Are there parallels between the 1929 and the 2007 financial crashes?

America’s Wall Street Crash started in October 1929 after the Roaring Twenties economic “bubble” popped. It was the biggest slump in US history and resulted in the “Great Depression”.

During the 1920s America experienced an era of peace and prosperity. The “Roaring Twenties” economic and cultural boom was fuelled by industrialisation and new technologies such as electrical goods, the automobile and air travel all became popular. Although the world economy was weak in the post-war years the good performance of the US economy during World War I meant that their share of the world manufacturing market rose from 36% in 1913 to over 42% by 1929.

The construction industry was booming there was low unemployment and a huge rise in income and living standards. Everybody wanted to make money but no one wondered where it came from and no one feared that one day everything might crumble. From 1927 onwards consumer markets were becoming saturated and the economic growth started to decline gradually but the stock market kept rising.

The Dow Jones soared from 1921 to 1929 as the general public had more disposable income. All sorts of people, many new to Wall Street, were investing in the hope of making a killing. Soon stock trading became America’s favourite pastime. Investors mortgaged their homes and invested their life savings. To the average investor, the stock market “always went up.”

Many investors purchased stocks ‘on margin’, which is borrowing stock to gaining financial leverage. The strong buoyancy of stock prices meant investors were able to increase their number of shares without using all of their own money. For every dollar of their own cash invested, a margin user would borrow nine dollars worth of stock. This meant that if stock went up 1%, the investor made 10%. Unfortunately, it also meant if stock drops, a margin holder can lose all of their investment and possibly owe money to their broker.

In 1929, the Federal Reserve raised interest rates several times in an attempt to cool the overheated economy and stock market. On October 24th 1929, a spate of panic selling occurred as investors realised the boom was, in reality, just an over-inflated speculative bubble. Margin investors were financially destroyed as large numbers of investors tried to sell off their shares to no avail. To make matters worse, many banks had invested in the stock market, using their depositors’ savings and as stocks fell, savings were lost. Bank clients tried to withdraw their savings all at the same time and 10,000 banks went bankrupt, adding more fuel to the stock market crash. In just three days, over billion was erased from stocks that were trading on the New York Stock Exchange.

In the early 1920s some believed the US had found the secret for sustainable economic success, however there were economists who had expected the slump earlier as it followed the classic pattern of extreme euphoria and irrational expectations that eventually lead to devastating financial loses.

The crash of 2007

It is important to recognise that the crisis did not occur overnight, it was the result of actions and mistakes made over previous years in the financial markets worldwide.

It began when there was a huge real estate boom in the United States and mortgages were given to everyone (including those on minimum wage) to buy or build real estate. The main fault in my opinion resides with the financial institutions that failed to verify credit worthiness. Although interest rates were very low, interest rates on guaranteed mortgage loans had variable rates, so the smallest change in the rate meant many debtors’ couldn’t pay.

The US government failed to understand that Fannie Mae (a private company that supply the US housing and mortgage markets with funds) and Freddie Mac (their business is to combine the residential mortgage markets with Wall Street dealers and investors) were taking huge risks that could lead the world into a financial breakdown. Instead of setting up regulations for these organisations, they continued to promote mortgage loans, even if the loans should have not been made in the first place.

The resulting risks and also the already existing ones were secured as bonds and bought from many banks. Once the housing industry boom stopped and debtors’ were unable to sell their houses, all the bonds lost their value.

The main crisis starting point came with the bankruptcy of Lehman’s Brothers, in September 2008. To compensate for its small sized capital base, Lehman Brothers took large risks and borrowed sums that ended up thirty five times the size of their capital. In addition A.I.G. experienced a downgrade of their credit, which resulted in them having to post huge sums of collateral, which the company obviously didn’t have.

After the bankruptcy of Lehman Brothers, the forced sale of Merrill Lynch and the A.I.G. crisis the panic in world credit markets reached historic intensity and hit record peaks across the globe. Retailers and investors pulled out their money in fear of further market collapses. The financial sector fell on a daily basis and the market sunk in what analyst call one of the most extraordinary series of developments in financial history.

Since the credit crunch first hit in 2007, lending has become tenser and now the lack of capital flow is affecting banks globally, threatening businesses with credit starvation.

What are the similarities between 1929 and 2007?

The difference between both crises is that 2007 was about a bubble that saw the housing market crash and then spill over into the rest of the economy and the1929 saw a stock market crash followed by bankruptcies.

The other main difference is that in 1929 most nations were on a gold standard, while nowadays nations have actually committed themselves to abolish their previous gold backing for their currencies.

However, despite the differences there are also some striking similarities of monetary foolishness.

A glut in the money markets and borrowers borrowed excessively because money was cheap.
In both cases, assets were bought with forever mounting credit and the money was borrowed under the assumption that the assets would appreciate faster than the pay back of the credit.

Banks invested heavily in long-time bonds using depositors’ funds. 
What aggravated the 2007 crisis were unsound financing practices by banks, such as maturity mismatching whereby a bank financed with short-term loans that rolled over every few months an “asset” that might run for years. When interest rates rose not only would re-financing become more difficult and expensive, the assets would reciprocally depreciate. In hindsight these were absurd schemes.

While likening some of the causes of the 2007 crisis to that of 1929 most maintain that today is different because not only are all world currencies off the gold standard but also economic science has progressed and it is easier to analyse previous “mistakes” and provide remedies.

Yet despite forewarnings, five years before the 1929 bubble burst economists were telling the markets and banks to slow down. Eighty years on and using innovative computing powers and better documented data from international bodies such as the World Bank, nobody was able to spot a crisis in the making!

So will this happen again? If history repeats itself it surely will but the next time it will probably be far more serious and devastating at least in the medium term. It could mean the total destruction of currency and world trade – because we haven’t solved any of the things that caused the previous crises.

date added: 21/02/2013

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