Wall Street does not have a mere headache - it has a severe migraine. Tens of billions of dollars of assets have either been lost or seized by the US government in an effort to prevent a further erosion of the entire banking system. While Fannie Mae and Freddie Mac, two titans in the finance industry largely unknown to most Americans prior to their catastrophic failures last week, received federal protection, Lehman Brothers, a banking house that survived the Civil War and the Great Depression, collapsed after a long and distinguished history. The investment firm AIG was granted a life-saving loan from the US government days later to remain afloat. What caused this crisis?.
Although it may be trite and banal, the phrase 'History repeats itself' is an accurate answer. In order to appreciate the parallel between 1929 and 2008, it will be necessary to recall the progression of events from the Hoover-Roosevelt era.
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The 'Roaring Twenties', presided over by the notoriously reticent Calvin Coolidge, may have been the greatest period of economic expansion in American history. After financing WWI on Liberty Loans, whereby an average citizen could buy a US bond and expect repayment of 4% annually until the retirement of the debt by the Treasury, returning soldiers, who were anxious to start families and buy homes and modern appliances, desired a life of comfort after surviving rat-infested trenches and the cruelties of war. Mass production and higher wages were the order of the day by the middle of the decade, and American consumers seemed to have an insatiable appetite for goods and services. As the economic outlook of the future appeared limitless, more and more people began investing money into the stock market, and many got rich in only a few months as the market climbed on the strength of the economy.
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By 1927, speculative fever was entering its highest pitch. In order to attract more investment, brokers began allowing individuals to buy stocks with only 10% down. Hence, if the price of a stock was $100 per share, one could buy a share for only $10 up front or 10 shares for $100 up front. Since stock prices only increased, conventional wisdom believed, buying stock on 'margin' (10% down) would pay for itself. For a time, it worked brilliantly. Many investors, who bought on 'margin', were able to pay the balance and make a considerable profit due to an appreciation of their stock. In 1927 and 1928, investors borrowed $4.0 billion and $6.4 billion respectively from brokers to finance their stock purchases. Unfortunately, overproduction and underconsumption caught up with the scheme, and the bubble burst in October 1929. In short, Americans were collectively in debt and possessed no more money to buy the commodities financed by Wall Street. The heyday of buying stocks cheaply on 'margins' was followed by 'margin calls'.
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After buying 100 shares of stock worth $100 per share on a 10% margin ($1000), an investor, once again, expected to be able to pay off the $9000 loan to his or her broker from the increase in value of the stock. When stocks crashed, however, banks demanded immediate payback of their loans (to give to their depositors during 'runs' on the bank) from brokers. The brokers, however, were broke (all of their money was loaned out to clients), so they demanded repayment of their loans from 'margin' investors. Hence, a person who bought $10,000 worth of stock for $1,000 (10% margin) was not only liable to repay the $1,000 down-payment but also the balance of $9,000. The $9,000 had been created from nothing - unbacked by silver or gold, and no one, neither the banks nor the brokers or investors had the capability of repaying the mounting debts. As a result of the high risk racket, a nation was brought to its knees by avarice and unscrupulous financing programs.
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Upon entering the White House, Franklin Roosevelt's first stated priority was to reopen the banks and put the American financial house on solid ground. In his famous first '100 Days', a period of legislative activity unrivaled by any administration or Congress in American history, Virginia Senator Carter Glass and Alabama Congressman Henry Steagall introduced legislation to divorce investment and commercial banking in order to stop financial institutions from colluding and using their capital to recklessly invest in high-risk ventures. Furthermore, the bill created the Federal Insurance Deposit Corporation (FDIC) which protected the assets of depositors in the case of financial mismanagement by banks. From 16 June 1933 to 11 November 1999, the Glass-Steagall Act successfully regulated the behavior of banks and guided the American economy through several periods of economic expansion (the 1950s, 1983-89, 1993-2001).
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On 12 November 1999, the Glass-Steagall Act was repealed after two decades and $300 million spent on lobbying for its demise from special interest groups in the form of the Gramm-Leach-Bliley Act. This new legislation ended many of the key regulations of Glass-Steagall and allowed complex mergers and billion dollar transactions to take place between a variety of financial institutions without governmental scrutiny. As a result of a lack of transparency, a new generation of speculators returned and loaned money on high interest rates to a new generation of reckless spenders, and the seeds of another banking crisis were sown at the end of the 20th century.
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Greed is a fundamental component of the human condition. When left unchecked by conscience or law, history tends repeat itself rather unkindly.
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J Roquen