History repeats itself, nothin’ new
“History repeats itself, nothin’ new.”
– Tupac, Black Jesus
I recently rediscovered “Have You Ever Tried to Sell a Diamond”, an article first published in the February 1982 issue of The Atlantic on De Beers and the diamond trade [1]. In the article, author Edward Jay Epstein describes how De Beers grew to become a large, multinational corporation seemingly in tight control over both the supply of and – with the help of N. W. Ayer, America’s oldest advertising agency – demand for diamonds. The entire piece is fascinating, timeless, and I highly recommend it.
One portion of the article caught my eye in particular. Near the end of the piece, Epstein describes how the diamond market approached the brink of collapse, nearly taking Israeli banks with it. What struck me was the similarity to the story we’ve come to know all too well – the American subprime mortgage crisis of the late 2000s. Here’s the passage, as published in February 1982:
During the recession of the mid-1970s, it had to use a large portion of its cash reserve to buy diamonds from Russia and from newly independent countries in Africa, in order to preserve the cartel arrangement. As it added diamonds to its stockpile, De Beers depleted its cash reserves. Furthermore, in 1980, De Beers found it necessary to buy back diamonds on the wholesale markets in Antwerp to prevent a complete collapse in diamond prices. When the Israeli banks approached De Beers about the possibility of buying back the diamonds, De Beers, possibly for the first time since the depression of the 1930s, found itself severely strapped for cash. It could, of course, borrow the $1.5 billion necessary to bail out the Israeli banks, but this would strain the financial structure of the entire Oppenheimer empire.
Sir Philip Oppenheimer, Monty Charles, Michael Grantham, and other top executives from De Beers and its subsidiaries attempted to prevent the Israeli banks from dumping their hoard of diamonds. Despite their best efforts, however, the situation worsened. Last September, Israel’s major banks quietly informed the Israeli government that they faced losses of disastrous proportions from defaulted accounts almost entirely collateralized with diamonds. Three of Israel’s largest banks—the Union Bank of Israel, the Israel Discount Bank, and Barclays Discount Bank—had loans of some $660 million outstanding to diamond dealers, which constituted a significant portion of the bank debt in Israel. To be sure, not all of these loans were in jeopardy; but, according to bank estimates, defaults in diamond accounts rose to 20 percent of their loan portfolios. The crisis had to be resolved either by selling the diamonds that had been put up as collateral, which might precipitate a worldwide selling panic, or by some sort of outside assistance from the Israeli government or De Beers or both. The negotiations provided only stopgap assistance: De Beers would buy back a small proportion of the diamonds, and the Israeli government would not force the banks to conform to banking regulations that would result in the liquidation of the stockpile.
“Nobody took into account that diamonds, like any other commodity, can drop in value,” Mark Mosevics, chairman of First International Bank of Israel, explained to The New York Times. According to industry estimates, the average one-carat flawless diamond had fallen in value by 50 percent since January of 1980. In March of 1980, for example, the benchmark value for such a diamond was $63,000; in September of 1981, it was only $23,000. This collapse of prices forced Israeli banks to sell diamonds from their stockpile at enormous discounts. One Israeli bank reportedly liquidated diamonds valued at $6 million for $4 million in cash in late 1981. It became clear to the diamond trade that a major stockpile of large diamonds was out of De Beers’s control.
After reading that passage and finding the narrative to be strikingly similar to what has transpired in the mortgage industry over the last few years, I thought I’d see how this passage might read by replacing some of the nouns (you can see which nouns I replaced at the end of this post). Here is the transformed excerpt – same narrative, new characters:
The Federal Reserve, however, is in no position to absorb such a huge cache of mortgages. During the recession of the mid-1970s, it had to use a large portion of its cash reserve to buy mortgages from Russia and from newly independent countries in Africa, in order to preserve the cartel arrangement. As it added mortgages to its stockpile, the Federal Reserve depleted its cash reserves. Furthermore, in 1980, the Federal Reserve found it necessary to buy back mortgages on the wholesale markets in Antwerp to prevent a complete collapse in home prices. When the American banks approached the Federal Reserve about the possibility of buying back the mortgages, the Federal Reserve, possibly for the first time since the depression of the 1930s, found itself severely strapped for cash. It could, of course, borrow the $1.5 billion necessary to bail out the American banks, but this would strain the financial structure of the entire Bernanke empire.
Ben Bernanke and other top executives from the Federal Reserve and its subsidiaries attempted to prevent the American banks from dumping their hoard of mortgages. Despite their best efforts, however, the situation worsened. Last September, America’s major banks quietly informed the American government that they faced losses of disastrous proportions from defaulted accounts almost entirely collateralized with mortgages. Three of America’s largest banks—the Union Bank of America, the America Discount Bank, and Barclays Discount Bank—had loans of some $660 million outstanding to mortgage dealers, which constituted a significant portion of the bank debt in America. To be sure, not all of these loans were in jeopardy; but, according to bank estimates, defaults in mortgage accounts rose to 20 percent of their loan portfolios. The crisis had to be resolved either by selling the mortgages that had been put up as collateral, which might precipitate a worldwide selling panic, or by some sort of outside assistance from the American government or the Federal Reserve or both. The negotiations provided only stopgap assistance: the Federal Reserve would buy back a small proportion of the mortgages, and the American government would not force the banks to conform to banking regulations that would result in the liquidation of the stockpile.
“Nobody took into account that homes, like any other commodity, can drop in value,” Mark Mosevics, chairman of First International Bank of America, explained to The New York Times. According to industry estimates, the average one-carat flawless home had fallen in value by 50 percent since January of 1980. In March of 1980, for example, the benchmark value for such a home was $63,000; in September of 1981, it was only $23,000. This collapse of prices forced American banks to sell mortgages from their stockpile at enormous discounts. One American bank reportedly liquidated homes valued at $6 million for $4 million in cash in late 1981. It became clear to the mortgage industry that a major stockpile of large mortgages was out of the Federal Reserve’s control.
Interesting, huh? It is, of course, not a perfect comparison. The Fed (hopefully) would not purchase mortgages internationally and (hopefully) not deplete its cash reserves. The scale of the crises were also dramatically different. Nonetheless, I thought it was a noteworthy (and entertaining) transposition.
That history is prone to repetition is a concept as old as history itself. Assets that increase in price at an excessive rate are probably being manipulated – either direct or indirectly – by an outside, speculative force. In the short run this “irrational exuberance”, as Alan Greenspan dubbed the Internet bubble of the 1990s, may seem like the new normal, but in the long run, that force is bound to weaken and eventually collapse. This happened with tulips in Europe in the 1630s, diamonds in the 1970s, housing in America in the last decade, and there is little reason to believe it won’t happen again. Keep this in mind the next time you hear someone speak of an asset or industry as if it is assumed it will continually increase in value. If history is any guide, it probably won’t.
Here is the list of nouns I replaced in modifying the excerpt:
replaced De Beers with the Federal Reserve
replaced Israel(i) with America(n)
replaced diamond(s) with mortgage(s) or home(s)
replaced Oppenheimer with Ben Bernanke
replaced trade with industry
[1] I rediscovered the article via Hacker News, following news from Russian news agency ITAR-TASS that a group of Novosibirsk scientists had announced the Russian government’s alleged declassification of “trillions of carats” of industrial-grade diamonds located in the 35-million-year-old Popigai meteorite crater. The agency describes the discovery as “a large deposit of super hard diamonds which are twice harder than usual ones.”