What Was Behind the Worst Crash in History?

On this day in economic and business history...

This is part two of a deep look at the Roaring '20s and the Crash of 1929 -- click here to start with part one.

The Dow Jones Industrial Average closed at 381.17 points on Sept. 3, 1929. It was the last day of the greatest uninterrupted bull market the United States has ever seen. No one knew then that nearly a decade of growth had ended, nor could they comprehend the utter ruin the market's crash would leave behind -- investors never realize they've reached the top of the mountain until they're tumbling down the other side. News from that day (printed a day later, as was then customary) is remarkably sanguine regarding the overheated and desperately overleveraged stock market, and in some cases it's obliviously prophetic:

"Stock and bond transactions involving $11,121,384,230 were settled through the Stock Clearing Corporation of the New York Stock Exchange (UNKNOWN:UNKNOWN) in August. This was an increase of $597,593,402 over ... July. The total for August, 1928 was $7,112,329,278."
--The New York Times

"With the bull party still in the saddle and riding still harder, the stock market entered the new month today, but progress became increasingly difficult during the afternoon, and before the close of the session some of the ground gained earlier in the day was lost. More than half a hundred issues were hurled up two to nearly 10 points to record high levels. ... Recessions of one to five points from the best levels of the day were fairly general, however, when a wave of profit-taking swept over the market in the afternoon."
--The Washington Post

"Announcement of the Stock Exchange figures for brokers' loans as of the close of August is expected this afternoon or tomorrow, and opinion in the Street is agreed that a heavy advance is certain. Between July 31 and Aug. 29 the Federal Reserve's total of brokers' loans advanced $257 million, running far into record high territory. Last month the Stock Exchange's total crossed the $7 billion mark for the first time in history. ... For the time being, the speculative community seems disposed to disregard record-breaking loans figures as being of purely academic interest."
--The New York Times

"The recent formation of numerous investment trusts in this country and the pouring of several billions of dollars into them are bound to play an important part in American industry and finance in the future. This is the opinion of Arthur Reynolds, chairman of the Continental Illinois Bank and Trust company, but it also is his belief that the chief function of these great accumulations of capital has been misunderstood."
--O.A. Mather, writing in the Chicago Daily Tribune

The last two reports are of particular importance. Both highlight the mechanism that brought the stock market to record-breaking highs but then, working in reverse, sent the Dow to a microscopic 41.22 points by mid-1932. That mechanism is leverage, and investors of the Roaring '20s elevated it to an art form only surpassed in modern times by Lehman Brothers and its investment-banking ilk.

The key difference between Lehman and investors of the Roaring '20s is that no ordinary investor was allowed, in the mid-2000s, to leverage up 30-to-1, as Lehman had. But in the latter 1920s, many "muppets," to steal a modern phrase, levered up 10-to-1 (90% leverage), posting as collateral the very stocks they had taken on loans to acquire. This was well and good while stocks climbed month after month, but a 10% loss of value would have been enough for creditors to shut down the stock market merry-go-round. In contrast, you're unlikely to find any broker that will allow trading with more than 50% leverage today, as is mandated by the SEC. Legislation on margin requirements didn't exist in 1929. In fact, few effective laws of any sort governed the activities of the stock market in 1929.

When the slide began in earnest, many investors were simply unable to extricate themselves before the market wiped them out -- in this pre-electronic era, orders were filled personally or over the phone, and the ticker might be delayed by an hour or more. There were no circuit breakers to stop stock prices from plunging throughout the day, so by the time an investor saw that his or her shares were down by 5% on a particularly busy day, they might actually be down by 15% or 25% or more. It was only by the actions of a dedicated group of bankers and billionaires that the market did not collapse further in October -- and even so, the Dow finished that bloody month 28% below the peak of Sept. 3.

Margin calls were common in the early days of the decline, but distressed brokers eventually began to close out underwater positions rather than suffer further losses. Since many investors were leveraged up to their eyeballs, this set up a cascade of sales that could leave some thinly traded stocks with no buyers at all. Compounding the problem was the fact that some of the worst abuses of leverage were undertaken by the issuers of hundreds of these thinly traded stocks: the investment trusts.

Grifters, schemers, and thieves
Hundreds of investment trusts, far from being misunderstood tools of the American financial future, were in the process of creating an amplifying feedback loop of leverage. An ordinary investor might be leveraged 10-to-1, but an investment trust, also leveraged 10-to-1, would then be invested in another investment trust similarly leveraged, which would in turn be invested in yet another investment trust, until a superstructure had been built with all the integrity of a skyscraper made of matchsticks. John Kenneth Galbraith would later condemn these newfangled schemes of American enterprise in his seminal work, The Great Crash, 1929, as:

The most notable piece of speculative architecture of the late twenties, and the one by which, more than any other device, the public demand for common stocks was satisfied. ... The investment trust did not promote new enterprises or enlarge old ones. It merely arranged that people could own stock in old companies through the medium of new ones. ... The virtue of the investment trust was that it brought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate assets in existence. The former could be twice, thrice, or any multiple of the latter.

Before 1921 in the United States only a few small companies existed for the primary purpose of investing in the securities of other companies. ... By the beginning of 1927 an estimated 160 were in existence. ... 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. ... In 1929 they marketed an estimated $3 billion worth [of new shares]. This was at least a third of all the new capital issues in that year; by the autumn of 1929 the total assets of the investment trusts were estimated to exceed $8 billion. They had increased approximately elevenfold since the beginning of 1927.

Galbraith highlights in particular the leveraged machinations of Goldman Sachs (NYSE:GS), a firm that seems to crop up in this sort of scenario with distressing frequency. At the end of 1928 Goldman established its first investment trust, the Goldman Sachs Trading Corporation, capitalized at $100 million. Two months later this subsidiary merged with another investment trust, and its valuation doubled. After this merger the Goldman Sachs Trading Corporation held a market cap twice as large as the value of its total assets, which consisted entirely of cash and investments. Goldman Sachs was essentially selling shareholders of its Trading Corporation a $10 bill for $20 -- and they were buying.

In the summer of 1929, Goldman launched two more investment trusts in rapid succession. The first, launched in July, contributed 40% of its float to the Goldman Sachs Trading Corporation, and the second, launched in August, contributed much of its float to the first. The valuation of these three investment trusts was by now beyond half a billion dollars. Much of the capital raised by one trust went toward buying shares of other trusts, if not toward repurchasing its own shares outright, which must rank among the most ludicrous acts of financial self-destruction ever undertaken.

These trusts, lined up like a chain of dominoes, were extremely susceptible to the movements of each other's shares, and so it was not particularly surprising when the crash of 1929 tipped them all over. After the dust settled years later, shares of the Goldman Sachs Trading Corporation were worth roughly a dollar apiece -- a 99% decline from the original offering price.

They're not making any more land
However, this was not the original wellspring from which the market's madness flowed. Every bubble must start with the spread of a mass delusion, and the Roaring '20s first found their fantasy in Florida. This story will be familiar to anyone who lived through the subprime meltdown.

Sunny Florida, largely undeveloped but increasingly accessible by car or by air, became a popular vacation spot for America's small but growing middle class during the 1920s. As tourists flocked to the area, so too did real-estate hucksters. The Miami Herald became the largest newspaper in the world during the first half of the 1920s -- not in terms of circulation, but rather sheer bulk, because its pages were so full of real-estate advertisements.

Land became valuable because it was expected to be more valuable in the future. It did not necessarily matter whether the land was well-situated; even Florida's gator-infested swamps had value. Undeveloped prime waterfront lots often sold for at least $75,000 apiece at a time when the average annual wage was approximately $5,000. Jesse Columbo points out just how insane things got in Florida:

As the Florida real estate bubble crescendoed in 1925, property prices quadrupled in less than one year. Investors made incredible fortunes, such as an elderly man who invested $1,700 in a Florida property and watched its value soar to $300,000 in 1925. It seemed as if investors could do no wrong by simply buying any property in Florida and riding it to lofty heights.

Soon, renters could no longer afford to rent, and the press began to notice that Florida's real-estate market had lost all sense of reality. A cold 1925 winter was followed by a sweltering summer that was ultimately capped off by a devastating category four hurricane, which killed hundreds on the Florida panhandle and left tens of thousands homeless. The bubble finally blew apart as everyone realized just how unprepared Florida was for bad weather.

Investors who made it out clung to the dream of easy money and rushed into the stock market, where they found plenty of easy money ready to help them follow that dream. As you'll remember from our examination of the market's fundamentals in part one of this series, the stock market reached a major turning point at the tail end of 1926 when stocks finally took off far in advance of the growth of business fundamentals. The dream of instant riches didn't die when the Florida real-estate bubble popped; it simply packed up and drove back north to Wall Street.

Giving them too much credit
Prosperity is rarely evenly distributed, and this was as true in the 1920s as it is today. More than two-thirds of all American families earned less than what might be considered a "living wage" by 1929, and 80% of all families had no savings to speak of. The top tenth of America's top 1% held 34% of the national savings, and these wealthy elites gathered unto themselves an income equal to that dispensed to the bottom 42% of the workforce.

When most Americans struggle to acquire the "indispensable" products of modern living, those attempting to sell such products have three options to handle the discrepancy between means and desire: They can lower prices, they can raise wages, or they can provide loans to cover the difference. In the 1920s, for the first time in modern history, millions of families of average means bought their way into the middle class with the help of someone else's money.

Margin investing is a popular target of blame for the crash of 1929, but it alone can't explain the economic tailspin the U.S. fell into after stocks began to decline. Galbraith has pointed out that there were only about 1.5 million trading accounts out of about 30 million families in 1929 -- and some unknown number of wealthier families may have held more than one account. Only 600,000 of those accounts were found to trade on margin. If all of these margin accounts were wiped out in the crash, it would account for 2% of all American families at the most.

In contrast, by 1927, 15% of all major consumer purchases were made on installment plans. Six out of every 10 automobiles and eight out of every 10 radios were purchased on credit. There were thousands of banks and hundreds of new "installment credit" companies ready to loan money to anyone who asked. Foreign gold and assets flowed to the banks, and in many cases the installment credit companies were simply lending arms established by major manufacturers to allow more people the chance to buy their stuff. Both of these parties -- banks and businesses -- were also heavily involved in distributing brokers' loans to margined-up investors. Consumer debt more than doubled as a percentage of income during the Roaring '20s. By the peak of the boom in 1929, total noncorporate debt amounted to 40% of GDP.

None of this would have been a problem if only the economy, and the flow of money into it, had grown forever. Of course, the notion of a never-ending economic expansion is ridiculous, but it's easy to get caught up in popular delusions when everyone appears to be doing well.

When lenders were left with underwater securities as their only collateral for brokers' loans, they had little choice but to tighten the purse strings on all other forms of lending in an effort to avoid diminishing already threatened cash hoards. Business activity slowed as fewer people were able to purchase big-ticket items on credit, and as a result, millions were laid off and thus left unable to pay off their loans. Banks failed by the thousands as they, too, succumbed to the downside of extreme leverage. One weakness fed into the other. Nominal debt declined after the crash, but the economy declined even faster, and millions of people wound up with loans they couldn't pay off because there were no jobs to be found.

The Great Depression that began after Sept. 3, 1929, can't be blamed solely on the expansion of debt or on investors' irrational exuberance. However, without these two actors working on stock prices during the latter 1920s, it's likely that the Dow's rise would have been less intense and its decline less economically devastating. Easy money on its own can't fuel a bubble if the public doesn't reach to grab all that it can and far more than it needs, nor can speculative manias wreck an economy without an unrestrained flow of unsecured money. One sure mark of investing insanity is to take on as much debt as possible to buy into a "sure thing." When that happens to an entire market full of supposedly rational participants, it's probably better to stay on the sidelines.

Click here to go back to part one of our look at the Roaring '20s and the Crash of 1929.