When Whiskey Was Too Big to Fail

Decades before cocktail partygoers chatted about mortgage-backed securities, it was whiskey-backed securities that stood poised to threaten the U.S. financial system. Prior to Prohibition, banks accepted whiskey as collateral on business loans. Whiskey’s durability made it an attractive way to finance distilleries. In addition, whiskey barrels were required to be aged in government-supervised warehouses, adding a desirable degree of assurance to the collateral, which came in the form of a warehouse receipt documenting ownership of the barrels.

As the 18th Amendment to the Constitution, a ban on the manufacture, sale, or transportation of intoxicating liquors was debated, there was much more at stake than morality. Banks realized that not only were distilleries likely to default on their loan payments but that the whiskey collateral they held would also become worthless.

In 1918, Percy H. Johnston, vice president of the Chemical National Bank of New York, estimated that $500 million in bank loans were backed by spirits; 250 million gallons, in fact. His dramatic address to congress conjured the great destruction of San Francisco by fire, an event not far in the rear-view mirror, and warned there could be far reaching effects.

“If the amendment becomes operative, the securities back of this indebtedness will become as worthless as if it was consumed by a great conflagration without any insurance whatever on the same. $500,000,000 in property value cannot be destroyed without seriously affecting our entire credit structure as the business is more or less interwoven with a great many other lines of business and the disastrous effect will be widespread and great.” (The Bankers’ Monthly, August 1918)

As Prohibition was enacted, the clamor for action grew. In August 1919, Attorney General A. Mitchell Palmer offered banks a reprieve, ruling that while whiskey itself could not be bought or sold, receipts still could be, and therefore could be used as collateral. He reasoned that the purchase of a receipt clearly could not lead to the transfer of any actual liquor, since the whiskey was impounded in federal warehouses (Official opinions of the Attorneys General, 1922). This left lenders in the clear—at least legally.

But to have collateral value, warehouse receipts would need a potential buyer. Who would buy a claim on an illegal asset? Even before his time, Warren Buffett’s mantra to be greedy when others are fearful had its devotees. Speculators snapped up warehouse receipts at bargain prices, betting on the eventual repeal of Prohibition.

National Distillers, popularly known as the Whisky Trust, plowed the profits from the sale of a yeast business and stock sale into pre-Prohibition whiskey, and by 1933 owned half of the 20 million gallons of whiskey in the U.S. National wasn’t alone in their prescience: helmed by Lewis Rosenstiel, Schenley Distillers acquired another 25 percent of whiskey stocks. (Fortune magazine, 1933).

By 1933, their bet paid off. With Prohibition repealed, the distilling industry was in the hands of a few dominant players. This small handful of speculators became powerful and affluent leaders of American whiskey over ensuing decades, and may well have provided some cover for the American banking industry in the process.

Bruce Carlin and William Mann, finance professors, UCLA’s Anderson School of Management

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