Chapter 12
One Of The Worst
Stock Market Panics In History
The panic of 1901 revolved around an attempted takeover of the Northern Pacific Railroad, and culminated in a battle between the Morgan-Hill and Harriman-Kuhn-Loeb groups for its control.
The 1907 collapse, which later became known as the "rich man's panic," followed a speculative spurt in copper stocks and a boom in corporate mergers.
The crash of 1920-21 resulted from the postwar accumulation of inventories.
The great crash of 1929 collapsed the huge stock pyramid built by brokers, banks, utility tycoons, and individual investors.
And the crash of '87, although fleeting, brought the steepest stock market decline.
On the surface, the Great Stock Panic was all of these wrapped up in one. In reality, however, it was none of these.
As in 1901, the Great Stock Panic was provoked by powerful corporate groups who used massive debt to gain control over corporate giants through mergers and acquisitions.
Like the 1907 collapse, the Great Stock Panic involved speculation in commodities. That time, it was primarily in copper and coffee. This time, it was in stock indexes, junk bonds, foreign currencies, bonds, mortgages, and a series of other financial instruments which had been transformed into "commodities" by the new futures markets.
As in 1921, the Great Stock Panic caught businesses loaded with inventories and productive capacity. Back then, auto and tire makers, sugar producers, and cotton farmers suffered most. This time, it surprised virtually every manufacturer and distributor in the industrialized world.
Most previous panics and crashes had been relatively isolated, limited to one geographic area, to one privileged class, to a few powerful cliques, to the weakest sectors of the economy.
Previous panics were cushioned by relatively liquid or flexible groups who reduced the steepness, the speed, and the depth of the declines. The Morgan group limited the 1907 panic to New York City. The DuPonts and powerful banking houses supported General Motors, Goodyear, and others during the 1920-21 crash.
The giant manufacturers and the federal government relied on the cash and gold reserves accumulated during the roaring twenties to fight the Depression, win the Second World War, and build the military-industrial complex. And in 1987, the Fed, the SEC, and the New York Stock Exchange stepped in aggressively.
During the Great Stock Panic, however, no single source of support would emerge.
Giant corporations and other powerful economic groups periodically convinced the Administration to bail out favored corporations and banks, but these schemes tended to backfire and were ultimately abandoned.
Once under way, the Great Stock Panic was both pervasive and relentless, always returning with greater and greater power despite several postponements, interludes of apparent calm, and sharp stock market rallies.
The debt pyramid set into motion a unique vicious circle, a chain of events no one could control. In simple terms, when the economy fell, it caused a sudden and acute shortage of money ... and this shortage caused the economy to fall that much more.
The unprecedented involvement of the consumer in the stock market created another cycle which was even more vicious. The more stocks fell, the less consumers were willing to spend; and the less consumers spent, the more sales, earnings � and stock prices � plunged.
In previous panics, the stock market was the centerpiece of the crash. In the Great Stock Panic, the US stock market was merely one of four arenas � (1) the stock market, (2) the US corporate bond markets, which reflected acute shortages of capital, (3) the foreign currency markets, which helped transmit the panic to the four corners of the globe, and (4) the real estate market where much of the wealth of Americans was still tied up. In short, the worst aspects of past crises converged into one time and place.
That's where most of the similarities ended. Because the underlying problems were so much worse, the government and the people tried that much harder to stop it from happening. And because they intervened so frequently, the crises, coming in fits and starts, dragged on longer than they would have otherwise.
Rather than ripping off the band-aid in one quick snap, America chose instead to peel it off one painful hair at a time, trying to enjoy life to its utmost between each and every phase of the crisis.
For those who were living through the panic, therefore, the crisis often appeared to be less severe than that of the 1930s. However, anyone who had to endure the years since the Great Stock Panic know that it was actually more severe, wearing down our energy, depleting our recovery powers.
It was believed that, since we had already endured one depression in the 1930s, we had more devices to combat the Great Stock Panic. True. What people didn't realize is that, in the long run, combating the crisis may not have been as desirable as it appeared. It merely deepened and prolonged it.
Unlike previous panics, there were also less tangible, but no less powerful positive factors � modern communications, sophisticated in nonviolent conflict resolution, and international cooperation. To the surprise of some pessimists, most Americans had the fortitude to withstand the psychological pressures. And when threatened by outside forces, they rallied together with amazing unity.
That helped saved the country. But it did not prevent the Great Stock Panic or save the economy from depression.
Did the government try everything possible to cover up, postpone, or offset the Great Stock Panic? Yes. But regarding the more critical question � did they succeed in those efforts? The answer is: "No."
For the longest time, the US government officials criticized Japan for intervening too frequently to stop their economic decline of the 1990s � forcing interest rates down to zero, running up the largest deficit in the world, and still not ending the slump. They pointed out to Japan four officially recognized recessions during the 10-year period between 1991 and 2001. They scoffed at Japan's failed attempts to stop them, or to prevent their stock market from plunging by 75% during that period.
Ironically, it was these same economists that urged Japan to do more to pump up its economy. Likewise, it was these same people who urged that America repeat the same mistakes as Japan did, just as soon as its economy and stock market began to plunge.
Did it have an impact? Maybe. For a while. But in retrospect, historians are arguing that the US government unwittingly contributed to a prolonging � not the prevention � of the crisis which enveloped the nation. Their biggest mistakes? Interest rates and the dollar.
As you saw in Dad's chapters, one of the most widely accepted textbook theories held that interest rates move up during inflation and down during deflation.
Government and private economists, business planners, banking executives � even the Jeremiah gloom-and-doomers who anticipated some sort of economic crisis � generally accepted this theory. In most cases, this theory did hold true. Inflation and high interest rates had been synonymous. In the 1950s, '60s, and '70s, whenever inflation went up, interest rates followed along, and vice versa.
However, starting in 1979 something different began to take place. First, interest rates surged well above inflation. Then the inflation rate tumbled but interest rates stayed high. In other words, contrary to the theory, the difference between interest rates and inflation grew wider and wider. We call this difference the real interest rate because it represents the true cost of money.
If you were a saver, this was good news. The net yield on your money, after subtracting inflation, stayed high even though there were temporary declines. One caution: To guarantee the value of your principal, and to make sure your funds were available, it was essential that you stashed it away in the safest possible place. Plus you had to commit to leaving it there, untouched, for longer and longer periods of time.
If you were a borrower, however, high real interest rates were bad news. It meant that the cost of money would be chronically high no matter what the government tried to do.
How do you calculate the real interest rate? Very simple. Just take, for example, the 20-year T-bond rate (let's say it's 7%) and subtract the inflation rate (for example, 3%). The real interest rate is 7% minus 3%, or 4%. If you repeat that calculation for each year and plot it over time, you will wind up with a result similar to that shown in the graph.
Note how the real rate stayed nearly flat around 3% or 4% for the first 20 years of the postwar period. Economists considered this "the normal level," so when it spurted upwards in 1979 and 1980, it was only natural for them to say it was "abnormal."
Some blamed the Federal Reserve for easing money too aggressively. Others blamed them for tightening money too persistently. Still others said the trouble was that they shifted back and forth too frequently from easy money to tight money. All agreed it was a fluke that would soon correct itself. They were wrong.
They made the same mistake twice � first during the 1980s, and again during the Great Stock Panic. In both cases, they failed to recognize that real interest rates were high for real reasons. They were driven higher by two forces that would take many years to fix
- Force #1. A chronic, long-term rise in the risk of lending.
Business failures surged as soon as the economy began to falter. As you saw in Chapter 4, personal bankruptcies surged even before the economy turned down, and then went still higher when the economy fell.
Default rates on corporate bonds followed a similar pattern � up sharply months before the recession began ... and then up even more sharply during the recession.
No matter which way lenders turned, they encountered far greater risk than they had ever experienced before. So to cover that risk, they naturally had to charge a higher premium for money over and above the inflation rate.
- Force #2. A chronic, long-term rise in the federal budget deficit.
Everyone knew about this in the 1980s. So it was not a surprise. But in the initial phases of the Great Stock Panic, it was widely assumed there would be no deficit � that there was a huge "budget surplus."
They didn't realize that (a) the surplus was almost entirely bogus, the result of budgetary accounting gimmicks and (b) the Treasury's coffers were bloated by tax revenues from the earnings boom. And yet, one of the very first "victories" by President Bush in 2001 was to spend away the budget surplus that really didn't exist in the first place; and both aisles of Congress gladly joined in this venture.
Trouble is, once the earnings boom vanished, the tax revenues slowed to a trickle, the surplus was gone and a record deficit loomed. To finance the deficit, the Treasury issued record amounts of new debt, driving real interest rates still higher.
The Merger Bust
On a cold rainy morning, the second wave of the stock market crash began. The main cause was not the WTC attacks or any other outside threat. It was plunging profits and the unraveling of the merger boom.It is in the nature of speculative orgies that every sector is swooped up into the madness, as individuals and institutions rush in to lend support or to grab their share of the purported benefits. The big banks, the brokerage firms, insurance companies, and the federal government itself all participated in the Great Merger Booms of the 1990s.
Likewise, when the merger boom fell apart, it followed that all these participants were dragged down with it.
The crash that began in tech stocks spread quickly to the blue chips, the Dow, and the S&P; 500. The stock market crash was not quite as sudden as the first. But it was larger in scope and depth. Before it was over, the decline in the Dow would be both greater and more permanent than that of October 1987, impacting twice as many investors and inflicting much greater damage on the economy.
Large companies were now undergoing severe financial difficulties. Why were they in such sorry shape? Because of the merger boom and corporate America's heavy debt load, even the slightest economic downtick mushroomed into a convulsive contraction. The merger boom of the 1990s fed the longest economic recovery of the postwar era. Likewise, the merger bust during the Great Stock Panic became one of the paramount causes of the sharpest economic decline since the Great Depression.
People asked: "Isn't stepped-up merger activity a normal element in the business cycle?" Yes, but as you saw in Chapter 12, the merger-and-takeover craze was unique in the history of corporate finance. It overshadowed all prior periods, both in the relative dollar amounts and the leverage used. In previous eras, it was unheard of for small firms to take over the giants. During the 1990s, it was a common occurrence.
Rumors of major corporate bankruptcies swept the news wires. Selling pressure, which had been very mild throughout a post-crash rally, cascaded into an avalanche as investors stampeded the exits. Most frightening of all, unlike Black Monday, 1987, when bond prices rallied sharply, both bonds and stocks descended in leapfrog fashion.
The First Domino
The rumors were true. One of the greatest success stories of the merger boom was on the verge of default and one of its major financial backers on the brink of bankruptcy.Two companies � Consolidated Industries and Metrobank (fictional for the sake of this chapter) � became the first victims of the merger bust. It didn't take a genius to figure out why: Like many illiquid companies in America, Consolidated had too many debts coming due. When the sales of its various subsidiaries declined, it could no longer afford to pay them.
Even before the second crash began, corporate raiders were beginning to discover that the legislative and regulatory environment for mergers was turning cold.
The party was over but the boys from Consolidated didn't want to go home. They didn't realize that the mergers, leveraged buyouts, and earnings manipulations needed the stock market bubble to keep them going. Indeed, the rationale for many mergers was to sell "undervalued assets" at higher market prices. This was the only way they could ever expect to repay the debt and build net worth in order to avoid bankruptcy. In a weak market and a poor economy, that door closed quickly.
And yet, even after the crash, Consolidated didn't want to give up. Most important, they failed to reconcile themselves to the reality that the convertible bond market had been decimated.
Earlier, in the months following the tech wreck of 2000, it became almost impossible for Consolidated to raise more capital with new stock offerings. So they used convertible bonds instead. These were bonds that allowed investors to convert their holdings into shares � it gave them relative safety of bonds plus a play in any future appreciation in the common stock.
But now, as the stock market crashed for a second time, the price of convertible bonds also plunged, the so-called safety features turned out to be bogus, and bids for new issues vanished. Consolidated had planned a big convertible bond issue to raise emergency capital, but at the last minute, they decided to shelve it. "Market conditions temporarily unfavorable," said their spokesperson on CNBC.
The pension funds and mutual funds wanted out too. Their shareholders or members were selling. So they had no choice but to sell, too. Previous buyers became sellers. Previous sellers sold even more.
The decision makers at Consolidated, however, were slow to act � always fighting the last war. As they plunged ahead, spouting meaningless optimism, their convertible bond holders suffered severe losses. Metrobank, as well as several brokerage houses that provided the bridge financing, took big hits. Suppliers who gave them trade credit were being drawn into the melee. Everyone was demanding their money.
One day, when two New York bank officers compared notes over lunch, they made an interesting discovery. "We finally scratched up some money to participate in the rescue of Consolidated Industries. I don't think they'll get as much as they want. But at least it'll tide them over until this great fog overhanging the bond market clears up."
"Consolidated, did you say?"
"Sure, what's wrong with them? Their rating is still OK."
"I don't believe this. You just made a loan to Consolidated so that they can take more time with their new convertible bond issue?"
"Sure! Why not? Do you have something personal against this company?"
"No, that's not it. Only that this morning I did some liquidating of my own and cleaned out 25% of our portfolio including, believe it or not, $20 million in long-term bonds and $30 million in ninety-day commercial paper issued by Consolidated."
The Great Stock Panic was accelerating.
| TOP: During the 1960s and '70s, interest rates tended to fluctuate around
the inflation rate, with only minor discrepancies between the two. But in
the 1980s, although the inflation rate fell sharply, interest rates
remained relatively high. As a result, there emerged a big gap between the two.
BOTTOM: The real T-bond yield represents the difference between the two lines in the top graph. It is the yield on Treasury bonds minus the average inflation rate for each year. For example, at the peak in this graph (in 1984), the yield on Treasury bonds was close to 11% and the inflation rate was about 3%. The difference between the two — approximately 8% — was the real T-bond yield. This was dramatically higher than the previous decades. In the early twenty-first century, real interest rates surged again. Data: Federal Reserve. |
Returning to the fictional Consolidated, in the first phase of the panic, it was already on the brink of bankruptcy. The finance subsidiary had over $3 billion in commercial paper (short-term corporate IOUs) and bank loans. To stay afloat, it ran on a treadmill, paying its creditors $50 million a day � over $2 million per hour! Meanwhile, the parent corporation struggled under the one-two punch of a slow convertible bond market and growing rumors of default.
The bankruptcy tripwire tightened, needing only the simplest trigger. Commercial paper owners � mostly cash-starved corporations themselves � decided not to renew. The standby credit at the banks, which was supposed to back up this commercial paper, could not be implemented. Attempts to borrow money from employees' pension funds were blocked by the unions.
Layoffs were ordered, but there were no immediate savings because of the severance-pay provisions in the new labor contracts.
When Consolidated's financial vice president emailed around the world and raced across the Atlantic on the Concorde to raise money in the Eurodollar market, the rumors, zapped instantly by email, arrived first and he returned empty-handed.
An emergency meeting called between a group of bankers and Congress people, which was expected to result in a 1970s' Chrysler-type rescue proposal, resulted instead in one collective and unanimous shoulder-shrugging session. The CEO's appeal � based on the idea that the temporary shutdown in September had contributed to his losses � was weak. Everyone realized that was just one of many factors in the company's demise, and that other industries � airlines and insurers � had been hit much more directly.
Consolidated had no choice. The lawyers were called in. The books were spread out on the boardroom table. There was a brief discussion followed by an even briefer sob session, after which the lawyers simply snapped their briefcases shut and took a last limousine ride to the bankruptcy courts.
Harry Pinkerton, the stocky, balding Chairman of the firm, disappeared from Wall Street and was never heard from again. But his counterpart at Metrobank, Robert Sheppard, suddenly turned over a new leaf. After years of cover-ups and pretense, and after a personal life crisis, he awoke one morning with the resolve to clean house. He moved swiftly to increase the bank's provisions for loan losses. He sold off a large chunk of the bank's riskier securities. He closed branches and laid off employees.
| In the 1980s, the majority of economists felt that high real interest rates
were abnormal. And in the Great Money Panic, they repeated the error.
However, these graphs demonstrate that real interest rates were high
for real reasons. The first correlates the real T-bond yield to business failures (as a percent
of GNP). The second shows the correlation between the real T-bond yield
with the federal deficit (also as a percent of GNP). (The real T-bond yield is
the nominal T-bond yield minus the inflation rate.)
Data: Federal Reserve, Dun & Bradstreet. |
Meanwhile, the market for commercial paper (the short-term IOU's sold by the company to investors for quick cash) died. "If Consolidated could go under," reasoned the commercial paper buyers, "what about GMAC? Sears Acceptance? Citicorp? Ford Motor Credit?" Nearly all issuers, whether solvent or insolvent, came under suspicion.
The Nasdaq and Dow, which had managed to stage a sharp rally, were suddenly knocked for a loop, dropping another 20% each in just days of trading. All stocks were hit with big selling pressure � the tech stocks, the blue chips � whether "old economy" or "new economy." There were no exceptions.
This is also when the brokerage firms suffered their most acute crisis of that era. One of the primary sources of their difficulties, in addition to the tech wreck and convertible bond fiasco, was arbitration claims by millions of investors.
Back in July and August of 2001, a US Congressional Committee had launched a major investigation of the "independence of research analysts." The SEC even testified before this Committee at that time, stating that almost all major brokerage firms were guilty of serious conflicts of interest. The consequence that the SEC envisioned was some compliance actions against the guilty firms.
The consequence the SEC did not envision, however, was far more damaging: A massive wave of arbitration claims by investors. To understand why, just take another look at those words I highlighted in the previous paragraph: Guilty! Serious! These words were an open invitation to millions of investors to take action. After the WTC crisis, the SEC was much friendlier to Wall Street brokers and much more willing to forget their offenses. But investors did not forget.
Investors continued to dump their shares of the falling brokers, tech companies, banks, and recently merged companies going bust. These companies, in turn, were dumping their own holdings in other brokers, tech companies, recently merged companies and bank shares. Soon nearly all corporations joined the selling rush to gain liquidity and to seek protection against further shock waves.
In the earlier stages, most economists and businesspeople anticipated a "soft landing" � a slowdown in the growth of the economy rather than an actual or steep decline. The main reason for their relatively optimistic outlook was the assumption that an inventory problem would not arise.
Because of "just-in-time" inventory systems � taking delivery of items only as needed on assembly lines � they figured their inventories would be trimmed to the bone. Superficially, they were right. But it soon became obvious that businesspeople and economists were making three cardinal mistakes:
First, they underestimated the extent to which sales had been artificially boosted by commercial credit, credit card, and installment buying � and the speed at which they would sink when credit became scarce. The auto industry was a frightening example. For months, Detroit executives had marched to the tune "relax, relax, everything is under control." But when the shortage of credit hit the auto business, they ran to Washington to ask for easy money and protection against foreign imports.
Second, they underestimated the fragility of the financial underpinnings that supported the inventories and receivables of America. As soon as major corporations began to feel the effects of the Great Stock Panic, the sole choice left them was to resort to mass dumping at cut-rate prices.
Third, businesspeople and economists � almost without exception � ignored what later came to be known as "regurgitated inventories." You see, marketing experts of that era tended to assume that if a consumer item was taken into the sanctuary of the household, it was absorbed and, in essence, gone forever.
They forgot that consumers, in a financial pinch, could readily become sellers of durables; that these new sellers could find a ready marketplace for their wares; and that this market was one of the most elaborate networks of secondhand dealerships, flea markets, and garage sales in the world.
It was at this stage that one of the most unusual economic events of the century occurred. There was an upsurge in inventories. Simultaneously, there was a decline in revenues sharply below the level needed for meeting debts coming due. The result was a sudden cash shortage � what some economists called illiquid demand for money. What made this demand for money so unique was that it took place while the economy was contracting � not while it was expanding.
When this demand could not be met, the alternative solution was bankruptcy or, as many prayed, a government bailout. The casualty list grew daily. Which firms were hit the hardest? The ones that were among the most cash poor and the most debt-ridden of all the large firms in America. Plus the ones that had been most guilty of earnings manipulations and balance-sheet gimmicks.
Nevertheless, most investment bankers, executives, and economists still hung onto the belief that, when presented with the magnitude of the crisis, the White House, Congress, and the Federal Reserve would come up with a bailout plan.
They believed that the government "had the power," that "where there was a will, there was a way." With the President waging a war on terrorism, they felt that it was their moral responsibility and patriotic duty to send a delegation of influential leaders to meet with the President and convince him to wage a similar war on behalf of America's established corporate giants, the heart of the American economy.
As long as it was just the stock market that was collapsing, they felt that there was little they could to convince the President to take action. But now, in addition to stock prices, the price of bonds was also falling � not just convertible bonds and other corporate issues, but also US Treasury securities.
This was a great mystery to everyone. Yes, they could understand why some corporate bonds could fall � they were being downgraded, with some bond issuers on the brink of default. But they couldn't fathom why Treasury bond prices were falling.
It was this decline in bond prices that raised some of the biggest concerns. And it was this that finally prompted business leaders to request a meeting with the President of the United States.
Their pitch: If the government did not take immediate action, the United States would be plunged into a morass from which it might never recover.
But as you will soon see, there was one factor they didn't understand and didn't anticipate: The fact that the US economy was so vulnerable to the flight of foreign capital and a sharp decline in the US dollar.
Remember our virtual tour of South America and Asia in Chapter 6? Remember how devastating it was when foreign investors pulled their money out of countries in those regions? Governments would resort to anything � even triple-digit interest rates � to keep that money from leaving.
But no one believed that could ever happen in the United States. Everyone assumed a flight of capital was something that only happened to third world countries. Industrial nations like the United States, they reasoned, were too big and strong to worry about those kinds of problems.
They were wrong. Foreign investors � especially in Japan and Western Europe � held the largest percentage of America's wealth in history. And it was this foreign capital that emerged as the swing factor that could make the critical difference between stable stock prices and a stock market panic ... stable bond prices and a bond market panic ... stable real estate and a real estate panic.
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