By Steven Albrecht
Before 2001, when the words “financial crash” were mentioned, most investors would think of 1929, The Great Depression. Few think of 1987, 1907, or 1825. Now, thoughts of 2008 are more in the forefront of people’s memories. In each case, investors thought this time was different. After it was over, they turned to governments to take steps to prevent the next great crash. I have been looking at the events that took place prior to each of these crashes and believe there is a common thread. Unfortunately, the thread does not identify a specific quantitative value that once exceeded triggers a crash. There is also no specific time interval in which a correction must take place such as every 10 or 15 years. However, there is a repeated occurrence that stands out in each of the financial crashes that I find interesting.
Let’s first move back in time to 1825, to England where since 1820, British bonds, called gilts, had been offered as safe investments and had had correspondingly low yields. They were safe and boring. In other parts of the world, yields were much higher, and it was well known that the risks were higher, as well. These risks were associated with a lack of good information about the bonds being offered.
Boring started to dwell on investors, and they wanted higher returns. Foreign bonds appeared to offer such an attraction. In 1822, Columbia, Chile, Peru and Mexico were offering bonds on the London Stock Exchange that offered higher yields and successfully placed over 21 million Sterling or what would equal $2.8 billion in current US$. Information on foreign bonds was poor and limited, but yields were great. Investors were ignoring the fact these investments were speculative and poured more money into Russian, Prussian and Danish bonds. Investors were so desperate to improve yield, that one bond was sold successfully for a country that did not even exist.
Spain was the first country to start to weaken from slower economic growth and was on the verge of default in 1823. With Spain in trouble, fear started to spread through the foreign bond market. Investors wanted out quickly. After all, they had planned on seeing this coming and wanted to get out before everyone else. Unfortunately, “everyone else” was ready at the selling desk. Peruvian bonds fell 40% in 1925, as did others. Eventually, the Bank of England had to step in to avert a major collapse, generated from runs on deposits at London banks.
The markets were calm for 30 years, and America started to greatly expand trade with Britain. By 1855, America was already running a $25 million current account deficit. In return, Britain was enamored with American company stock. British holdings of American company stock was approaching $80 million. Railway companies such as the Illinois Central and Philadelphia & Reading were popular investments. They were so popular that several prominent British investors were serving on American railway boards.
There was one problem with the excitement over railway investments; current earnings did not justify the share prices. Almost the entire price was based on speculative, future earnings and the hope to sell in the future at a higher price. The British were not alone; railway investments filtered into American corporate portfolios as well. Ohio Life invested over 63% of their insurer’s assets in railways. This amounted to over $3 million of a $4.8 million portfolio. Prices were hot, and lack of earnings were ignored.
Eventually, around 1857 doubts started to creep in as to whether or not expectations were going to materialize in the case of the railroads. Costs were constantly eating up higher revenues, and money was always being used for expansion and development. Investors were tired of waiting for tomorrow, and selling pressures started in the spring of 1857. Ohio Life was caught in a difficult situation because it had borrowed, thereby leveraging their investments, in hopes of enhancing the future return. It didn’t work. Ohio Life failed and the market grew concerned about bank investments in railway enterprises. If Ohio Life could fail, maybe the banks could fail as well?
By October 1857, banks were starting to see deposit redemptions build due to market concerns with the banks railway investments. As deposits slowed, the banks’ financial strength began to weaken to the point some banks refused to convert deposits into cash. America’s financial system started to collapse. This spread to England because British merchants who traded with American companies began to suffer from late and failed payments. A large lender, Overend & Gurney, eventually failed. The Bank of England refused to step in with a rescue plan. Panic spread across Europe and eventually hit America. Again just as in 1825, speculative investments crept into mainstream investing where earnings should have made a difference.
Moving forward another 50 years America was enjoying growth rates in excess of 5%. By 1907, banks had become very common: the country was populated with 22,000 banks, almost one bank for every 4,000 people. Larger investors were moving into trust companies where deposits could be placed into investments of stocks and bonds. Over the years, even better returns were sought out by including more speculative investment options such as underwriting, property, and management of companies such as railroad enterprises.
Knickerbocker Trust in New York was a favorite amongst the wealthy in Manhattan. In just ten years, from 1896 to 1906, they had grown from $10 million in deposits to $60 million. The trust company had leveraged investments to increase returns even more. Unfortunately, when the economy started to slow in 1906, management started to borrow funds from the banks it managed. Speculation had entered the investment options offered by Knickerbocker. Losses became larger, not smaller, and internal loans increased. Eventually, depositor redemptions started. On the first day, Kinckerbocker redeemed $8 million in deposits but eventually had to stop as it ran out of funds.
Panic spread throughout New York trust companies leading to depositor runs, which began at the largest trust companies such as America Trust and, eventually, Lincoln Trust. The financial system of the U.S. was coming into question, and for protection depositors’ hoarded cash at home removing it from the money supply. Interest rates started to climb and eventually reached 125%. One banker, JP Morgan, decided to create a pool of assets to reinforce confidence in the banking system. It worked for a while but eventually ended as runs spread throughout the country, and GDP fell by 11% in 1908. Speculative investments again had moved into main stream investing as investors ignored dangerous positions to gain returns.
The United States returned to prosperity quickly, and by 1925 Ford was building affordable cars for everyone. Banks were back to earlier levels at 25,000 institutions with $60 billion in deposits. Investments were conservative, placing 60% in loans, 15% in cash reserves, 20% in bonds, most of which were government bonds, and only 5% in stocks.
New technologies were exciting to everyone. Most americans owned a radio, some were traveling by plane and aluminum was making things possible that had never before been contemplated. With these advances, stock investments started to focus on future opportunities rather than on dividends and earnings. New capital was needed to fuel rapid growth in new technology; otherwise, investors and enterprises would be left behind.
At the same time, established companies started to weaken because consumer prices were falling, even while stock prices were rising. The “new” market was chasing the future opportunity and reaching new highs, while the existing market was slowing. Earnings of established companies eventually weakened. The Federal Reserve wanted to slow speculation in the market and in 1928 raised interest rates from 3.5% to 5.0% in an attempt to slow stock speculation. Shortly thereafter, in 1929, the DOW reached a new high of 381. This increase in interest rates did not accomplish what the Fed so desperately wanted.
In October of 1929 an unrelated investment scandal broke out in London, and the British stock market began a rapid decline. Unfortunately, it spread to the U.S. and the Dow dropped from the previous high of 381 to 198, just slightly half of what it had been at its peak. With falling valuations in their portfolios investors’ turned to the banks to redeem deposits. Bank failures started to appear in the Midwest as agriculture-based prices declined. Consumer prices had been falling, and all levels of businesses were under pressure on earnings. Loans which needed to be repaid, were not, and by 1931 bank failures were common and carried into major markets such as Chicago, Cleveland, and Philadelphia.
In an unrelated move, Britain dropped the gold standard in an attempt to gain control of the country’s currency. It was no surprise, except perhaps to England, that the currency devalued. This created another financial blow to theU.S. by hitting export-related companies resulting in further stress on the American banking system. The Federal Reserve started buying bonds to move money into the economy. Eventually, panic started to spread and by February 1933 banks across the country began closing their doors. Interior banks of the Midwest started calling on Eastern banks to retrieve their deposits. This stripped the Eastern banks of reserves and the Eastern banks called on the Federal Reserve. The Federal Reserve refused to lend, and 11,000 banks failed.
The Federal Reserve’s decision to not backstop the banks started a cascading effect of public fear, and the money supply dropped by 30%, reducing economic activity and investment. Unemployment, which escalated as enterprises attempted to wrestle with survival, reached 25%. Again, speculation in new technologies that should have remained a small portion of investors’ portfolios crept into the mainstream as people chased returns. The following events, some directly related, others just circumstance, caused another financial collapse.
In each case, speculation became a main focus of investment portfolios, certainly not by everyone, but by enough investors that it created a potential stress crack in the overall financial foundation. The stress speculation creates may not be the only direct cause, but when the stress is there, sometimes all it takes is one outside event to create the break.
I think it is apparent to most investors that the 2001 “dot. com” crash was created by investors who were chasing new technology and forgot about earnings. Remember the “New Economy”? The same was true in 2008 as investors chased mortgage derivatives without good knowledge of credit quality or repayment. Investors were chasing yield and return. Maybe that was the “New and Improved Economy.”
On their own, none of these speculative investments would have caused the financial markets to collapse, especially on a global basis. What should have been a limited investment became mainstream. In 2000, no one cared about GE, but knew everything about a new start-up with no revenues and no earnings. If the speculative investments had remained limited in portfolios, who knows what the global economy would be today? Investments in new technology might be more consistent rather than all-in or all-out, and, yes, they would still carry risk, but maybe more manageable?