Here’s how the narrow-minded think about stock market blow-ups: next time mortgages are made readily available to unqualified home buyers, you should be very careful or next time owners of internet companies without any profits tries to sell me an IPO at billion-dollar valuations, I’ll definitely stay away.
Because of recent and ongoing events in the stock market, it would be fitting to talk about previous stock market crashes. We will see that these failures have something they can teach us as long as we don’t get bogged down in the particulars like these guys. Of course, hindsight is always 2020 but forewarned is forearmed.
1907 – The Panic
In 1898, rules were introduced that allowed a company to own another company. This created the first corporate trust simply holding companies of many other companies. With these, truly large corporations were created such as Standard Oil and Northern Securities, and these trusts represented a large part of the total stock market in the early 1900s.
Theodore Roosevelt, the then precedent, thought that these companies were like monopolies that hindered American trade. He thought that they were depriving the public of the advantages of free trade. So he started to go after them, taking many of them to court. Markets saw Roosevelt’s move as very unpredictable and didn’t know how far he’d go in this witch hunt. As is always the case, uncertainty is the harbinger of stock market crashes.
Meanwhile, in 1906, a great earthquake struck San Francisco. More than half of the city’s population of 400,000 people were left homeless as a result. Homeowners didn’t typically have insurance against earthquakes, but they did have against fire. So what did they do? If a house was damaged by the ruptures but spared from the flames, people typically set their own homes ablaze.
Many of the insurers were from Britain and the bank of England had to pay a lot of gold in insurance claims. Britain was tied to the gold standard at that time, and to restore the gold vaults, it started offering higher interest rates to borrowers.
The trust companies weren’t typically regulated in the same way as banks in that they didn’t have to keep as much collateral or equity on their balance sheets. In this way, they were able to leverage deposits more to offer higher interest rates to customers to beat those offered by the British.
So this scene was set up. Now, all that what was necessary was a small ignition, a catalyst for the whole system to go down, and in October 1907, it got one.
It all started when there was a failed attempt at stock manipulation in a company called United Copper. As a result, the stock fell tremendously. This caused banks and corporate trusts that had used the stock as collateral to fall into financial difficulties. Consequently, people who had deposited their money in these companies sensed this and immediately wanted their money back, causing numerous runs on these banks and trusts.
The Dow Jones industrial average hit a low of 53 on November 15th, 1907 after reaching 103 at the top on January 19th, 1906, the market would regain almost the whole loss by the end of 1909. It is also worth mentioning that the market rallied 42% in 1904 and 38% in 1905 before beginning to halt in 1906 and then come crashing down in 1907.
1929 – The Great Depression
The federal reserve was founded in 1913 as a response to the 1907 panic., when JP Morgan, together with a few other bankers, had to step up as the lender of last resort to save the market. The government thought that they should have that responsibility instead. The federal rules of the so-called discount rate, which essentially is the interest rate that banks can borrow at.
In 1924, this was lowered to the then-record low-level of 3%, which fuelled the American stock market. When money is cheap, stock ownership becomes easier to finance and it also becomes relatively more attractive to bonds. It is hilarious to compare the record low rate of 3% of that time to what we see today.
Meanwhile, disappointed by the low-interest rates, corporations and rich individuals started to offer call money, essentially loans issued to other investors. This was primarily used for stock market speculation and it provided slightly higher interest rates than those offered by the banks.
The 1920s were referred to as the roaring twenties because the market truly rallied during those years. Because of this, many investment trusts were formed and it was easy to attract capital from individuals that had never owned a single stock before. You could see that the speculation had gone too far when brokers started opening temporary offices at cruising ships and golf courts to allow investors and speculators to place orders anywhere in the world.
Anyhow, these investment trusts were quite sober, but only until they started using a lot of leverage, especially cold money. It wasn’t unusual to use at least two times more borrowed capital than equity. Then, all that was needed was a little push and a large investor in London called Clarence Hatry offered one. He was revealed to be a fraud and to have fooled many banks into lending him money using fake stock certificates as collateral. Investors in both Britain and America became suspicious after this, wondering what were their certificates worth if even banks could be fooled so easily. The basic soundness of the market was questioned. Once the market started to slip, brokers had to issue margin calls to individuals and investment trusts. Many of them were too leveraged and couldn’t put up the additional money. The result was that the stocks were immediately liquidated, and so the great depression had begun.
The Dow Jones industrial average hit a low of 41 on July 1932 this was even lower than the bottom of the panic of 1907. The top was at 381 on September 3rd, 1929, which means that the market fell almost 90% during these three years. The market couldn’t return to the levels of 1929 until November 23rd, 1954 as much as 25 years later. Sure, there was World War II war in between here but still, this crash was insane. Also, note that the market rallied 29% in 1927 and 48% in 1928.
1987 – Black Monday
Portfolio insurance was supposed to be a financial innovation that allowed investors to sit safely through market crashes. So, they could later enjoy the rallies that typically follows. A small fee which was paid upfront to essentially ensure the portfolio from falling below a certain level.
On a smaller scale, it would have been a very successful financial innovation. But the problem was that on a larger scale, portfolio insurance had many flawed assumptions. One of them was that stock prices move smoothly. Another one was that there would be enough liquidity for all the sell orders that were necessary to hedge against the downside. But someone calculated that just a 3% drop in the market would encourage selling. That was equivalent to a whole day of trading in S&P 500 futures, and this was for just one of the firms using portfolio insurance.
Leveraged buyouts of companies became popularized during the 1980s; companies started buying each other using a ton of leverage. This spurred the stock market.
The trade deficit of the US had mushroomed eight times larger in 1986 than in 1981. As a result, the dollar was weakened and the Fed responded by increasing interest rates. It wanted the supply of the dollar to decrease to stabilize the value of the currency. The higher interest rates made the stock market relatively less attractive to bonds after the stock market had been spurred on for many years.
On Monday morning, October 19th, 1987, the US attacked Iran firing missiles at the military targets in the Persian Gulf in a retaliation attack. No one could blame people for thinking that the US was at war with Iran when waking up that morning; the missiles would trigger an initial downturn in the stock market, which in turn would trigger portfolio insurance sales that were too great for the market to handle. Sell orders activated more sell orders, which activated more cell orders, which activated even more sell orders, which activated even more.
Black Monday was born.
After the top of 2722 on August 25th, 1987, the bottom of 1739 was hit on the day of Black Monday, October 19th, 1987. The Dow was down 22.6% on the day, which was the largest loss in a single day in the history of the stock market. The next top would be reached two years later on August 24th, 1989. Notice that the Dow was up 28% in 1985 and 23% in 1986.
2008 – The Financial Crisis
In the 2008 financial crisis, mortgage-backed securities and MBSS were created by pooling a portfolio of mortgages. By choosing borrowers carefully, the pool could be very secure and had higher interest rates than government bonds. So far so good, but what was going to be a large problem much later was that the mortgage issuers didn’t have any skin in the game and longer if the loans that they issued defaulted, it didn’t matter since they had already sold these off to someone else who had pooled them and then sold them to invest us. Many of the MBSS was to be backed by people with poor credit and bought houses in a real estate bubble. The first MBSS was created in 1970, long before the eventual crash homeownership was happened and still is seen as something of great importance to self-esteem and life satisfaction. Politicians, therefore, wanted everyone to own a home, even those with a Berry questionable finances.
They accomplished this by lowering the required standards of mortgage down payments down to zero with the installment of the Bush administration in 2001, because of these subprime mortgages, the home market was open to many more buyers, and so home prices increased sharply.
Not many investors were interested in the lower grades of MBSS. Those that consisted of portfolios of these subprime loans as a special type of MBS, the so-called collateralized debt obligation, or CDO proved to be the solution. It had been used previously for other types of loans, but what’s now applied to mortgages, it worked something like this. If you pile enough crappy loans on top of each other, you can get something safe and sound. Thanks to diversification, this was going to be proven to be a flawed assumption.
Another innovation was the credit default swap or CDs not to be mistaken with the previously mentioned CDO. It’s as if someone made this whole thing confusing, so it was easy to get away with. The CDs weren’t insurance that a company could buy from company B, which promised that if company C, which had borrowed money from a company couldn’t fulfill its obligations, company B would step in and pay. These were now applied to mortgages and other loans between financial institutions which makes the whole system connected.
Finally, we had the rating agencies. These companies were and still are responsible for giving securities ratings based on their default risk, and they were either fraudulent or stupid or perhaps a little bit of both as they braided many of the subprimes backed MBSS triple, which means the lowest possible risk of default.
AAA MBSS didn’t require much collateral to secure through CDSS and allowed for more borrowing as the risk of default was deemed so low. Then, the whole system was focused around home prices, and if they were to fall, chain reactions could be felt throughout the whole financial system, and they felt.
The catalyst of this crash was that the investment bank, Lehman Brothers went bankrupt on September 15th, 2008, the interconnectedness of financial firms threatened the whole economic system and the crisis was the ultimate effect.
The high was reached on October 9th, 2007 at 14,164 and the bottom hit on March 9th, 2009 at 6,547. Once again, the market had gained quite a lot before the crash happened in 2006, 16% and up until the top of 2007 which was 14%, that was not as much as occurred in the previous crashes.
The next top was not reached until March 5th, 2013 but before that, another crash was lurking around the corner.
2010 – The Flash Crash
Greece wanted to become a part of the new common currency of Europe, the Euro. It tricked itself into the Union in 2001 by using financial shenanigans that made it seem like it fulfilled the economic criteria of the Union. It went on a borrowing binge between 2000 and 2010, and in early 2010 it seemed like it would default on its debt. A member of Angela Merkel of Germany’s coalition said that you don’t help an alcoholic by putting a bottle of Schnapps in front of him. But no matter, the IMF provided Greece with a loan to help it survive, but the conditions of the loan were painful for the people of Greece.
During Black Monday of 1987, the worst day in the history of the stock market, at least trades were executed by humans. On May 6th, 2010 the crash was caused by computer algorithms going crazy. The main algorithm causing the crash used the same technique of dynamic hedging that had caused the crash in 1987. The catalyst of the Flash Crash was the riots in Greece on May 6th that happened after its government had accepted the conditions of the loan from IMF. Their riots started the initial crash that was enough for a firm called Waddell and Reed to try to hedge its portfolio before the market close. An algorithm provided by the British bank, Barclays, was used.
The only problem was that the volume was going to snowball once Waddle and Reed tried to sell so much. The higher volume suggested through the algorithm that the market was more liquid and that more sell orders could be filled. The selling became self-reinforcing and liquidity disappeared when it was needed the most.
On May 6th, 2010, the dowel fell to 9,869 intra D down 9.2% for the day. What was interesting about the flash crash was the fact that due to reckless selling of the algorithms, some companies traded at truly stupid levels which no human would execute a trade at. On that day, more than 3 million shares were traded at 90% or lower than their previous day’s value.
These crashes certainly shaft three common characteristics. There had been a creation of new financial innovation. There was leverage whole too much leverage, and the stock market had two years of strong market returns just before the crash, except for the flash crash. The catalyst is the unknown but with these conditions in place, we know that there’s a tendency for markets to fall apart, no matter what the particular catalyst may be. The most important thing to remember is that the tough market always rebounds. Great rewards await for those who stay in the market for the later upswing. This book illustrates the events and characters that contributed to the various panics in a very excellent way which helps readers in understanding the five crashes very easily. More importantly, the insights shared by the author can help investors in better understanding the context of future events and avoiding short-term decisions.