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Synopsis
The great economic crashes are not just about economics. They are stories filled with drama, mistakes, and heroic rescues. As a nation, America has reached incredible heights in financial power. Still, America is also vulnerable to huge dips for people who have invested heavily. A History of The United States in Five Crashes outlines the most significant historical economic crashes while also applying them to America’s political and cultural fabric. We can learn something from each of these five economic crashes.
About Scott Nations
Scott Nations has a solid background in finance. Scott began his trading career as a floor trader at Stafford Trading in Chicago. Subsequently, he joined The Arbitrage Group (TAG) as a floor trader and manager of their fixed income operation at the Chicago Board of Trade. In 2002, Scott co-founded Fortress Trading as a Chicago-based trading firm that focused on equity index volatility trading and arbitrage. Ultimately, Scott’s current company, NationsShares, grew out of Fortress Trading. He currently works as the president of NationShares, which is an American financial engineering firm. Scott is also a frequent contributor to CNBC, providing expert insight on markets, derivatives, and other investment topics.
Because of recent and ongoing events in the stock market, it is fitting to talk about previous stock market crashes. We will see that these failures have something they can teach us.
1907 – The Panic
“The history of modern stock market crashes invariably includes some theoretically sophisticated yet poorly understood financial contraption that mutates when stressed, pushing an already weakened system closer to the cliff.” – Scott Nations
In 1898, a new rule allowed companies to own another company. These rules led to the creation of the first corporate trust. Put simply, holding companies within one company. With this, giant corporations were created. Examples of such corporations are Standard Oil and Northern Securities. These trusts represented a large part of the total stock market in the early 1900s.
Theodore Roosevelt, the then president, thought that these companies were like monopolies that hindered American trade. He felt that they were depriving the public of the advantages of free trade. So, Roosevelt started 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 messenger of stock market crashes.
Meanwhile, in 1906, a great earthquake struck San Francisco. As a result, more than half of the city’s population of 400,000 people were left homeless. Homeowners didn’t typically have insurance against earthquakes. They did have insurance against fires. So, what did they do? When the ruptures damaged houses, people typically set their own homes ablaze.
Many of the insurers were from Britain, and the Bank of England had to pay a lot in insurance claims. Britain was tied to the gold standard at that time. Because of this, the Bank of England started offering higher interest rates to borrowers.
The trust companies weren’t typically regulated in the same way as banks because 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. These high interest rates were provided so they could beat those offered by the British.
So, the scene was set. Now, all that was necessary was a small ignition—a catalyst for the whole system to go down. In October 1907, we 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. Those who used the stock as collateral fell into financial difficulties, including banks and corporate trusts. Consequently, people who had deposited their money in these companies sensed this. They 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. This was after reaching 103 at the top on January 19th, 1906. The market would regain almost the entirety of its loss by the end of 1909. It is also worth mentioning that the market rallied 42% in 1904 and 38% in 1905. It then started to halt in 1906 and crashed in 1907.
1929 – The Great Depression
Founded in 1913, the Federal Reserve was a response to the 1907 panic. Together with a few other bankers, JP Morgan had to step up as a lender. They were the last resort to save the market. The government thought that they should have that responsibility instead. This responsibility was federal rules relating to discount rates. Discount rates are the interest rate that banks can borrow.
The interest rate lowered in 1924 to the then-record low-level of 3%. This reduction then fuelled the American stock market. When money is cheap, stock ownership becomes easier to finance. Additionally, it also becomes relatively more attractive to buy bonds.
Meanwhile, disappointed by the low-interest rates, corporations and wealthy individuals started to offer call money. Essentially, these were loans issued to other investors. Primarily used for stock market speculation, call money provided slightly higher interest rates than those provided by the banks.
The 1920s were referred to as the roaring twenties because the market rallied. During this time, the formation of many investment trusts occurred. Also, it became easier to attract capital from individuals that had never owned stock before. You could see that the speculation had gone too far when brokers started opening temporary offices on cruise ships and golf courses. They were doing this to allow investors and speculators to place orders anywhere. This approach worked.
These investment trusts were quite sober. However, they only remained this way until they started using a lot of leverage. This leverage was predominantly 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. A significant investor in London called Clarence Hatry offered one. He was a fraud and found to have fooled many banks into lending him money. He managed to do so by using fake stock certificates as collateral. Investors in Britain and America became suspicious after this. They started to wonder what their certificates were worth if banks were fooled so easily. The fundamental legitimacy 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 in 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. This was over 25 years later. There was World War II war in between these dates, but this crash was still colossal. It is also important to note that the market rallied 29% in 1927 and 48% in 1928.
1987 – Black Monday
“Since Leland and Rubinstein were hitching a ride with Black and Scholes, portfolio insurance would rely on these “ideal conditions” and would fail when reality intruded.” – Scott Nations
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 follow. This insurance involved a small fee paid upfront to prevent the portfolio from falling below a certain level.
On a smaller scale, it would have been a very successful financial innovation. However, the problem was that portfolio insurance had many flawed assumptions. These assumptions became more apparent when used on a large scale. One of the flawed assumptions was that stock prices move smoothly. Another one was that there would be enough liquidity for all the sell orders necessary to hedge against the downside.
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 considerable leverage. This act of purchasing 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 weakened. The Fed responded by increasing interest rates. It wanted the supply of the dollar to decrease. They were hoping this would stabilize the value of the currency. The higher interest rates made the stock market relatively less attractive to bonds. This unattractiveness was significantly exaggerated as the stock market had been spurred on for many years.
On Monday morning, October 19th, 1987, the US attacked Iran. They fired missiles at the Persian Gulf’s military targets in a retaliation attack. No one could be blamed 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. This downturn triggered portfolio insurance sales that were too great for the market to handle. Sell orders activated more sell orders, which enabled more sell orders, which activated even more sell orders, which activated even more.
Black Monday was born. After the high 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. This was the most substantial 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. Scott recommends that readers 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. However, mortgage issuers didn’t have any skin in the game. This meant that if the issued loans defaulted, it didn’t matter as they had already sold these off to someone else. This ‘someone’ else would have pooled them and then sold them to invest. MBSS was backed by people with poor credit and those who had bought houses in a real estate bubble. The first MBSS was created in 1970, long before the eventual crash. Then, as is still the case now, homeownership was seen as something of great importance for self-esteem and life satisfaction. Politicians, therefore, wanted everyone to own a home—even those with very questionable finances.
They accomplished this by lowering the required standards of mortgage down-payments. They reduced these standards to zero with the Bush administration’s installment in 2001. Because of these subprime mortgages, the home market was open to many more buyers. Hence, home prices increased sharply.
Not many investors were interested in the lower grades of MBSS. The solution was portfolios of these subprime loans as a special type of MBSS. These portfolios were called collateralized debt obligation or CDO. CDO had been used previously for other types of loans. However, it was now being applied heavily to mortgages. The idea was: If you pile enough crappy loans on top of each other, you can get something safe and sound. Due to diversification, this was a flawed assumption.
Another financial approach at the time was the credit default swap or CDS. CDS is not to be mistaken with the previously mentioned CDO. The CDS was insurance that a company could buy from company B. Company B promised that they would step in and pay if company C, which had borrowed money from a company, couldn’t fulfill its obligations. These were now applied to mortgages and other loans between financial institutions. Therefore, the whole system was now connected.
Finally, we had the rating agencies. These companies were and still are responsible for giving security ratings based on default risk. They braided many of the subprimes and backed MBSS triple-fold, which means the lowest possible default risk.
MBSS didn’t require much collateral to secure through CDS. This 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 financial system as a whole. They fell.
The catalyst for 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. The result was a crisis.
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. A 16% increase occurred, and that was the least that had occurred during a crash.
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. These shenanigans made it seem like Greece fulfilled the Union’s economic criteria. It went on a borrowing binge between 2000 and 2010, and, in early 2010, it seemed like Greece would default on its debt. A member of Angela Merkel of Germany’s coalition said, “you don’t help an alcoholic by putting a bottle of Schnapps in front of him.” The IMF provided Greece with a loan to help it survive, but the loan conditions were painful for the people of Greece.
During Black Monday of 1987, the worst day in the stock market’s history, humans were the ones making mistaken trades. On May 6th, 2010, the crash was caused by computer algorithms going crazy. The main algorithm causing the crash used the same dynamic hedging technique that had caused the crash in 1987. The catalyst of the Flash Crash was the riots in Greece on May 6th. These riots occurred after Greece’s government had accepted the loan conditions from the IMF. Their riots started the initial crash, which was enough for a firm called Waddell and Reed to try to hedge its portfolio before the market closed. An algorithm provided by the British bank, Barclays, was used.
The only problem was that the volume would 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 fulfilled. The selling became self-reinforcing, and liquidity disappeared when it was needed the most.
On May 6th, 2010, the Dow fell to 9,869 intra D down 9.2%. Interestingly, due to the algorithms’ reckless selling, some companies traded at idiotic levels. No human would execute a trade at these levels. On that day, more than 3 million shares were traded at 90% or lower than their previous day’s value.
These crashes undoubtedly rely on three common characteristics. There had been a creation of new financial innovation, there was too much leverage, and the stock market had two years of strong market returns just before the crash. The only exception to this is the flash crash. For all crashes, the catalyst is unknown. However, with these conditions in place, we know that there’s a tendency for markets to fall apart. The particular catalyst does not matter. 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 next upswing.
The text shot above is based on The Swedish Investor Youtube video.
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