How We Got Here (17)
June 4, 2014
And there was the stock market! A wonderfully entertaining and accurate history of the 1920s, Only Yesterday, was full of anecdotes about the post-World War I stock market and its fabulous, almost unbelievable history. As with most group contagions, it started small, and bred got-rich-quick anecdotes that lured in others, some of whom generated similar stories, only in the 1920s it kept on going, and the music kept playing faster. It was all pretty wonderful, as long as stocks kept going up. (Will Rogers told his readers it was simple to make money on the stock market. “Buy a stock, and when it goes up, sell it. If it don’t go up, don’t buy it.”)
You could buy stocks on credit, or on margin, and could use the value of the stock to buy more stock on margin, and use the value of the new stock …. You get the idea. And of course, because it was so pleasant and profitable, people persuaded themselves that it was going to go on forever. True, it never had in the past, but “this time is different.” It always is. And it always works out more or less the same way.
Herbert Hoover, “the great engineer,” was expected to preside over continued prosperity. Inaugurated in March, 1929, he got about half a year before the roof fell in. In late October, the market crashed. At first it seemed to recover, then on Black Tuesday it went into free fall. The mechanism for the free-fall was the same as the one that had boosted stocks in the first place: margin.
Few people understand it, but it’s simple enough in concept.
Say a stock sells for $100 a share and you buy ten shares on 10% margin. You have bought ten shares, worth $1,000, by putting up $100 and borrowing, from your broker, $900 against the value of the stock. If the price goes up to, say, $120, the stock you have pledged against your loan is now worth $1,200 and you look like a genius. You could sell your shares, pay off the $900 loan from the broker, repay yourself your initial $100, and walk away with an additional $200. This, of course, is what people were counting on. Stock prices were going up, and would continue to go up, right? They never had in the past, but this time it was different, right?
So what happens if for some reason the stock price falls to $80. If your only problem was that your original $100 had shrunk to $80, you could live with that. But you still owe the broker that $900, and now you’re securing that $900 loan with stock that is only worth $800. At some point (and pretty damn quick!) your broker issues a margin call, and you have to deposit more money in the account. If you can’t meet the margin call, the broker can sell enough of your stock to bring your account back up to the maintenance margin. They can (and will) do this without consulting you, and they can sell anything they control. Still sound like a fun game?
(Joseph P. Kennedy, the father of the future president, added to the fortune he had already made by extensive stock-market speculation in the 1920s, but – in a spectacular display of good judgment and good timing – he got out of the market entirely in the spring of 1929. A bellboy had given him a tip on the stock, and the stock had in fact gone up, and Kennedy said later, any market in which a bellboy could pick stock was no place for him. One wonders, what would it have done to the history of our country if Joe Kennedy had lost his fortune, or a good part of it, like so many others at all income levels? Fortunately, he didn’t.)
Okay, the stock market crashed, for many reasons but most simply because too many people were buying too many stocks by borrowing too much money. As one economist explained later, when asked what had caused the crash, “Somebody asked for a dollar.” In other words, someone was asked to put up actual money in place of borrowed money, and couldn’t, and therefore sold some stock. This in turn caused someone else (working on margin) to have to sell stock, which in turn ….
The result was dreadful.