Three Financial Crises That Left a Dent in the World.
What were they? Why did they happen? And what have we learnt from them?
The 1929 Stock Market Meltdown.
The autumn of 1929 witnessed the biggest stock market crash in history with people losing billions and opening the path to the longest economic depression in the industrialized world. When it comes to duration and aftermath, it is even bigger than the 2008 financial crisis.
The years after the first world war were characterized by wealth and a rise in industrial production and growth which were naturally accompanied by a rising stock market fuelled with speculation that didn’t truly justify the current fundamentals. A bubble is defined as an unjustified rise in market value. But before discussing the crash and the aftermath, we have to discuss the main causes that led to this crisis.
- Overheating economy.
Overheating, overconfidence, and overproduction were three words to describe most of what was happening. First of all, the unjustified rise in stock prices meant that the buying of the shares was purely for speculative reasons. The buyer didn’t really care about the prospects of the company in a few years, he was only looking to join the party with everyone else. Of course many industries beforehand showed increases in profits (namely, steel production and railway), but people went overboard with the buying activity. Second of all, overconfidence of market participants led to the fact that they didn’t have a plan B in case there was a crash, everyone was sure that markets will continue to go up forever. And third, industries were overproducing products which led to a glut. This means that the excess supply will force prices lower and thus companies suffered.
- Easy credit.
This is self-explanatory and everytime we see the word easy credit, we know that there is trouble ahead. During the years leading up to the crisis, there was a huge growth in bank credit and loans. Buying on margin also fuelled this bubble as it is the act of borrowing money from stockbrokers while providing very little collateral.
- Interest rates.
Weeks before the crash, the Federal Reserve raised interest rates from 5% to 6%. Rising rates means costlier borrowing costs for companies, thus, lowering profitability and economic growth. Jobs can also be lost due to the impacted earnings.
- A fuel from the London Stock Exchange.
Days before the the US stock market crash, a top British investor named Clarence Hatry and some of his associates were jailed for fraud, prompting the London Stock Exchange to crash and infecting its American peer with pessimism. By this time, it was very unstable and so any bad news could have a magnified negative effect.
As is the case in every crisis, panic amplifies the negative effects and worsens the impact. Amidst the panic and the crash, people started to withdraw their funds from banks (or tried to). This effect led banks to fail even quicker than one would expect
Needless to say, stocks started to gradually decline until October, 1929, where the fall grew more serious. During that time, panic started to further amplify the effects and even though big investment companies and banks tried to stabilize the market by buying shares, the market didn’t stop there and kept heading south.
The 2000 Dot Com Bubble.
A new era was on the horizon. The internet has presented limitless opportunities to revolutionize the world of business and many wanted to join in either through an enterpreneurship spirit (1 in 7 Americans said they were building a business in a survey in 1999) or through acquiring stocks of internet-based companies.
Now, to put things into perspective, what caused the bubble? The answer is excessive speculation from both institutional and retail rades in internet-based companies. The 1990s saw an explosion in internet companies which prompted market participants to buy these shares in anticipation of a further appreciation. By disregarding the fragile fundamentals, people kept buying into the bubble until it was no longer sustainable. Hence after rising about 400% during the mid-90s, the NASDAQ composite found its doom during the beginning of the new millenium by losing around 80% of its value.
NASDAQ Composite leading up to 2000–2002 where it peaked.
The promise was that we will be moving into an economy that is based on information technology and if you were one of the first ones to invest, then you would’ve become rich by being at the beginning. The stock market culture in the United States further fuelled many to invest their savings into a field that is not very well-known to them. but why were there many internet companies?
Well, aside from the technological revolution, venture capital funds were practically investing everywhere. Investment banks that led IPOs also tried to spark more speculation and buying so that they make more money on their exit.
The issue wasn’t that the companies were bad, but it was due to the fact that they were fragile and badly managed. For example, some companies spent an enormous amount of their budget on Marketing expenses and have neglected their main business. It was a race to be noticed and cash out as soon as possible. The revolution happened at an astronomical speed and this is one of the first signals of a bubble. Of course, in hindsight, this is very easy to say and had we been given the opportunity to invest in the 90’s we would have done it.
The term irrational exuberance surfaced in December 1996 by Alan greenspan the then Fed’s chairman. This is just another word to say “Buying without fundamentals to justify the decision”. Of course, having coined that term, Alan Greenspan didn’t do much about the markets until 2000 where he decided to raise the interest rate and decrease money supply. A tight monetary policy is supposed to cool down an overheating economy by trying to decrease inflation through interest rates and money supply. Remember, a higher interest rate discourages businesses from borrowing money to conduct their operations or to open up new businesses.
Not all companies were bad. Some were solid companies founded by very smart people. We still have Amazon, Oracle, Ebay, Intel, etc. But other companies were absolute failures such as Pets.com and Webvan.com. Some investors were smart enough to allocate most of their internet-related funds to the solid companies but other were unfortunate enough to place all their baskets into the failed ones.
The moral of the story is that you should never forget fundamentals. It is what actually makes prices go high or low over the long-term. You cannot expect to invest in something without understanding its prospects. There is another term for that, it is Gambling.
The 2008 Global Financial Crisis.
Greed is good, right?
Well, not really. The consequences of that greed are still present nowadays. But what was the cause of the global financial crisis in layman’s terms?
It all started in AIG, the American International Group. As flows started to pour into the US in the early 1990’s, domestic banks had a lot of cash that wasn’t really moving so, they have decided to start lending this money at looser rates. Most people could get home loans that were previously unattainable.
The banks simply took the properties (houses) as collateral which is the normal thing to do. The bottom line is that Americans could buy homes even if they couldn’t afford to. How was the “couldn’t afford to” state evaluated? Simply, by individual credit scores, which tell you how likely the applicant will pay back the loan. However, too much money lying inside the banks meant that they could take the added risk and this prompted the creation of subprime mortgages. Knowing that these loans were carrying too much risk, banks started packaging them up into more exotic products called CDOs — Collateralized Debt Obligation. They would then sell these products as diversified (remember they did contain bad loans but they were different bad loans). Buyers went wild for these financial instruments; little did they know how toxic they were.
By selling these products, banks got back their money much quicker than if they have waited for the loan to be completely repaid (if ever). The problem did not stop there, buyers were not that stupid and demanded some form of guarantee, so, banks ensured payment through insurance companies. Now, naturally, since these products were risky, buyers bought them at a discount and knowing that they are insured, they have looked for even more risk so as to maximize their returns.
Let’s review what we have so far. The banks have provided an opportunity for lower-income people to buy homes through subprime mortgages, packaged these mortgages in diversified products and sold them to buyers at a discount all while insuring them with insurance companies. But, why would insurance companies accept this? Well, they had a nice vision but rather an incomplete one. What would you say will happen if people kept buying houses due to the fact that banks gave them this golden opportunity? Housing prices would go up, right? This is the main reason. People started to flip houses rather than occupy them.
Even if someone could not repay their house now, they can just wait for a couple of years and actually sell it at a hefty profit. People who could not afford houses were not only buying them but actuall yselling them at a profit. This caused the prices to skyrocket. Insurance companies saw this as an opportunity to charge greater premiums and were actually making lots of money alongside the banks, so the music was still playing.
AIG is the largest insurance company in America that has roots all over the world. They had the biggest exposure to CDOs underwriting and buyers of CDOs were sure that AIG would pay them back in case the products default. AIG was swapping the bad ratings of the CDOs through its reputable rating by underwriting them and this is known as a CDS (Credit Default Swap). These products were in high demand and made lots of money to AIG. But the insurance conglomerate did not have reserves equivalent to the possible payouts in case of default, they have relied on some shady probabilistic measures which is a fancy way to say, that won’t happen to us.
They have also used some accounting manipulations to hide this. By 2007, the bubble finally burst and borrowers defaulted because they could not sell their houses at a profit anymore and had no actual income to repay their mortgages back. This chain reaction led to the mass default of the different CDOs. The final result? AIG defaulting on its insurance, and thus, many banks relying on AIG for providing the insurance went bankrupt. Lehman is the most famous example of this. In the aftermath, AIG was bailed out by the US government because letting it fail was simply going to be too catastrophic, it however, turned its back on Lehman brothers.
Still, the result of all of this fancy talk is that millions lost their jobs and homes. Hopefully, this type of greed will be controlled in the future but as history tells us, we will always be creative in finding new mistakes.