The Bear’s Lair: Financiers have learned nothing in 250 years

We are coming up next year on the quarter-millenary of the Ayr Bank crash of 1772 and last year we had the 300th anniversary of the 1720 South Sea Bubble. When looking at these 18th Century disasters I am reminded again and again that the financiers’ failures were very similar to those of 2007-08, or those that are being perpetrated now. Given the advances of human civilization since the 18th Century, financiers’ inability to learn from history, find better techniques or maintain competent risk management is truly remarkable.

The Ayr Bank crash had a simple cause: excessive trading in East India Company put options. Sound familiar? Ayr Bank, founded only in 1769, had by 1772 grown to one of the largest banks in Scotland, with a balance sheet of £1.2 million, which does not sound much but was about 10% of Scotland’s GDP, and two thirds of Scotland’s currency stock. It lent money to favored customers without much in the way of credit checks and funded itself through short-term bills of exchange sold through the London market, using a London broker Neale, James, Fordyce and Down. Being so new, the bank had not accumulated much in the way of consumer deposits. Buyers of the bills of exchange on the London market felt secure; after all, the bank had £150,000 of capital (mostly not paid in) and no fewer than 131 partners, several of whom were Scottish Dukes. With so much Scottish wealth behind it, committed through unlimited liability to bailing out the bank’s liabilities, nothing could go wrong, it was thought.

Alas, the optimism of human financial dealings was as misguided in 1772 as it is today. Alexander Fordyce, the managing partner of the broker, had become convinced that the East India Company was doomed to fail. That company had taken on new responsibilities in 1765, through Robert Clive’s acquisition from the Moghul ruler of the “firman” giving it responsibility for the lives of 20 million Bengalis, and the ability to collect taxes from them. Alas, being a commercial operation with limited staffing, it had proved lamentably incompetent at managing its new empire. Tragically, in 1770 Bengal suffered one of the worst Indian famines in history, with millions of people dying. The EIC consequently made large losses, since it was unable to collect taxes from a starving populace, and was coming up on a re-chartering in 1773, due every 20 years.

To Fordyce, it was clear that the EIC was doomed. Of course, we with more experience of government bailouts know that it was nothing of the sort. The EIC was bailed out by Lord North’s government, allowed another 20 years’ charter, and its Indian responsibilities were brought under highly competent management in the form of the great Warren Hastings. Unfortunately, a side-effect of the EIC bailout was that it was allowed to supply surplus tea to the American colonies, another operation it bungled irretrievably, resulting in the Boston Tea Party.

Fordyce being wrong, his short position and put options on the EIC brought him liabilities he could not pay; he escaped debtors’ prison by absconding to the Continent. However, his brokerage declared bankruptcy, and that resulted in the insolvency of the Ayr Bank.

The story has a happy ending – sort of. Everybody got their money back, eventually. However, it took 55 years, the last liabilities being settled in 1827. Even though the Ayr Bank partners were liable for its debts, the sum of those debts was so great that most of its 131 partners were themselves ruined when reimbursement was demanded of them. Eventually, the inexorable Scottish legal process, focusing on the fewer and fewer partners who could reimburse not only their own share of the liabilities, but those of the insolvent partners also, came to focus on the last few solvent partners, the Scottish Dukes, and by 1827 Ayr’s gigantic liabilities were finally paid off.

The lesson of all this is: if you are a Scottish Duke, don’t invest in a fly-by-night bank with unlimited liability. It may take half a century, but the lawyers will get you in the end.

Returning regretfully from the 18th Century to the 21st, we can see that several of the mistakes made in the Ayr Bank collapse are being repeated in our time. Large institutions cannot believe that their analysis of the failings of a (to them) obviously doomed institution can possibly be wrong. Hence several hedge funds’ disastrous losses in GameStop (NYSE:GME) – the company’s support from the retail investor community was such that it could raise enormous amounts of new capital and thereby save itself. Sheer incompetence is not a universal recipe for failure, in a world where dei-ex-machina swarm all over the place. With political connections (the East India Company) or appeal to lockdown-crazed bros (GameStop) even the worst run company has a chance at redemption. Betting against such redemption may or may not be profitable on average, but it certainly should not be done to the extent of endangering the franchise, as with the GameStop hedgies or Neale, James, Fordyce and Down.

Another error of the 18th Century repeated in the 21st is that of assuming that if several Dukes are behind an institution, it must be OK. Today, we do not really have Dukes – a pity, in many ways. However, there are many institutions that perform the functional equivalent of Dukes in guaranteeing the apparent solidity of institutions that are in fact unsound. One is the government itself, that universal underwriter of folly. 2008 appeared to show that if governments offered even an implicit guarantee of something, or regulated something that was large enough, its creditors could rely on a bailout.

However, the bailouts of 2008 relied on the monetary policy of 2008, and that in turn relied on the strange non-appearance of inflation for over a decade despite massive expansion of the money supply. That holiday from history may now be ending, in which case governments will once again not be able to print money ad infinitum and their bailouts may not be so reliable.

Even beyond bailouts however, investors have taken to assuming that if a company is large enough and well enough established, it will either be there forever, or will be bailed out if it gets in trouble. However, the explosion in management stock buybacks and overpriced acquisitions in the past decade has made that proposition very unsound. Companies like Boeing (NYSE:BA), McDonalds (NYSE:MCD) or AT&T Inc. (NYSE:T) have no stockholders’ equity at all, either through excessive buybacks, gigantic foolish acquisitions or both. When the economic tide of the business cycle goes out, some or all of these companies will be unable to get finance, like Ayr Bank in 1772 and will go bust, as did Ayr Bank. Since their shares do not carry unlimited liability, there will be no Duke shareholders to bail them out. Ayr Bank, in that respect, was a much sounder operation, having both capital and wealthy shareholders with unlimited liability.

Finally, there is the question of modern banks’ risk management. 18th Century banks did not have risk management in the modern sense, but how many modern risk management systems would catch the risk of all the bank’s obligations being issued through one broker, so that the failure of that broker would result in the inability to roll them over? The risk that sank Ayr Bank was a highly sophisticated second-order one that many modern risk management systems would have missed. Ayr Bank would never have done anything as foolish as invest in crypto-currencies, for example.

Similarly, the valuation work carried out by Archibald Hutcheson MP (1659-1740) at the time of the South Sea Bubble and published in several pamphlets, showed the folly of that scheme and the overvaluation of South Sea Company shares, both considerably more clearly than equivalent work at the time of the dot-com bubble, the housing finance bubble or any of today’s ubiquitous bubbles. As for cryptos, Hutcheson would have pointed out the folly of those, too; they are no sillier than modern state-issued fiat currencies, but they have a much greater regulatory risk, because state central banks dislike the competition. Just as the South Sea Company’s slave trading Asiento was not worth what the markets believed it to be, because the Spanish colonial governments would not submit meekly to British competition, so too the anonymity of cryptos and their blockchain technology are not government-proof, nor even recession-proof.

Finance is an odd business. It devises new tricks all the time, but never learns from its mistakes, and never devises a foolproof system of managing risks. And today, we have nobody as reliably solvent as a Scottish Duke to bail out our losses.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)