A History on Financial Crashes and Bubble Bursts: Part 2

In part 1 of our 2 part series on financial crashes and bubbles we explored some of the earliest events that occurred prior to the 1900s.  In part 2 we will explore more ‘modern’ crashes.

Wall Street Crash of 1929

The 1920s was known as the “Roaring Twenties” as it was a time of prosperity and the greatest creation of wealth in history.  The Dow Jones Industrial Average began 1929 trading at a value of 300 having doubled several times over the previous years.   Everyone was getting rich off the stock market through the use of “leverage” which involved purchasing a stock using only 10% of the total value and the banks providing the other 90% for a small fee.  New inventions like radios and cars were being bought by individuals using profits made in the markets, and culturally Americans were swept up with the new fascination of jazz music.

Beginning in the summer of 1929, unemployment has been rising, automobiles revenue and department stores sales were falling both representing danger signs that the booming economy is slowing down.  Investor’s suddenly took notice and stock prices became volatile.  As summer ended and fall began, the mood changed.  On September 5, 1929, two days after the Dow Jones all time highs of around 380 , economist Roger Babson gave a speech saying: “Sooner or later a crash is coming, and it may be horrific”. 

On Thursday October 24, brokers began calling in margin calls meaning investors were being asked to provide cash for the balance owed from their purchases.  Mass selling began as investors started selling their positions to avoid these margin call expenses.  Outside of the stock exchange crowds formed on the street in an attempt to gather information on what is going on.  Billions of dollars were evaporated from the stock market leaving investors with nothing else to do but pray for a miracle to come.  Everyone believed that their prayers have been answered when a coalition of bankers had agreed to pump hundreds of millions of dollars in the stock exchange to prevent further declines. 

The following day on Friday as the market appeared to have stabilized the banks had withdrawn their funds.  Investors were given the weekend to evaluate the situation, and the selling increased on Monday October 28.  The following day, October 29, 1929 known as “Black Tuesday” was the most intense day of selling.  Hour after hour the markets were collapsing under the panic of selling.  Any rallies were very brief and short lived.  16 million shares were traded as sellers were all eager to get out at any cost.

The dream of making it rich through the markets had now become a nightmare.  Total losses from investors was over $30 billion, an amount greater than the total cost to finance World War Two spending by the United States.  The thousands of small investors were hit the most.  They all believed that everyone can be rich and borrowed carelessly to finance their dreams.  Their life savings were now not only gone, they were still left with the bill to pay for the margin used. 

The stock market continued its downward trend where the Dow Jones index hit the lows of under 100 in July 1932.  It would take a decade and a half for the American economy to recover from the ensuing recession and depression.  The most famous of quotes used to describe the effects of the crash are attributed to the famous economist Richard Salsman: “Anyone who bought stocks in mid-1929 and held onto them saw most of his or her adult life pass by before getting back to even.”  The Dow took 25 years to erase the losses and hit new all time highs only in 1954, surpassing the previous highs set before the crash.  The record volume seen on Black Tuesday was a record that was not broken until 1968.

1997 Asian Crisis

As globalization grew, so did international investments in developing nations.  The economies of Southeast Asia offered foreign investors with potentially higher returns on investments.  Nations such as Thailand, Malaysia, Indonesia, Singapore and South Korea benefited from an influx of capital and tremendous growth rates in their GDP.  This influx of new capital in their markets resulted in large quantities of available credit.  A highly leveraged economic climate developed where investors would only have to put a small amount of their own money into a project and the banks will cover the remainder. 

Major developments requiring substantial investments such as real estate and construction projects were undertaken all across Asia.  This resulted a building boom which has never occurred in Asia before.  Office and apartment buildings were erected all over, with funding made possible through the influx of foreign investments.  So long as the value of the properties would rise, on paper everything is all good.

The nature of these Asian nations exports has also changed from basic materials to high technology products, such as semi-conductors and consumer electronics.  Many companies found themselves borrowing as much as four times their equity to finance new activity.  Governments invested billions of dollars in infra-structure projects and unnecessarily large power generators with the assumption that an economic boom would continue indefinitely. 

Some nations like Indonesia and Malaysia saw their GDP grow by over 16% annually.  Money was being thrown all over the place with little oversight and rational decision making.  Investments in new ventures were based on unrealistic demand projections that were simply not possible thus making the quality of investments poor.  Asian factories were over producing to the point where they were choking on their own supplies.  Moreover, years of excess demand in the property market had been replaced by excess supply.

The Asian meltdown began in Thailand on February 5^th 1997 when one of the largest property developers announced they were no longer able to make an interest payment on an $80 billion loan.  Other developers followed suit and became victims of speculative overbuilding in the Thai property market.  Financial institutions that had easily raised billions of dollars in the international market were also in financial trouble since they were not able to collect interest payments from their clients and can not pay their interest payments to the international investors.  The Thai banks borrowed funds in US dollars at a low interest rate and converted the dollars to local currency (Thai Bhat) and leant these funds at a much higher interest rate earning a nice profit on the exchange rate.  The largest financial institution in Thailand, Finance One declared bankruptcy unable to pay its obligations of over $30 billion.

The Thai Baht was also under tremendous pressure as businesses and financial institutions have to exchange Bahts for dollars to purchase imports and pay their debt.  The currency began collapsing and the Thai government had to intervene and spend $5 billion in their foreign reserves to exchange US dollars to Baht to prevent the currency from collapsing even more.  Interest rates of 12.5% were offered to attract investors to purchase Baht.  The Thai government had used up all of their foreign reserves and was no longer able to prevent the Baht from dropping anymore.  The government was essentially out of money and can no longer finance international trade and offer basic services to it’s citizens.  The Baht lost over 50% of its value versus the US dollar which presented a nightmare scenario for the businesses and financial institutions that originally borrowed in US dollars since it is now 50% more expensive to convert Bath to US dollars.  To make matters worse the Thai stock market lost over 45% of its value since the highs of the mid 1990s. 

The International Monetary Fund (IMF) stepped in July 1997 and guaranteed $17.2 billion in loans but demanded the Thai government to increase taxes, cut public spending, privatize key state industries and close financial institutions that were illiquid.  These demands resulted in laying off 20,000 people and increasing the financial woes of the country. 

Within 5 years all Asian nations rose from the difficulties and began growing again.  Protectionism and financial regulations were put in to place to prevent another crisis.  Today many of these Asian nations are the fasting growing economies in the world such as South Korea and Singapore.

Dot.com Bubble of 2000

The US economy was absolutely booming starting in the late 1990s, and this new craze known as the internet was gaining in popularity by the day.  One of the new features of the internet was the ability for individual investors to buy and sell stock through an online brokerage account.  Meanwhile, internet based companies were popping up every day and investors were buying their stocks without fully understanding what the companies even do.  “prefix investing” was the term used to explain how virtually any company with a “.com” in their name saw their stock prices flying up.  Wall Street investment banks were under-writing IPOs at an extremely fast rate, even for companies that did not earn a profit or even have a revenue stream.  It didn’t matter for the Wall Street giants since most firms had a brokerage service that falsely convinced their clients to invest in new ventures.  Xcelera.com was a dot.com holding company that saw its shares rise from 30 cents to $223 in one year.  This represented a 74,000 percent gain and the greatest one year rise of any exchange listed stock in the history of the stock market.  Everyone was making money and stories of people quitting their jobs to day trade made headlines worldwide.  Super Bowl XXXIV featured commercials for 17 dot.com companies, and there appeared to be nothing to stop or even slow down the boom.

The US Federal Reserve increased interest rates multiple times between 1999-2000 and the economy cooled down.  The Nasdaq index peaked on March 10, 2000 at 5,132.52 having more than doubled in a year.  A few weeks later, the poster-boy for the dot.com boom Sean Parker (founder of Napster and later became a key player in Facebook management team) shocked the investment community by stating that he believes within a year the majority of these new dot.com companies will not only show losses but blow through all their cash.  A study has shown that 371 dot.com companies had grown to be valued at over $1 trillion which represented 8% of the stock market.  These are clearly warning signs that the market is highly overvalued.  At the same time Microsoft was found guilty of operating a monopoly in a court hearing finalized on April 3.  The following day the market showed signs of danger and the Nasdaq index lost over 600 points before rallying and erasing almost all losses.  Financial experts claimed that the markets are healthy and the good times will continue.  These reports were conflicted with the fact that six of the last seven trading sessions the Nasdaq index was in the red.  The selling continued and on April 9 the Nasdaq had it’s largest daily point loss, a record it will hold on to for five days before losing 9% on April 14.  The Nasdaq was down over 34% from the record highs seen only a short month ago.  Analysts were still confident in the market:  "I think you'll see healthier and broader advances in the market. Now is the time for optimism," said Bill Meehan, chief market analyst with Cantor Fitzgerald. ¹

Stocks continued to fall as examples of corporate fraud (Enron, WorldCom) and illegal accounting practices to exaggerate profits were brought to light.  The terrorists attack on September 11, 2001 shattered investor confidence.  Stocks only began to rebound in 2002 after $5 trillion in market value was lost.  Investment firms that issued misleading reports to investors were fined millions of dollars.  President Bush signed in to law the Sarbanes-Oxley Act of 2002 which was intended to reduce corporate fraud and restore confidence in the stock market for investors.  Stocks rebounded for several years until 2007 when the next financial bubble occurred.

2007/2008 Global Financial Recession

Interest rates were very low in the mid 2000s and there was a tremendous influx of investments to the United States from foreign banks and wealthy individuals seeking new opportunities at a higher rate.  Housing prices were booming over the years and due to the huge quantity of cash available banks began granting mortgages to individuals with low credit scores (sub-prime mortgage.)  The rational behind this was the value of the loan was “secure” because it was backed by an asset (house) that seemed to only appreciate in value therefore the funds are safe.  Million dollar mortgages were handed out to low income families as the total sub-prime lending was valued at over $1 trillion.  Mortgages salesmen were offered incentives to sign as many clients as possible.  Many of these loans had stipulations that only interest payments are due immediately, and actual re-payment does not have to be made for several years.  These mortgages were then sold to Wall Street hedge funds such as Morgan Stanley and Lehman Brothers who now owned on paper millions of mortgages across the country and collected the interest payments.  Foreign banks and investors bought in to hedge funds that held mortgages pouring in billions of dollars.  Everyone was making money and will continue to do so as long as the housing market continues to rise.  Between 1997 and 2006, the price of the average American house increased by over 100%.  Economists who predicted a crash were ridiculed as the mainstream thinking was that the housing market will continue to rise indefinitely.

In 2007 the danger signs started to appear.  Home sales were declining and many individuals were contractually obligated to begin repaying the principle of loans which was not financially possible.  Housing prices were falling and homeowners looking to re negotiate mortgages were unable to receive lower monthly payment obligations despite their homes losing value.  In March many of the largest subprime lenders started declaring bankruptcy, the most recognizable firm Countrywide Financial who lost over $1 billion in 2007.  In June many of the largest Wall Street firms started issuing reports that their mortgage investments are in trouble as delinquencies have risen to the highest level since the previous financial bubble in 2002.  Banks all over the world broke their silence and admitted to holding assets in American subprime mortgages.  Swiss giant UBS lost almost $700 million in third quarter of 2007, while American giant Merrill Lynch announced a $5.5 billion loss which was later revised to $8.4 billion.  Other banks affected included HSBC (United Kingdom Bank), Deutsche Bank (German bank) Societe General (French bank), Bank of China (Chinese bank) ICICI Bank (Indian bank) and dozens others throughout the world. 

2008 claimed the first victims of the financial crisis as JP Morgan JPM bought Bear Stearns for $2 a share which was essentially a fire sale, and two fund managers from Bear Stearns were arrested by the FBI for misrepresentation of their funds which caused investors worldwide to lose billions of dollars.  Bear Stearns had losses of $25 billion and this was the first time in almost 100 years that the bank had reported a loss.  By the end of the year Lehman Brothers filed for bankruptcy protection and Lehman Brothers was acquired by the British bank Barclays for a very cheap amount. 

The United States and other governments worldwide were left with no other option but to inject hundreds of billions of dollars in to the slumping economies.  Most famous of which was the $700 billion bailout by the United States for the large banks that were affected.  There was mass panic and fear that spread beyond the financial sector.  Investors sold any stocks they held and found refuge in commodities such as gold and silver.  By October American stocks had lost over $8 trillion in value.  Stock markets worldwide were plummeting, and any bank that still had capital available were not lending it out even to businesses that had a fantastic track record and verifiable ability to replay the loans.  By 2009 the worst of the financial crisis was over and the world saw a recovery.  By 2009 it was reported that the vast majority of stock markets worldwide were at least 75% higher than they were at the peak of the financial crisis.  It was announced in June that the recession officially ended earlier than originally expected.  By January 2010 the United States government has recovered the majority of the funds committed to aid troubled institutions.  By 2011, the markets were stable and for the most part the signs of a global depression had vanished or drastically reduced.

.