110: How To Protect Yourself From Bail Ins

What are bail ins and how to protect yourself from them.

In this episode you’ll learn:

• What is the difference between a bail out and bail in.
• How France’s first foray into fiat currency led to a bail in.
• How a bail in of Cyprus banks caused depositors to lose half their bank deposits.
• How bail ins can be applied to banks and pension plans.
• What to do protect yourself against bail ins.

Show Notes

The Economist Explains: What Is A Bail In?

Money Changes Everything: How Finance Made Civilization Possible – William N. Goetzmann

Extraordinary Popular Delusions and the Madness of Crowds – Charles Mackay

Summary Article

John Law and the Mississippi Company Bubble

John Law was born in Edinburgh, Scotland in 1671. His father was a goldsmith and banker, and at the age of 14, Law joined his father’s counting house and for three years he learned the family business.

At eighteen, after his father’s death, Law left for London, where he frequently visited the gaming-houses and usually won due to his astuteness in calculating probabilities.

Early success in gambling led Law to take greater and greater risks and eventually he began losing more than winning to the point he had to mortgage his inherited estate in order to cover the losses.

The Duel

Nine years of London gambling life ended when Law was challenged to a duel by the jealous Edward Wilson who did not appreciate Law’s flirtatious advances with the lady Elizabeth Villiers.

Law won the duel but was accused of murder and sentenced to death. The sentence was later reduced and Law managed to escape prison.

The notice in the local newspaper seeking his capture read “Captain John Law, a Scotchman, aged twenty-six; a very tall…lean man; above six feet high, with large pock-holes in his face; big nosed and speaking broad and loud.”

Law spent most of the next 18 years traveling through continental Europe, spending his mornings studying and developing theories on finance and banking and his evenings at the gaming houses. Gambling was his primary source of income due to his improved ability to calculate probabilities.

France's First Central Bank

In 1715, the French King Louis XIV died, leaving France’s finances near ruin due to three major wars waged by the king. The national debt was $3 billion livre (later know as francs).

The heir to the throne, Louis XV, was only seven when the king died so Regent Philippe d’Orleans, the Duke of Orleans, came to power to lead France until the young king came of age.

Fortunately for John Law, he was good friends with the Duke of Orleans and the perilous state of France’s finances provided Law with the opportunity to test his financial and banking theories.

Law was given a charter to open the Banque Generale in 1716. The bank was capitalized by government loans and deposits by the Regent and other prominent citizens. It issued banknotes, made commercial loans and by 1718 it began to collect state tax revenues that were denominated in the bank’s notes.

That same year, the bank’s name was changed to the Banque Royale, the banknotes were declared government issued, and John Law became the finance minister of France and head of the central bank.

The Mississippi Company

As finance minister, Law had to deal with the huge national debt. His most novel idea to reduce the debt burden, which he launched in 1717 before becoming finance minister, was to create the Companie d’Occident (commonly known as the Mississippi Company).

He offered shares in this company in exchange for government debt. Investors could swap their illiquid government holdings for shares in a company that held the economic rights to the entire Louisiana Territory in the New World with the city of New Orleans sitting at the mouth of one of the world’s largest navigable rivers.

With the newly raised capital, Law absorbed other French trading companies, giving Law and the Mississippi company a virtual monopoly on long-distance French commerce. Law and the Mississippi Company also acquired the tobacco monopoly, the royal mint, the French tax collection agency, and the entirety of the French national debt.

William Goetzman writes in “Money Changes Everything” that “within a few amazing years, John Law had achieved a remarkable feat. Using the new financial engineering…and his own economic analysis of the role of money in the economy, he had effectively privatized the financial operations of France and put them into the hands of the public through the issuance of public shares of stock. He had replaced a depleted currency based on scare silver specie with fiat money that could respond to market demand. He created a corporate governance structure that could respond strategically to France’s competitors in the rush to globalization. He had also created a world that depended fundamentally on the financial market.”

The Bubble

Given the Mississippi Company’s scale and growth prospects, its shares became extremely popular in the secondary market with prices rising from 400 livres in August 1719 to 1,800 by December 1719.

Meanwhile, throughout 1719, the Banque Royale was busy printing money. At the same time, the French government took measures to prevent its citizens from transferring specie, such as gold and silver, to other countries or to display objects of precious stones and metal, all in attempt to establish the preeminence of fiat currency.

In February 1720, Law merged the Mississippi Company with the Banque Royale. A month later, Law set a fixed exchange rate between banknotes and company shares, essentially turning equity shares into money. This is akin to the U.S. Federal Reserve merging with Google and the central bank setting a fixed U.S. dollar to Google share exchange rate.

The Crash

This fixed exchange rate was Law’s fatal mistake, given the Banque Royale continued to print money.

Holders of the original French national debt who had converted their illiquid claims into shares of a publicly traded company which had then soared in value could now cash in those shares for a fixed amount of money while avoiding the risk of sending share prices lower as they liquidated their equity holdings. Some investors used the banknotes they received from converting their Mississippi Company shares to buy gold and silver and ship it out of the country, despite the laws against cross-border transport.

So many investors lined up to take advantage of the exchange offer that the central bank began printing even more money to redeem shares. Inflation ensued and the bank was forced to devalue the currency by lowering the exchange rate from 9,000 livres to 5,000 livres per share.

This caused panic as investors rushed to the bank to redeem shares. Riots ensued as investors realized the system would not hold. There were too many banknotes and only individuals with “super abundant gullibility” still believed in the vast gold and wealth of the Louisiana territory, according to Charles Mackay in his book “Extraordinary Popular Delusions and the Madness of Crowds.”

Share prices crashed, the Banque Royale’s offices were ransacked, and John Law fled the country.

What’s the lesson? All financial systems rely on trust, credibility and good judgment. When these are lacking, the system can quickly collapse.