Is Failure Not an Option?

Yesterday, I was reading "The Great Crash," by John Kenneth Galbraith, and I was struck that in 1929 and in the present crash the crisis was exacerbated by a seemingly arbitrary decision to let a large financial institution collapse.

Bank of United States was founded on the Lower East Side of Manhattan in 1913 (in a building that now houses Winda Restaurant Supplies and White Slab Palace). By 1930 it was one of the largest banks in New York, but it had passed from the capable hands of its founder Joseph Marcus to his differently-abled son, Bernard. The younger Marcus sold equity in the bank. The shares came with an ironclad guarantee: the bank would buy them back at the issue price of $200. In 1930, when the shares were trading at $90, a shareholder went into a branch in the Bronx and asked the bank to buy back her shares. They tried to talk her out of it. When she came back the next day, she came with friends who also had shares to sell. Thus began the first post-1929 bank run.

Even though the New York Superintendent of Banks thought "management was on an extremely dangerous and probably illegal course of action" (Trescott, The Failure of the Bank of United States, 1930; Journal of Money, Credit, and Banking, August 1992, 384). He asked J. Herbert Case, president of the New York Fed, to step in and rescue the bank. Case proposed a plan to merge Bank of United States with three other large banks, but during a late night meeting on December 8th, the plan fell apart (Proposal to Merge Four Banks Abandonded, New York Times, 12/9/30).

Bank of United States failed on the 11th. At the time, it was the largest bank failure in US history. "The demise of this bank worsened the panic. As deposits were withdrawn, banks contracted credit, driving the economy deeper into recession." (Glasner and Cooley, Business Cycles and Depressions: An Encyclopedia, Taylor & Francis, 1997) The failure of Bank of United States made depoistors across the country fear for their savings. As John Steele Gordon put it: "Wall Street refused to help a bank it could have saved. That touched off a wildfire of failure throughout America."

The Wall Street Journal called the downfall of Lehman Brothers "largely of its own making. The firm bet heavily on investments in overheated real-estate markets," but, the Journal adds, "Lehman's bankruptcy ... proved far more destabilizing ... than many had expected." Many, but not everyone - the French Minister of Finance Christine Legard warned Henry Paulson not to let Lehman fail.

The government's decision to allow Lehman to collapse made other investment banks appear vulnerable. The Wall Street Journal called it "a turning point in the way investors assess risk."

For more on Bank of United States see the entry in Wikipedia (it really is good).