December 1993 | Volume 44, Issue 8
A nineteenth-century blueprint for the savings-and-loan scandal
It was a banking system. The act that made it possible slipped through Congress with hardly any debate and little attention to economic reality. Many of its highestranking officials knew little or nothing about the peculiar nature of the banking business. More than a few were incompetent, and some were plain crooks. When it failed to flourish, Congress expanded the sorts of investments it was permitted to make without regard to the risk involved. It collapsed at great cost.
No, it was not the savings and loan industry in the 1980s. It was the Freedman’s Savings and Trust Company in the 186Os and 187Os. But to read Carl R. Osthaus’s worthy book on its sad history, Freedmen, Philanthropy, and Fraud (University of Illinois Press, 1976), is to know déjà vu on a historical time scale.
When the Civil War ended, social and economic chaos reigned throughout the devastated South, and no one felt the effects of this chaos more than the freed blacks. How were they to make a living? The former slaves had no property and, hardly surprisingly, were very reluctant to work under the old system of gang labor, regardless of the wages they might be paid. And the landowners, their liquid assets wiped out by the war, usually lacked the cash to pay wages in any event. Over the next decade the sharecropper system would evolve to accommodate the new realities, allowing the barter of land use for labor.
But ironically, many of the blacks, who had hardly ever seen cash money in the days of slavery, now had some cash in their pockets. Hundreds of thousands of the men had joined the Union Army and received both bonuses for joining up and regular pay. Many people, educated blacks and whites alike, feared that unless a safe place was quickly devised where these soldiers could store their army pay, they would quickly be fleeced out of it by the camp followers and other lowlifes who inevitably surrounded Civil War armies.
On January 27, 1865, the Reverend John W. Alvord, a Congregational minister and dedicated abolitionist, but no banker, invited twenty-two prominent New Yorkers to a meeting to discuss the creation of a permanent banking institution to serve the needs of the freedmen. This group, which included such nationally prominent men as Peter Cooper and William Cullen Bryant, decided to act at once and sent Alvord to Washington to ask Congress for a banking charter.
Congress was near adjournment by the time the bill reached the floor of the Senate on March 2, 1865, introduced by the abolitionist Charles Sumner of Massachusetts. Sumner’s bill would have allowed, in the words of one objecting senator, “a kind of roving commission for these persons to establish a savings bank in any part of the United States.” Sumner quickly agreed to limit the bank’s charter to the District of Columbia, and it passed the Senate.
The bill then became law as Sumner had originally introduced it. John Alvord, with no credentials beyond good intentions, eventually became president of the bank.
Because the amendment limiting the bank’s charter to Washington, D.C., was accidentally dropped from the enrolled bill, and because the intended depositors were scattered widely over the South and border states, the Freedman’s Bank quickly became the first since the old Second Bank of the United States—killed by Andrew Jackson in 1836—to have branches in more than one state. (It would also be the last until late in the twentieth century.) By the 1870s the bank had thirty-eight branches in no fewer than sixteen states as well as the District of Columbia.
But while the bank became far-flung, it did not become profitable. In form the new Freedman’s Savings and Trust Company was a simple mutual savings bank. It was owned by its depositors, and their deposits were to be invested in securities issued by the United States Treasury. But there was no initial capital subscribed, so the bank would have to be entirely financed out of deposits. This greatly increased the difficulty of earning enough on deposits to pay a good rate of interest.
And the branches, while many, were small, some too small ever to be profitable. Also, because the bank was intended for the use of the poorest stratum of American society, the individual accounts were invariably small as well. But it is an unfortunate reality of the banking business that each account, regardless of size, tends to cost much the same amount to service. As a result, the expenses of the Freedman’s Bank were extraordinarily high.
At that time the rule of thumb was that expenses should be no more than one-half of 1 percent of deposits. The Freedman’s Bank, however, with many branches and no large accounts, had expenses upward of 5 percent of deposits. Since Treasuries, the only investment the Freedman’s charter permitted, were paying 6 percent interest at that time, there was little, if any, profit with which to pay dividends. The pressure to find more lucrative investments never ceased.
The Freedman’s Bank had two other grave weaknesses. The first was that because its expenses were so high relative to deposits, it simply could not afford to pay the going rate for competent bank help. As a result, it hired many people whose hearts were in the right place but whose bookkeeping skills were lacking and sometimes nonexistent.
The other weakness was at the very top. In theory the Freedman’s Bank was governed by a board of fifty trustees. The original list was a who’s who of the American business establishment of the day. But seven of the most prominent members resigned almost immediately. Apparently their names had merely been used as window dressing to impress Congress, and their consent to serve had never been obtained.
The bank’s board of trustees, in fact, never kept close tabs on what the bank and its officers were up to. By 1870 power at the Freedman’s Bank was effectively in the hands of these officers and a three-man finance committee, with no one monitoring their performance. If anything is clear from the history of American banking, it is that whenever a few people, with interests of their own and little supervision, find themselves in charge of large sums of other people’s money, disaster is on the way.
The officers of the bank began lobbying Congress for changes in the charter. Soon a bill allowing the bank to invest in real estate—the most illiquid, thus potentially the most troublesome, form of investment—passed the House without debate.
In the Senate only two senators raised objections. Significantly, one of them was Simon Cameron, the boss of the Pennsylvania Republican party, who had made his own very considerable fortune in the banking business. “Depend upon it,” he warned, “the moment you allow them to put their money … in real estate, that moment you weaken the credit of the institution and its stability.”
But the Senate did not listen to Cameron, and the bank was allowed to make loans on real estate.
With the new amendment to the charter, the Freedman’s Bank, with astonishing swiftness, became highly speculative. It began lending its available fund, money supposed to be at hand to meet any demand for withdrawal, on such dubious security as railroad bonds, often the junk securities of the day. The trustee who proposed this, in fact, was the director of a railroad that promptly borrowed $175,000 from the Freedman’s Bank.
And incompetence vied with speculation and fraud to hasten the bank’s end. Anson Sperry had been with the bank since its earliest days and had a genuine interest in helping the freedmen. But as the bank’s inspector, charged with checking each branch’s books, he was hopeless. “I should have known more and had less enthusiasm,” he admitted after the bank’s failure. Indeed. He certified many of the bank’s book balances, labeling them as “correct, E&OE.” Asked what that meant by mystified congressional investigators after the collapse, he admitted that “E&OE” stood for “errors and omissions excepted.” That’s rather like certifying a ship as seaworthy except for whatever holes may be found in the hull.
The panic of 1873 dealt a deathblow to the bank as depositors rushed to withdraw their money. It weathered the immediate storm by liquidating most of its government bond portfolio. The incompetent John Alvord was replaced as president by Frederick Douglass, in the hope that the great man could reassure the black depositors.
But the comptroller of the currency quickly reported a deficit of $217,886.15. With total assets, many of them questionable, of only $3,000,000, this was no small sum, and panic withdrawals resumed. Douglass, who had been misled prior to accepting the presidency, quickly realized that the situation was hopeless, and on July 2,1874, the bank closed. Few depositors ever saw a dime of their hard-earned savings as many of the loans proved uncollectible. The bitterness in the black community over the debacle lingered for decades.
To quote Santayana correctly for once, “Progress, far from consisting in change, depends on retentiveness. … Those who cannot remember the past are condemned to fulfill it.” The Freedman’s Bank and the S&L disaster are perhaps the best examples of that truth I know. I hope that the well-meaning apostle of change now in the White House may read this and know that good intentions are never enough.