Five Financial Crashes; Is A Sixth Coming?
Scott Nations, founder of an investment company that creates option-based funds, explores the sources of the five largest stock market collapses in American history in his recently published book A History Of The United States In Five Crashes. To be clear, Nations is not talking about ordinary market corrections driven by business cycles. He’s addressing trading market collapses, commonly caused by new, complex, and poorly understood investment “contraptions,” lax regulations, and the lack of market liquidity caused by too much selling too quickly. He makes a compelling case that human ingenuity, coupled with greed, is likely to continue to keep the financial industry ahead of regulators, maintaining the potential for such a problem to recur.
The proximate cause of the first crash, the Panic of 1907, was newfangled trust companies (the precursors to today’s investment banks). Operating outside banking regulations, they made illiquid and highly leveraged investments without maintaining adequate reserves. Many of their owners were greedy pirates bent on amassing as much wealth as they could get their hands on, legally or otherwise. Charles Barney, Otto “Fritz” Heinze, and Charles Morse were among the perpetrators whose maneuvers, when finally exposed to the public, caused a run on the Knickerbocker Trust Company and others that ultimately drove the Dow down to close to half its starting value in a matter of weeks and resulted in its second worst-ever annual loss of 37.7%. It took a private citizen (J.P. Morgan) to stop the panic by coercing bankers to lend millions of dollars to keep some key firms from running out of money and end the run.
The Crash of 1929 had similar antecedents. The trust companies had morphed into investment trusts, allegedly much safer because they promoted investment diversification. But this time there was a new government regulator on the scene, the Federal Reserve Board, having been created in the wake of the Panic of 1907 to help manage credit. Unfortunately, instead of tightening up on interest rates to reduce speculation, Ben Strong, the Fed Chairman, did exactly the opposite. This helped to exacerbate the decade’s growing investment frenzy, much like adding fuel to a fire. The ultimate catalyst for the crash was Clarence Hatry, a British war profiteer, who had issued counterfeit stock certificates in a bid to take over a British steel company. After his machinations came to light, and three London brokerages had failed, U.S. investors began to wonder about the value (not to mention authenticity) of their own stock certificates. The culmination was the Dow’s 12.8% plunge on Monday, October 28th, 1929, until that time its worst one-day drop ever. The Dow went on to fall 17.2% in 1929, 33.8% in 1930, 52.7% in 1931, and 23.1% in 1932, ushering in the longest and most severe depression the U.S. had ever seen. (Nations additionally faults Andrew Mellon, U.S. Treasury Secretary, for doing nothing to help.) It would take 25 years before the Dow was able to reach a new all-time high again.
Black Monday (October 19th, 1987), when the Dow experienced its biggest one-day drop in history (22.6%), was caused by several factors. The “new contraption” was portfolio insurance, a synthesized “put” option created by Hayne Leland and Mark Rubenstein that enabled companies to invest more in stocks in the belief that they were hedging their risk. This was also the era of the corporate raider and the leveraged buyout, whose actions helped to drive stock prices to higher and higher (some would say artificial) valuations. By 1987 prices were rising on mere speculation of takeovers, and Congress was proposing legislation to make them much less attractive, causing investors to fear that the tap was about to dry up. On October 19th, after the U.S. started shelling Iranian oil platforms in the Persian Gulf in retaliation for a missile attack on a U.S. tanker, sell orders from the portfolio insurance hedges began to pile up, overwhelming the exchange systems. Leo Melamed, Chairman of the Chicago Mercantile Exchange clearinghouse, was the hero of this event, exhorting (in the middle of the night) the firms that owed money on trades to pay up immediately so that the clearinghouse and consequently the NYSE could open the next day. Without his efforts, nervous investors might very well have turned the one day drop into a protracted rout.
The meltdown of 2008 we all know well. Mortgage-backed securities (MBS), which had become largely detached from the underlying credit worthiness of their holdings, and credit default swaps (CDS) designed to offload counter-party risk, were the newfangled devices that set the market up for failure. In particular the sellers of the latter viewed them as free money since they never believed that they would ever have to pay out. The bankruptcy of Lehman Brothers was the catalyst. And again, the regulators contributed to the problem. Alan Greenspan (Fed Chairman) was vilified for failing to rein in the rampant mortgage abuses. His response: those who “believed lending institutions would do a good job of protecting their shareholders are in a state of disbelief.” Nations also blames the ratings agencies, and I couldn’t agree more. The problem, though, is that as long as they make their money from the very same firms that benefit from their ratings, this risk will persist.
Lastly, there was the so-called flash crash of May 6th, 2010. Waddell & Reed, fearful of a Greek default, decided to sell over $4 billion of S&P futures in a very short time using an automated trading algorithm created by Barclay’s. Unfortunately, the algorithm was flawed: it assumed that increased volume was a sign of increased liquidity. This is never the case when sell orders vastly exceed buy orders. The result was trading system gridlock, with the Dow losing over 1000 points during the day and a number of stocks losing almost 100% of their value before the systems were able to catch up and refresh their prices.
Will there be another crash? All but one involved panicked investors desperately trying to sell lots of stocks all at once. This herd mentality, intensified by the media, is likely to occur again barring any change to human nature. So, too, is the greed that investment bankers have demonstrated in the past when given free rein. And as trading volumes increase, Nations asserts that safety will continue to take a back seat to speed. Until the U.S. government recognizes that the risk exceeds the benefit of having the financial industry earn tons of money, a sixth crash is all but inevitable.