A History of the United States in Five Crashes: Stock Market Meltdowns That Defined A Nation

Scott Nations, “A History of the United States in Five Crashes: Stock Market Meltdowns That Defined A Nation,” Harper Collins, 2017, 302 pp.

In writing about the five significant stock-market crashes of 1907, 1929, 1987, 2008, and 2010, CNBC contributor and investment professional and author Scott Nations presents a comparative history on how these crashes occur and some common elements in all crashes.

The Panic of 1907: When the Knickerbocker Trust Company failed, after a brazen attempt to manipulate the stock market led to a disastrous run on the banks, the Dow lost nearly half its value in weeks. Only billionaire J.P. Morgan was able to save the stock market taking the place of the not yet formed Federal Reserve.

Black Tuesday (1929): As the newly created (1913) Federal Reserve System repeatedly adjusted interest rates in all the wrong ways, investment trusts, the darlings of the ‘20s, became the catalyst that caused the bubble to burst, and the Dow fell dramatically, leading swiftly to the Great Depression.

Black Monday (1987): When "portfolio insurance," a new tool meant to protect investments, instead led to increased losses after corporate raiders drove stock prices above their real values, the Dow dropped an astonishing 22.6 percent in one day. (I well remember that day.  One of my employees was only weeks away from retirement and his face was very contorted as the news developed.)

The Great Recession (2008): Various financial contraptions severed the link between the borrower and the ultimate lender of mortgages and credit cards. Without that link, there was no reason to self-regulate as Alan Greenspan maintained free-markets do.  As homeowners began defaulting on mortgages, investment portfolios that contained them collapsed, bringing the nation's largest banks, much of the economy, and the stock market down with them.

The Flash Crash (2010): When one Chicago investment manager, using a runaway computer algorithm that was dangerously unstable and poorly understood, reacted to the economic turmoil in Greece, the stock market took an unprecedentedly sudden plunge, with the Dow shedding 998.5 points (roughly a trillion dollars in valuation) in just minutes.

This book fills in the stories behind above listed great crashes, and others.

In studying the stock-market crashes of 1907, 1929, 1987, 2008, and 2010, CNBC contributor and investment professional Nations offers a comparative history of how crashes occur. For the 1907 panic, he details the backdrop of the San Francisco earthquake, President Theodore Roosevelt's trust-busting campaign, and the poor capitalization of the burgeoning trust company sector. He explains that all it then took to spook investors and crash the market was a mistake by one of the trust companies. For each ensuing financial disaster, Nations similarly lays out the root causes, profiles the central actors, and offers a fast-paced narrative of the events leading up to it.

Analyzing the five events, the author concludes that the triggering mechanism in each was a poorly understood financial innovation that, when stressed, spiraled out of control, tearing the over-valued markets apart.

My Notes:

Pg. xi:  The stock market will crash again and all crashes are strikingly similar.  They share important phenomena, including steep appreciation in the stock market.  Two-year periods of particularly aggressive buying inside a robust decade are common just before most crashes.  Less obvious commonalities also appear, including new financial contraptions that we are (overly) confident we understand, only to learn that they inject uncertainty and leverage into the stock market at its weakest moment.  The government generally waits too long before intervening, having waited until the financial stresses are finally too much for their constituencies. 

Pg. 6: Trusts.  In 1898 a new corporate form was wedded to the corporate trust when New Jersey began allowing one corporation to own stock in another.  By 1904, 318 corporate trusts were dominating the business world. 

Pg. 18:  The 1906 San Francisco earthquake was the catalyst for the Panic of 1907.  Sixteen days after the earthquake, Teddy Roosevelt resumed his battle against the trusts, this time focusing on Standard Oil, accusing Standard Oil of benefiting from secret rate deals with railroads. 

Pg. 87:  As 1928 ended, 12.3 percent of Americans owned stocks or bonds, possibly through one of the 186 new trusts formed that year.  The Dow had gained 90.8 percent from 1927 through ’28.  By September 3, 1929, the Dow closed at 381.17.  It had nearly quadrupled during the 1920s and would not reach this level for 25 years.

Pg. 114:  Monday, October 28, was the worst day the American stock market had ever experienced.  Tuesday, October 29, was the second worst.  Neither day would be surpassed until October 19, 1987, and neither has been passed since.   The Dow which had been up as much as 271. Percent, closed 1929 down 17.2 percent, falling from 381.17 to 41.22 on July 8, 1932.

Pg. 115:  The Federal Reserve System had been built in response to the Panic of 1907.  The Crash of 1928 would lead to the Securities Act of 1933, which required that issuers provide disclosures about securities being offered for sale, and which prohibited market participants from willful deceit in the sale or trading of securities.  The ’29 crash also led to the Securities Exchange Act of 1934, which created the Securities and Exchange Commission.

Pg. 118:  A put option is bought with a premium payment to protect against a stock price dropping, the put ensures you can sell your stock at a predetermined price.  From this concept would arise portfolio insurance which eventually led to the 1987 stock market crash.  The creators, Leland and Rubinstein had to take into account certain assumptions Black and Scholes had made about how the financial world worked.  The most glaring assumption was that the stock prices moved smoothly.  A second was that interest rates and the volatility of the stock were constant through time.  A third was that there were no transaction costs.  Lastly, that trading in this insurance would not itself affect the stock price.  This product was created in 1979 and would not metastasize until 1987.

Pg. 122:  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.  In 1907 it was the trust company, a hedge fund dressed as a savings and loan.  In 1929 it was the levered investment trust, a massive stock market wager with little room for error.  Portfolio insurance was another of these contraptions (1987 crash), though it would take more than a decade to metastasize when they were married to futures contracts. 

Pg. 123:  The 1970s had been dismal for the stock market.  The Dow ended the decade a measly 38 point, or less than 5 percent, above where it had ended the 1960s.  The Dow closed at 7777 on August 12, 1982, and was below the closing level from 1964.  Investors didn’t know it at the time but this was the bottom, it would only go up from here.  The bull market began in 1982. 

Pg. 133:  Futures contracts are standardized agreements made on an exchange to buy or sell an asset, such as the S&P 500 index, at a price agreed on today but with delivery and payment made later.  Since delivery and payment is pushed to a predetermined later date, only a small payment is initially due, making futures the perfect instrument for speculation or hedging.  It turned out that selling futures, instead of the specific stocks in a client’s portfolio made it much easier to execute portfolio insurance, by replicating a protective put option on the S&P 500 index.

As early as 1983 Bruce Jacobs, a Ph.D. working for Prudential, pointed out that if a large number of investors utilized the portfolio insulation technique, price movements would tend to snowball.  

Despite this warning, portfolio insurance would grow about ninety-fold by October 1987, when the snowball started downhill.  (In June 1987 calculations showed that in certain circumstances a stock market drop of just 3 percent would require selling S&P futures contracts in an amount that would be the equivalent of an entire average day’s trading on the New York Stock Exchange.  What had begun as an elegant idea had grown too large to work.)

Pg. 135:  Michael Milken at Drexel in 1984 convinced Drexel to underwrite and sell junk bonds for companies that had never been able to sell bonds before because they weren’t considered ‘investment grade.’  Milken understood these new bonds could support the sort of speculative takeover that was fueling the stock market’s rise.  This would grow into billions of dollars.  Thirty bills were introduced into Congress in 1984 and ’85 meant to regulate takeovers.  None passed.  The investment banks led by Drexel were making a lot of money, enough to lobby these bills to death.

Pg. 163:  On October 19, 1987, the market crashed.  Corporate Raiders like Ichan and Pickens had come to understand the unseen value in some companies, then bid them beyond the sustainable value of their cash flows.  The Dow had lost 508 points, a 22.6 percent drop, becoming the worst day the American stock market has ever had.    The year had begun with the longest winning streak the American stock market had ever known, it would take two years to recover.

Pg. 179:  Prior to 1981, adjustable-rate mortgages were illegal.

Pg. 181:  In 1983 the Federal Home Loan Mortgage Corporation (Freddie Mac) assembled a pool of mortgages and then split it up into risk levels (tranches).  The first tranche to be paid was the least risky and offered the lowest interest rate.   Even though they were considered extremely safe, they paid more in interest than Treasury bonds.  Now even pension plans could invest in these safe vehicles.  Now a mortgage lender no longer had to stash every mortgage in its vault for thirty years.  Instead, it could sell them to be bundled into mortgage-backed securities that would then be sliced into tranches, with the tranches again sold to investors. 

Pg. 182:  On March 23, 1989, the Valdez sailed from Alaska.     When it went aground, eight of its eleven cargo tanks ripped open.  More than 10.5 million gallons of crude oil poured out.  The financial contraption created in response to Exxon’s liability would result in a different kind of damage nineteen years later.  In anticipation of paying a $5 billion fine for the mishap, Exxon borrowed $4.8 billion from JPMorgan.  Even though Morgan wasn’t worried about Exxon paying it back, a bank, like Morgan, was required to sequester capital to cover the small but real risk of default.  In this case, they had to set aside an additional $384 million in reserves—money that would be sitting idle, not earning a nickel, instead of being lent out to others who would have been charged 7 percent interest, about $26,9 million a year.  So, the credit default swap was invented.  Morgan would pay an ‘insurance premium’ less than what they could earn and be released from the need to maintain a reserve.  In this case, the premium payment was made to the European Bank for Reconstruction and Development (EBRD).

By 1997, it seemed that every bank had caught on and had begun peddling its own version of the credit default swap.  They began bundling groups of debts, thus providing the famous ‘diversification’ that the credit rating agencies liked so well.

Pg. 189:  Subprime lending started relatively slowly; of mortgage loans made in 1994, subprime loans totaled just $34 billion, less than 5 percent of the total.  Then in 1995, Clinton launched his National Homeownership Strategy, and by 1996 subprime loans totaled $70 billion—9.5 percent of the market.  When Clinton left office, subprime loans reached $160 billion.  At this same time, JPMorgan was approached by a German Bank that wanted Morgan to structure $14 billion of American mortgages that it wanted to insure (i.e. a CDS on the tranches of bundled mortgages).

Pg. 200:  Whereas Clinton had required at least 3 percent down payment on mortgages, Bush proposed 0 percent down.  Bush hoped this would create an additional 5.5 million minority homeowners during the next six years. 

Pg. 209:  Prior to 2000, the rating agencies were the referees of the bond world.  Then on October 4, 2000, Moody’s was spun off from Dun & Bradstreet in an IPO and became a publicly owned, for profit, business.  Moody’s market share went from 43 percent to 78 percent in its first full year (2001) as a publicly held corporation.  Moody’s even asked the banks which of their analysts were troublesome.

Pg. 212:  Every modern stock market crash has been fueled by a new financial contraption that was poorly understood and that metastasized at the worst moment.  

Pg. 215:  In 2004, 11.2 percent of all subprime mortgages were defaulting in the first twelve months.  In 2005 it reached 16.2 percent.  But in 2006, 23.8 percent of subprime mortgages defaulted in the first twelve months, more than double the number of just two years before.  Also, in 2003 subprime had still been less than 10 percent of the total mortgage origination market, by 2005 it reached 22.7 percent.

Pg. 219:  On July 19, 2007, the Dow closed at 14,000 for the first time.  When 2008 came to an end, the Dow was at 8776, down 33.8 percent for the year.  The bottom finally came for the Dow on March 9, 2009, when it closed at 6547, 53.8 percent below the all-time high in 2007.

Pg. 226:  The total amount of US mortgage-related securities outstanding at the end of 2007 was $9.4 trillion.  A product that hadn’t existed twenty-five years earlier was now half the size of the entire US stock market.

Addenda:

The 2008 stock market crash was fueled by a half-dozen contraptions.  Adjustable-rate mortgages eliminated interest rate risk for the lender by teasing the borrower with a low rate for the first few years that could go much higher later, a potential shock that many mortgage originators were not explaining and many buyers didn’t understand.  The Pick-a-Payment scheme allowed too many borrowers to pay less than a full monthly mortgage payment, money that was likely then spent elsewhere when it might have been building equity in a home.  Mortgage-backed securities made sense, but when the bundles of mortgages became a dumping ground for securitizers, underwriting discipline disappeared.  Credit default swaps (CDS): mitigate the risk of their investment by shifting all or a portion of that risk onto an insurance company or other CDS seller in exchange for a periodic fee). 

Flash Crash stuff:

Pg. 249:  By the end of WWI, Greece had accumulated mammoth debts.  It repudiated them in 1932, the fifth default of the country’s sovereign debt in barely one hundred years, in what had become a comic habit.

Pg. 287:  In March 2010, six weeks before the May 6^th Chicago institution of Waddell & Reed unwittingly conspired to crash the stock market, electronic traders were being warned about runaway computer algorithms, allowed to run without human intervention.  In the May 6, 2010, crash, the runaway selling of S&P futures caused the crash.  The Dow lost 1,000 points, closing the day at 10,520.  This became known as the Flash Crash, as three million shares traded at prices more than 90 percent below where they’d closed the previous day in less than twenty minutes.  Securities exchanges canceled 21,000 trades that were executed at unexpectedly low prices during the crash. On June 10, 2010, the SEC voted unanimously to enact new rules which automatically stop trading for any stock in the S&P 500 whose price changes by more than 10% in any five-minute period.