The current financial crisis is often compared to the Great Depression of the 1920s. Both originated in the United States and their effects were and are felt throughout the world. Do these two crises have something else in common besides their place of origin? The answer to this question is a resounding yes. The crises were both preceded by a stock market crash caused by a credit fueled asset price bubble; the stock market bubble in 1929 and the housing price bubble in 2008.
During the 1920s, the United States of America experienced a decade of prospering technologies such as radio, film, automobiles and electricity grids. At the same time there was a growth in the mass production of consumer goods that made life easier for the average American. Everyone wanted to have a refrigerator and a vacuum cleaner. Because of the all-round feel-good atmosphere in these years, widely known as the Roaring Twenties, people did not hesitate to buy these household appliances. Due to their positive outlook on the future they were even prepared to buy them through installment plans (O’Callaghan, 1990).
The same concept could be seen taking place in the banking world. It was during the 1930s that ordinary Americans started investing their money in stocks. Like with the household appliances, people started buying stocks with borrowed money; this is called buying on margin. Investing in the stock market became almost like a popular pastime and more and more ordinary men wanted to be a part of this, resulting in a stock market bubble (Hovde & Meyer, 2009).
The larger part of the stock exchange, however, remained in the hands of a wealthy few. Among them were William C. Durant who was the founder of General Motors, Jesse Livermore, and Charles Mitchell (Klein, 2001). Since the stock market was not at all regulated at that time, because President Coolidge (and later Hoover) was greatly opposed to this (Sobel, 1998), these large stock holders were able to influence the stock exchange by pooling money and buying a large amount of stocks driving the price of the stock up (Klein, 2001). Once the price was up, they sold these stocks to the gullible public, who would eventually come to realize that they had paid – often on margin – more for the stocks than they were actually worth. As a consequence, the value of the stocks went down eventually resulting in the making of margin-calls.
Meanwhile, the Federal Reserve Board, whose job it was to keep an eye on the financial system, made their qualms about the current circumstances known. They were mostly worried about the fact that large amounts of stocks were bought on margin. As a matter of fact, without the borrowed money, it was no longer possible to buy stocks and keep the stock market afloat. Their worries, in turn, caused people to start to sell their stocks (Hovde & Meyer, 2009). When the market started to get shaky on October 24 of 1929 (Black Thursday) a panic ensued; people started selling their stocks en masse. On October 29 the stock market crashed, in effect putting this day in the history books as Black Tuesday. This crash became known as the Great Crash of 1929 (Stock market crash of 1929, 2001).
The United States Senate issued the Levin-Coburn Report that stated that the stock market crash of 2008 and the resulting financial crisis were caused for a large part by a credit fueled housing bubble (Permanent Subcommittee on Investigations, U.S. Senate, 2011). This housing bubble started with President George W. Bush’s American Dream Downpayment Assistance Act which would make home-ownership possible for low-income minorities in the US (HUD.GOV, 2011).
First of all, where a down-payment used to be necessary for getting a mortgage, the down-payment would now be paid with American tax payers’ money. Government sponsored enterprises like Fannie Mae, Freddie Mac and Home Loan Banks agreed to buy more loans made by American banks to African-Americans, Hispanics and other minorities (President G.W. Bush, 2002). Secondly, teaser rates – interest rates that were low at the beginning and would gradually increase during the runtime of the mortgage – were also offered and more people, who at first weren’t able to afford a house, started buying houses on so-called subprime mortgages. Thus, the housing demand was artificially increased; creating a credit fueled housing bubble (Sanders, 2008).
Banks giving out the subprime mortgages pooled them together in mortgage backed securities (MBSs). These were then sold to investment banks, which kept some of these MBSs and sold the others to investors. The home-owners essentially no longer owed the banks the money for their mortgage but they owed the investors. This caused the banks to feel less responsibility for the mortgages they gave out and to relax their rules regarding mortgages, making it even easier for low-income families to get a mortgage (Morgenson, 2007).
After some years, when the teaser rates had become regular rates, a lot of the people owning houses on subprime mortgages were no longer able to afford their mortgage and had to foreclose (Sanders, 2008). This, in turn, made the value of the MBSs drop, rendering the assets of some of the large investment banks worthless. These banks, like Bear Stearns and Lehman Brothers, were then unable to get any new loans or to pay off old loans, resulting in their collapse and the crash of 2008 (The Financial Crisis of 2008, 2011).
In conclusion, the buying stocks on margin and the taking out of subprime mortgages together with the malpractices of some key financial players have caused credit fueled asset price bubbles and, in turn, stock market crashes in the United States. The person who said that history doesn’t repeat itself was clearly mistaken. The expression “once bitten twice shy” clearly doesn’t apply to the financial market.
References
- Hovde, E. & Meyer, M. (Producers). (2009). The Crash of 1929. [The American Experience]. Arlington, VA: PBS.
- HUD.GOV U.S. Department of Housing and Urban Development (2011). American Dream Downpayment Initiative. Retrieved from http://www.hud.gov/offices/cpd/affordablehousing/programs/home/addi/
- Klein, M. (2001). Rainbow’s End: The Crash of 1929. New York: Oxford University Press.
- Morgenson, G. (2007, March 11). Crisis looms in market for mortgages. The New York Times. Retrieved from http://www.nytimes.com/2007/03/11/business/11mortgage.html?scp=2&sq=mortgage- backed+securities+financial+crisis&st=nyt
- O’Callaghan, B. (1990). An Illustrated History of the USA. Harlow: Pearson Education Limited.
- Sobel, R. (1998). Coolidge and American Business. Retrieved from <web.archive.org/web/20060308075125/http://www.jfklibrary.org/coolidge_sobel.html
- Stock market crash of 1929. (2011). In Encyclopædia Britannica. Retrieved from http://www.britannica.com/EBchecked/topic/566754/stock-market-crash-of-1929
- Permanent Subcommittee on Investigations, U.S. Senate. 2011. Wall Street and the Financial Crisis: Anatomy of a Financial Collapse.
- President G.W. Bush’s 2002 speech at the Conference on Minority Home Ownership at George Washington University [transcript]. Retrieved from http://www.freerepublic.com/focus/f-news/2094023/posts
- Sanders, A. (2008). The subprime crisis and its role in the financial crisis. Journal of Housing Economics, 17, 254-261. doi:10.1016/j.jhe.2008.10.001
- The Financial Crisis of 2008: Year In Review 2008. (2011). In Britannica Book of the Year, 2009. Retrieved from http://www.britannica.com/EBchecked/topic/1484264/Financial-Crisis-of-2008-The
