Fads And Finance — A Disastrous Combination
History fades, memories are lost as those who were the eyewitnesses pass into eternity.
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This October will mark the 95th anniversary of the 1929 Stock Market Crash.
Few people are alive today who remember that event, and most of them were mere children at the time. Unfortunately, that leaves us with financial historians who often use current events to interpret this fascinating history.
An excellent example of this is the Summary presented by Google.
“The 1929 crash was caused by many factors, such as a boom after World War I, overproduction in key industries, increased use of margin for purchasing stocks, lack of global buyers worldwide due to the war, and so on.”
You come away from this explanation with the impression that somehow capitalism was to blame for the Crash, “[economic] boom, overproduction, etc.” Google then blames the lack of “global buyers,” presumably of stocks. It is particularly disingenuous as global stock trading would not happen until the advent of the Internet in the 1990s. Finally, they do touch on “increased margin” as a contributor to the Crash, but as we’ll see, other types of lending, rather than “margin” per se, were the more critical factor.
Wall Street’s Crash
I’ve been very fortunate to have met many Wall Street Veterans who survived the crash. My career began in 1972, 43 years after Black Tuesday when markets lost $9 billion, equal to 1% of the nation’s GDP. Today’s equivalent loss would be roughly $250 billion, or about thirty times an average day’s trading.
Among those veterans was Professor Charles McGolrick, my chief advisor at the New York Institute of Finance. Charlie, as he was known to his many friends on the “Street,” was a young man of 20 some years when the Crash occurred. Like most of his generation, including other stock brokers I would meet and my grandparents, it was apparent that the Wall Street Crash, combined with the subsequent Depression, profoundly impacted their lives. These were the survivors.
It’s essential to put this economic and financial disaster in context. It was a time of relatively poor communication, unlike today. So, while Wall Street was preoccupied with the events at hand, it would be days, sometimes even weeks, before the rest of the nation would comprehend the full ramifications of the street blowup.
Most Americans, at that time, had little understanding of the far reaches of this New York-based financial system. That quickly changed.
It was also a time when the role of the government was nearly non-existent when it came to financial matters. For instance, when thousands of local banks declared bankruptcy because their stock and bonds became worthless, the depositors and the bank shareholders were wiped out. There was no FDIC or other insurance when your bank went belly up; you lost everything.
Entire classes of stocks, once considered among the safest investments, failed. It was particularly true for many of the small, local railroads. Investors had piled into the rails precisely because they had tangible assets: the tracks, the trains, the property. The average American viewed these visible assets as a haven of safety. Unfortunately, that did not prove to be the case during the Depression. Although they possessed substantial assets, that was only of value when the trains were making money. Cut off their freight or passenger volumes, and cash flow dried up. No one wanted a railroad that didn’t carry anything.
America began to realize the far-reaching scope of that far-off stock exchange in lower Manhattan. The country started to see the intimate connection between finance and reality, between the Stock Market Crash and the Economic Collapse.
On Capital Hill, the Representatives were acutely aware of the unfolding crisis. What many had considered just a problem for those “wealthy investors” was becoming an existential threat to the nation.
By the Summer of 1934, the Congress had passed two resolutions (S. Res. 56 and S. Res. 97 of the 73rd Congress). These resolutions authorized a Committee to investigate the Stock Exchanges in buying, selling, borrowing, and lending of listed securities. The banks also deal with securities in financing, borrowing, and distributing securities.
The Senate hired former New York Assistant District Attorney Ferdinand Pecora as the Chairman. A hard-headed lawyer, Pecora was used to dealing with brutal criminals; no one would be beyond his investigation. He even brought the head of the nation’s largest bank, National City Bank (now JP Morgan Chase), Charles Mitchell, to testify before the Committee.
Pecora began to uncover a free-wheeling, open, and often unscrupulous financial system that had gone out of control — a place where a single stock could have multiple loans. “Bucket shops” took investors’ money but never actually purchased the stock. Instead, like a modern-day bookie, they paid off any investor “winnings.” Where “Pools” or “Syndicates” ran the price of stocks to garner public support, only to reverse their position, trap the “little fish,” and scoop up their crooked profits.
Many of these crooked practices had been happening for years; devil-may-care lending by banks and other financial companies was old hat. “Painting the tape” by Pools and Syndicates was an everyday practice. Bucket shops were a standard operation, especially west of the Hudson River.
What made it different this time was that the entire country was now suffering. In the official report to the Senate, Chairman Pecora writes:
“Transaction is securities on organized exchanges, and over-the-counter markets are affected with a national public interest. Directly or indirectly, the influence of such transactions permeates our national economy in all its phases. The business conduct on securities exchanges has attained such magnitude. It has become so closely interwoven with the economic welfare of the country that it has been deemed an appropriate subject of governmental regulation.”
https://www.senate.gov/about/resources/pdf/pecora-final-report.pdf
It was an auspicious beginning. One that would directly contribute to what I consider to be the most essential set of securities regulations. By the time this investigative Committee finished its work, Congress had already passed the 1933 Securities Act, which regulated exchanges; the 1934 Act, which regulated the issuance of securities; and later, the 1940 Act, which regulated Funds.
America Had Learned Its Lesson, Or Has It?
Pecora and his Committee had pointed the way. They showed how indiscriminate lending (leverage), especially in a frenetically charged environment (the Roaring 20s), could create a “Bubble” and, from there, a “Crash.”
It made perfect sense to Professor McGolrick and the rest of the ’29 Crash Survivors. It’s just what they wanted to see. After all, they had been to the other side of the mountain and didn’t like the alternative. All the Crash survivors I met were financially conservative. They welcomed stricter regulation. After all, they survived the Depression by avoiding risk, and anything the government could do to reduce financial risk was a step in the right direction.
There was an old saying about the RAF (Royal Air Force Pilots) of World War II: “There are old pilots and bold pilots, but there are no old, bold pilots.” In the 1970s, I met the ones who made it through. Those traders, brokers, and investors who were the most aggressive (i.e., “bold”) were no longer around. Like a distant Uncle, some lived their remaining days in poverty, having lost everything in the Crash. Some, most tragically, had taken suicide as a way to escape. But no matter how, there were none left on Wall Street who were both old and bold.
The Risk of Financial Leverage
If you take all the problems with the 1920s financial system and roll them in a ball, you’d still not have nearly the problems and issues presented by leverage. For McGolrick and all the rest, it was leverage that crossed the line. That transformed a faraway Market Crash into a nationwide existential threat. After all, without leverage, those unscrupulous speculators and traders would be dealing with just their own money. But with leverage, they were now dealing with everyone’s money.
Today
Currently, the Financial Sector of our economy is more leveraged than ever in the past. In January 2023, the Financial Sector of the US Economy had a total debt exceeding $19 Trillion, a record. (Please note: this does not include Government debt.)
Just like the 1920s, the financial environment of the 2020s will be determined by our ability to manage excessive debt. The focus on financial debt will fall mainly on the nation’s commercial banks and the role of the Federal Reserve. As the mountain of debt grows, the margin of error for the Fed shrinks. Hold interest rates too high or tighten loan requirements too far, and the result could be a financial collapse.
One of the little-noticed triggers for the 1929 Crash was when the New York Federal Reserve Bank raised the Discount Rate from 5% to 6%. Today’s equivalent Fed Funds effective rate is 5.33%.
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