I have often repeated that my biggest worry currently is the U.S. government's increasing movement towards protectionism, intervention, and regulation.

That movement can be seen in the ill-advised political-pandering toward protectionism, as well as the potential intervention and regulation of the hedge fund community. Granted, one could substitute the words "hedge funds" for their 1907 counterpart "trust companies" and draw some interesting parallels, but with the U.S.' banking complex in good shape the comparisons stop there.

Nevertheless, credit is tightening, the economy appears to be slowing, stocks are stalling, and the spider web of finance between banks, hedge funds, and private equity is legion. Moreover, there appears to be a seizure in the financing mechanism often referred to in these missives as the "Tinkers to Evers to Chance" sequence. In this case, however, I am not referring to the fabled double-play baseball artists of an era gone by, but Tinkers (being the investors needing the money) to Evers (the banks creating the loans) to Chance (the investors buying those loans). Recently, however, this financing sequence has been called into question, causing one savvy seer to exclaim, "What happened to Chance?" What happened to Chance indeed, for it appears that Chance has walked off the field and is waiting to see if the price decline in the "loans" is contained or if it is spreading.

Plainly, the "loans" in question are of the subprime flavor, which as measured by certain indexes have lost roughly 70% of their value over the past few quarters. For leveraged investors attempting to eke out incremental returns in the subprime mortgage complex the result has been a disaster. Last week the subprime contagion spread abroad as a number of investment funds "froze" withdrawals of investors' money.

The situation is concerning because since the beginning of the year my understanding is that only $200 bln worth of such adjustable rate mortgages have repriced their interest rates at higher levels. It is forecast that over the same seven months in 2008 an anticipated $600 bln will reprice. Consequently, it is difficult to envision just how "contained" the situation can be.

Certainly the bond market thinks there is a problem, given the decline in the 10-year T'note's yield since mid-June. Alarmingly, those lower interest rates have done little to stabilize stocks with a top-to-bottom price decline for the Russell 2000 of 12.6%, an 8.2% S&P 500 slide, and a 6.7% Dow dip. All three of those indices peaked on July 19, making last Friday the 16th trading session off of the "top." Despite investors' panic, I have argued that on a short-term basis participants should take heart, for my work suggests that these selling-stampedes tend to run only 17–25 sessions before exhausting themselves on the downside.

While a few such skeins have extended for 25–30 sessions, anything over 30 sessions is rare. Therefore, this week shapes up as a pretty key week.

Consistent with these thoughts, I think the averages will make a trading bottom shortly. As to whether the Fed cuts interest rates to precipitate that bottom depends on if the indices are involved in a mini-crash or not.

Failing a "crashette", I seriously doubt the Fed will cut rates. Rather, I believe the markets will merely exhaust themselves on the downside. Of more importance is if the subsequent "throwback rally" sustains itself above S&P "1500." My fears of sustainability center on the ferocity of the three-week heart-attack decline combined with the unusual occurrence of three 90% downside-days where points lost, and advance/decline figures recorded showed over 90% negative daily readings since the July 19 highs.

In fact, if the downside day of June 7 is included, there have been four downside days without an intervening 90% upside day. This is not an unimportant point, for as the Lowry's service notes, "Multiple 90% Down Days serves as an important reminder of a critical change in investor psychology."

The call for this week: Ralph Waldo Emerson once noted, "Most men gamble with her (Fortune) and gain all, and lose all, as her wheel rolls." Regrettably, Frederick Heinze was not satisfied with his $12 mln fortune prior to the "Panic of 1907" and lost it all.

I, however, am not so greedy! My portfolios are "up" nicely this year with the Analysts' Best Picks List better by 24.5% and the Strong Buy List gaining 9.9%, while the Focus List has improved by 10.0%. I believe that risk appetites are now falling, implying risky assets are likely going to underperform going forward. This should give retail investors a huge "leg up" on institutional investors since they can re-jigger their portfolios more quickly. I continue to invest accordingly.
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