Foreshadowing LTCM: The Crisis of 1763

Transcription

1 Foreshadowing LTCM: The Crisis of 1763 Isabel Schnabel University of Mannheim Hyun Song Shin London School of Economics

2 1763 Crisis

3 Background Prussia, emerging market Scarcity of capital Underdeveloped financial market Seven years war Amsterdam, Accumulated wealth Sophisticated financial system: Bank of Amsterdam, organized exchanges

4 Amsterdam Hamburg

5 How can credit be channeled from Amsterdam to Berlin? Commitment/enforcement Collateral Banks were merchant banks, rather than modern, deposit-funded banks

6 Bills of exchange and acceptance loans Drawer: Hamburg merchant banker Draw bill Accept bill Commission Drawee: Amsterdam merchant banker Bill Commission Beneficiary: Berlin merchant Bill Money Holder: Amsterdam investor

7 Bills of Exchange Bill is order to pay, rather than promise to pay. Enable string of interconnected obligations that mimic loan from Amsterdam to Berlin Commitment Collateral 7

8 Acceptance Loans (at maturity) Drawer: Hamburg merchant banker Money Drawee: Amsterdam merchant banker Money Contingent claim Bill Money Beneficiary: Berlin merchant Contingent claim Holder: Amsterdam investor

9 Negotiability of Bills Endorsement: Selling within credit insurance wrapper Holder in due course : separation of bill from underlying transaction Economic rationale: payoffs insensitive across states Prevent passing of bad bills Constant payoffs across states, bills as inside money 9

10 Negotiability of bills Expand the universe of feasible contracts by binding in diverse interested parties Emergence of bill-like instruments (Veksels) in 1990s Russia but dark side web of obligations increases externalities across interested parties 10

11 Balance Sheets Hamburg merchant banker (drawer) A L + Claim on + Liability towards Berlin Amsterdam merchant banker + Contingent liability towards bill holder Berlin merchant (beneficiary) A L + Bill + Liability towards Bill Hamburg banker + Cash + Contingent liability towards bill holder Amsterdam merchant banker (drawee) A L + Acceptance + Acceptance loan to liability Hamburg towards bill banker holder Amsterdam investor A L + Bill Cash

12 Seven Years War ( ) Two separate wars War conjuncture in manufacturing and trade Expansion of credit through bills of exchange Speculation in war goods and exotic goods

13 Rise of de Neufville Brothers [succeeded against their competitors] by extending loans in a particularly broad-minded way... Again and again they maintained their pre-dominance by inventing methods that were at first considered revolutionary, but soon imitated by other merchants 13

14 Stylized Facts Sequence of failures Many failed banks reopened their doors Decline of prices Increased correlations in returns 14

15 29. Jul 31. Jul 2. Aug 4. Aug 6. Aug 8. Aug 10. Aug 12. Aug 14. Aug 16. Aug 18. Aug 20. Aug 22. Aug 24. Aug 26. Aug 28. Aug Sequences of failures 30. Aug 1. Sep Hamburg Amsterdam 15

16 Jan-60 Apr-60 Jul-60 Oct-60 Jan-61 Apr-61 Jul-61 Oct-61 Jan-62 Apr-62 Jul-62 Oct-62 Jan-63 Apr-63 Jul-63 Oct-63 Jan-64 Apr-64 Jul-64 Oct-64 Sugar Prices Mar Sugar Amsterdam Sugar Hamburg 16

17 Jan-60 Apr-60 Jul-60 Oct-60 Jan-61 Apr-61 Jul-61 Oct-61 Jan-62 Apr-62 Jul-62 Oct-62 Jan-63 Apr-63 Jul-63 Oct-63 Jan-64 Apr-64 Jul-64 Oct-64 Berlin Grain Price May Aug-63 Grain Berlin Grain Berlin "cleaned" 17

18 Chronology February 1763: Peace of Hubertusburg Price declines in exotic and war goods before conclusion of peace Evidence of distressed selling in summer 1763 Asset side contagion

19 Failures 30 July 1763: de Neufville fails Private attempts to rescue unsuccessful Accord 10% August/Sept: full-blown crisis Waves of bank failures in Amsterdam, Hamburg, Berlin, Stockholm Large number of failures Many reopened their doors

20 Counterparty risk correlated with credit risk (aggregate risk) Asset side contagion (liquidity risk)

21 Stylized Model After BM s liquidation of project, but before repayment AMB HMB BM Sugar Grain L A L H L B Cash 0 0 F Debt -F 0 -F

22 Fundamental values (independent) Sugar: θ Grain: x But finite elasticity of residual demand p = xe λ L x 22

23 AMB has an additional loan (F) to fund sugar position Just prior to maturity: HMB, BM pay their debts as scheduled But AMB uses these funds to repay sugar debt

24 Distress Sales AMB sells sugar to redeem the bill If θ < F, AMB forced to sell grain (L): Resulting price of grain: = S x x L λ λ log 1 < = F F x F x p θ θ λ θ )if ( if

25 Correlation of Prices p x λ F θ

26 Cascading of Failures AMB is solvent IFF F θ If AMB is insolvent, HMB becomes liable HMB is solvent IFF F θ BM is solvent IFF F θ 1 e x λ x λl A H 1 e x λ ( L A + L ) λ A H B 1 e λ ( L + L + L ) λ

27 Solvency boundaries x Solvency boundary for AMB Solvency boundary for HMB Solvency boundary for BM F θ

28 Scatter Plot of Prices I Barley and Wheat, Hamburg May 64 Wheat (H Oct 63 Nov Sept Barley (H) 28

29 Scatter Plot of Prices II Sugar and Wheat, Hamburg Dec Wheat (H) Oct 63 Oct 62 Nov 62 July Sept Sugar (H) 29

30 Peculiarities/General Lessons Some peculiarities Transferability of bills, peculiar to 18 th C. Difficulty of work-outs Open-endedness of commitment (lack of finality ) Cares about subsequent owners, as well as previous owners, but this is beyond one s control

31 Some Universal Themes Excessive leverage Aggregate risk: limits to hedging and of guarantees Asset-side contagion: very different from simple B/S domino effect There is such a thing as systemic risk 31