Manias, Panics, and Crashes

History is replete with episodes of manias, panics and crashes. People go crazy and chase assets that are hot and in turn bid up the price to stratospheric levels. All these manias end with a crash. But these crashes were obvious only in the hindsight. In this post I am writing about the crashes that I read about and the ones that I have seen.

1. Tulip Bulbs – Holland (1637)

A tulip is a fat, round and bulging plant that usually flowers during spring. It comes in number of shapes and colors and it is one of the most magical flowers on earth. How much would you pay for it? I can buy 56 tulip flowers for $24.99 today. In Holland at the peak of tulip craze, in March 1637, a single tulip bulb sold for more than 10 times the annual income of a skilled craftsman. In 2011 the median household income in the United States is $50,000. Ten times that is $500,000. This is the price of a single tulip bulb if the bubble happened today. In the book Extraordinary popular delusions – Charles Mackay writes

Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favored clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clothes women, dabbled in tulips.

During the time of mania, a wealthy merchant received a very valuable consignment from Levant. In order to reward the sailor who brought the consignment, the merchant gave him a present of a fine red herring (fish) for his breakfast. The sailor noticed the tulip bulb in the counter of the merchant, mistook it as an onion and grabbed it to eat. The merchant and his family chased the sailor to find him eating a breakfast whose cost might have feed a whole ship’s crew for twelve months. The sailor was jailed for eating the bulb.

The mania finally crashed in 1637.

2. South Sea – United Kingdom (1720)

The South Sea company was formed in the year 1711. It assumed the government debt and in turn was granted a monopoly to trade in the South Seas – South America. The thought was that the shipments of wool can be traded for gold and silver which is abundant in South America. The trade never really materialized as Spain claimed monopoly over all trades in this region. In the end, Spain allowed the company to do exactly one voyage a year. For this the company had to share its profits.

Although unsuccessful in South Sea trade, the company did effectively persuade the British government to approve the conversion of successive portions of the national debt into South Sea Company shares. In January of 1720, South Sea Company stock was trading at a modest £128. Excerpt from Harvard Business School

In an effort to stir up popular interest in the company’s stock, the directors circulated false claims of success and fanciful tales of South Sea riches.

The public in the hopes of getting gold and silver from South America bid up the stock price to extraordinary levels. The price rose 330 pounds in March, 550 pounds in May, 890 pounds in June and around 1000 pounds later in the summer. The story ended with a crash. By September it was down to 175 pounds and by December to 124 pounds. Even Sir Issac Newton lost money in this company. He wrote

I can calculate the movement of stars, but not the madness of men

3. The Great Crash – United States (1929)

America came out victorious in World War 1. During the 1920s – Home Refrigeration, Popup toasters, Automatic Home Dishwashers, Traffic Signals, Radio and Television Broadcasting were invented. In the field of medicine Insulin Injections and Penicillin were invented. This was a great time to be an American. Every one was optimistic about the future.

In 1925 people were making lots of money by speculating on the real estate market in Florida. Excerpt from the book The Crash of 1929

The Florida boom contained all the elements of the classic speculative bubble. There was the indispensable element of substance. Florida had a better winter climate than New York, Chicago, or Minneapolis. Higher incomes and better transportation were making it increasingly accessible to the frost-bound North. The time indeed was coming when the annual flight to the South would be as regular and impressive as the migration of the Canada Goose.

Lots of people were speculating as only 10% down payment was needed to purchase the property. The only intention for the purchase was to sell it quickly for a higher price. In the spring of 1926 the supply of new buyers started to go down. Without the new buyers the prices did not go up any further. To add to the misery in the autumn of 1926 hurricane stuck Florida. Without any income from the property and unable to service the loan the real estate prices had only one direction to go. The bubble burst. The sad part is that people did not learn from this mistake.

Nearly every community contained a man who was known to have taken “quite a beating” in Florida. For a century after the collapse of the South Sea Bubble, Englishmen regarded the most reputable joint stock companies with some suspicion. Even as the Florida boom collapsed, the faith of Americans in quick, effortless enrichment in the stock market was becoming every day more evident.

People were buying stocks on margin. What does it mean? Imagine a stock of a Company X is selling for $100. To buy a single stock you just pay $10 and for the remaining $90 the stock will be held as a collateral by your broker. You are only putting 10% down. For the remaining 90% the broker will charge you an interest. In one year If the stock goes up to $200 then you pay the broker $90 and get to keep $110. Even though the stock doubled your investment grew 11 times ($10 to $110). This is an easy way to riches. But there is a problem. What happens if the stock goes down to $50. Your broker will ask you to pay $40 to cover the loss. People in the 1920s believed that stocks will always go up. Initially the margin interest rates were at 5% and in the 1928 it steadily rose to 12%. This is a lot of return and the companies started to lend money for 12% return instead of producing goods. Local Banks borrowed money from the Reserve bank for 5% and lend it for stock speculation at 12%.

In Montreal, London, Shanghai, and Hong Kong there was talk of these rates. Everywhere men of means told themselves that 12 per cent was 12 per cent. A great river of gold bean to converge to Wall Street, all of it to help Americans hold common stock on margin. Corporations also found these rates attractive, At 12 per cent Wall Street might even provide a more profitable use for the working capital of a company than additional production. A few firms made this decision: instead of trying to produce goods with its manifold headaches and inconveniences, they confined themselves to financing speculation. Many more companies started lending their surplus funds on Wall Street.

Investment Funds were being formed during this time. They are similar to what we call mutual funds in the present days. These funds hold stocks and bonds. These funds in turn issue their own stocks which are traded in the exchange. These stocks were getting traded more than the value of the underlying assets. On top of that all these funds were highly leveraged.

During 1928 an estimated 186 investment trusts were organized; by the early months of 1929 they were being promoted at the rate of approximately one each business day, and a total of 265 made their appearance during the course of the year. In 1927 the trusts sold to the public about $400,000,000 worth of securities; in 1929 they marketed an estimated three billions worth.

The authorities were aware of the speculative bubble. Why did they not act? No one wanted to bear the cause of bursting the bubble. Why take the trouble of being a persian messenger.

President Coolidge neither knew nor cared what was going on. A few days before leaving the office in 1929, he cheerily observed that things were “absolutely sound” and that stocks were “cheap at current prices.” In earlier years, whenever warned that speculation was getting out of hand, he had comforted himself with the thought that this was the primary responsibility of the Federal Reserve Board.

Credit was getting tight and on March 26, 1929, the rate on the call market reached 20 percent. If the money supply had been kept tight then the crash would have happened early. Charles Mitchell head of the National City bank (now Citibank) did not want the crash to happen. He said that National City bank would loan money as necessary to prevent liquidation.

Mitchell’s words were like magic. By the end of trading on the 26th money rates had eased, and the market had rallied. The Federal Reserve remain silent, but now its silence was reassuring.

On September 3rd 1929 Time Industrials index reached its peak of 452. On October 24 1929, called as Black Thursday – identifies with the panic of 1929. Heavy selling occurred across the board. Around 13 million shares changed hands. Many were not able to respond to their margin calls got sold out. Bankers meet and agreed to support the market.

Word had already reached the floor of the Exchange that the bankers were meeting, and the news ticker had spread the magic word afield. Prices firmed at once and started to rise. Then at one-thirty Richard Whitney appeared on the floor and went to the post where steel was traded. Whitney was perhaps the best-known figure on the floor… At the Steel post he bid 205 for 10,000 shares. This was the price of the last sale, and the current bids were several points lower… He continued on his way, placing similar orders for fifteen or twenty other stocks.

Prices stabilized that week. Every one praised the bankers for preventing the crash. Many agreed that stocks were cheap and there will be a rush to buy. President Hoover remarked that

The fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis.

Tuesday, October 29, was the most devastating day in the history of the New York stock market, and it may have been the most devastating day in the history of the markets. During the first half hour sales were at 33 million a day rate. Time Industrials index was down by 43 points. There was no support from anyone. The gains of the entire year got wiped out and the party was over. By mid November 1929 the index went to 224. This is a drop of 50% in less than 3 months. The market did not recover even after this point. It reached 58 points on July 8,1932. The index lost almost 90% of its value from the peak. Given below is the DJIA stock price index before and after the crash.

4. Dotcom Crash – Silicon Valley (2000)

Internet was created by the US military and it made its way into the commercial market in 1995. Lots of people started using it. For the companies it meant that they can get consumers throughout the world. Also it was very easy to start a business in the internet without much capital. There is a story and investors were willing to bid up the price of the internet company stocks to the sky. The party was on. Jason Zweig in the commentary for The Intelligent Investor wrote

In the mid-1999, after earning a 117.3% return in just the first five months of the year, Monument Internet Fund portfolio manager Alexander Cheung predicted that his fund would gain 50% a year over the next three to five years and an annual average of 35% “over the next 20 year”

At this rate $10,000 invested in the fund will grow to $4,000,000 dollars in 20 years at 35%. What actually happened? If you had invested $10,000 in the fund in May 1999 it would have reduced to $2,000 by end of 2002.

Inktomi Corp an internet searching software company IPO in June 1998. At the peak on March 17, 2000 it hit a new high of $231.625. The market capitalization was $25 Billion. It was not a typo. What was the company’s profits? The company never had any profit it was losing money all along. On September 30, 2002 the stock was trading for 25 cents.

Cisco Systems (CSCO) worldwide leader in manufacturing network equipments that connects the internet. During the peak of March 2000 its market capitalization was 555 Billion dollars. By the end of 2001 its market cap shrank to 151 Billion dollars. Investors lost more than 400 Billion dollars.

In 1999 Berkshire Hathaway book value grew only by 0.5% while the S and P 500 grew by 21.0%. Buffett underperformed the general market by 20.5%. In the 1999 letter to shareholders Buffett wrote

Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don’t get into judgments in those fields. … Right now, the prices of the fine businesses we already own are just not that attractive. In other words, we feel much better about the businesses than their stocks. That’s why we haven’t added to our present holdings. Nevertheless, we haven’t yet scaled back our portfolio in a major way: If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price. … Our reservations about the prices of securities we own apply also to the general level of equity prices. We have never attempted to forecast what the stock market is going to do in the next month or the next year, and we are not trying to do that now. But, as I point out in the enclosed article, equity investors currently seem wildly optimistic in their expectations about future returns.

In 2000 Berkshire’s book value grew by 6.5 while the S and P 500 lost 9.1%. Buffett outperformed the market by 15.6%. In the 2000 letter to shareholders Buffett wrote

Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars. … What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising bird less bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen. But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street a community in which quality control is not prized will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

On March 10th 2000 the NASDAQ Composite index hit a peak of 5048.62. On Oct 4th 2002 it was at 1139.90. The index gave up 77% of its value from the peak. On Aug 2nd 2013 the index is at 3689.59. Even after 13+ years the index did not come back to its peak value.

5. Financial Crisis – United States (2008)

Following the dot com crash of 2000 the US economy went into recession. To combat this, Alan Greenspan, chairman of Federal Reserve at that time, kept the short term interest rates very low at 1%. This meant more money was available. Because of this buying homes became easy. Lots of people with good credit were buying homes.The prices of the homes went up. On the other end there were investors with lots of money to invest. Since the current interest rates were low they were not satisfied with the returns.

Banks had an idea. They bundled these mortgages and it sold to the investors. The investors received the mortgage payments made by the home owners as an yield for the investment. Banks got commissions for underwriting these loans. Banks, Investors and the Home owners were happy. Why? Banks were getting their commissions. Investors were getting a decent yield on their investment. House prices are going up.

There were not many people with good credit. This is a problem for the banks as they do not have people to underwrite loans. Banks had another idea. What if you issue loans to people with bad credit. The loans issued to people with FICO score less than 620 is called as subprime loans. Banks started issuing subprime loans. In the book The Crash of 1929 – James Galbraith wrote a foreword about what happened by taking a simple case.

At age 61, after 13 years of uninterrupted unemployment and at least as many years of living on welfare, she got a mortgage. She got it even though at one time she had 23 people living in the house (576 square feet, one bath) and some ramshackle outbuildings. She got it for $103,000, an amount that far exceeded the value of the house. The place has since been condemned… Halterman’s house was never exactly a showcase – the city had since cited her for all the junk (clothes, tires, etc.) on her lawn. Nonetheless, a local financial institution with the cover-your-wallet name of Integrity Funding LLC gave her a mortgage, valuing the house at about twice what a nearby and comparable property sold for… Integrity Funding then sold the loan to Wells Fargo & Co., which sold it to HSBC Holdings PLC, which then packaged it with thousands of other risky mortgages and offered the indigestible porridge to investors. Standard and Poor’s and Moody’s Investors Service took a look at it all, as they are supposed to do, and pronounced it “triple-A.”

The prices of the houses stopped to rise. At some point every speculation had to burst. The borrowers did not have enough inflow to pay their mortgage. This should not be a surprise as they never had a job in first place. They defaulted. The investors who purchased these securities they did not receive any more payments. These losses soon spread to other asset classes, fueling a crisis of confidence in the health of many of the world’s largest banks. Lehman Brothers went bankrupt in September 2008, which resulted in a credit freeze that brought the global financial system to the verge of complete collapse. The central banks had to step in to resolve this crisis. In the 2008 letter to shareholders Buffett wrote

As the year progressed, a series of life-threatening problems within many of the world’s great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.” By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A free fall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear. This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had one occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.

S and P 500 index from the highs of 1561.80 in 2007 went down to 683.38 in 2009. The index was down by 56%. Watch the House of Cards – CNBC documentary which explains the crisis very well.

Closing Thoughts

Shrink the world to a football field. Every few decades matches will be played. These matches are manias, panics and crashes. The players inside the ground are the participants. Each game will be different as the period and the players are different. But the end is very predictable. A pin always waits for the bubble. Bubbles are obvious only in the hindsight. Some of the common themes we can see across all these bubbles are

1. There will be a strong story. The participants will have an amnesia from the previous crash.
2. Social proof and Envy/Jealousy will make lots of people to participate.
3. Middle men and Authorities will be peddling these assets to the gullible public. They operate under incentive caused bias.
4. Participants ignore the base rates and fall victims to the availability cascade.
5. People ignore the asset valuation basics and realize later that anything that goes up very fast regress to the mean.