Beating the bear: lessons from the 1929 crash applied to today's world

BEATING THE BEAR Lessons from the 1929 Crash Applied to Today’s World

Harold Bierman, Jr.

Beating the Bear

BEATING THE BEAR Lessons from the 1929 Crash Applied to Today’s World

Harold Bierman, Jr.

Copyright 2010 by Harold Bierman, Jr. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, except for the inclusion of brief quotations in a review, without prior permission in writing from the publisher. Library of Congress Cataloging-in-Publication Data Bierman, Harold. Beating the bear : lessons from the 1929 crash applied to todayÊs world / Harold Bierman, Jr. p. cm. Includes bibliographical references and index. ISBN 978-0-313-38214-7 (alk. paper) · ISBN 978-0-313-38215-4 (ebook) 1. Stock Market Crash, 1929. 2. Global Financial Crisis, 2008–2009 3. Bear markets·History. 4. Investments. I. Title. HB37171929.B387 2010 330.973'0916·dc22 2010014496 ISBN: 978-0-313-38214-7 EISBN: 978-0-313-38215-4 14

13

12

11

10

1

2

3

4

5

This book is also available on the World Wide Web as an eBook. Visit www.abc-clio.com for details. Praeger An Imprint of ABC-CLIO, LLC ABC-CLIO, LLC 130 Cremona Drive, P.O. Box 1911 Santa Barbara, California 93116-1911 This book is printed on acid-free paper Manufactured in the United States of America

I still think keeping that memory green a useful service, if only for the minority so saved. John Kenneth Galbraith

CONTENTS

Acknowledgments

ix

Introduction

xi

1. How High Is High? The Stock Markets in 1929 and 2008

1

2. The Events Prior to the 1929 and 2008 Crashes

9

3. Market Myths in 1929 and 2008–2009

19

4. The FedÊs Role in Good Times and Bad

29

5. Practice for the October Crash: The Week of March 25, 1929

55

6. The 1929 Market in Depth: The Ups and Downs of the 1929 Stock Market

63

7. The Great Crash of 2008: The 2008–2009 Market in Depth

77

8. Stopping the Speculators: Margin Buying, Pools, Trusts, Short Selling, and the 1929 Crash

95

9. The Senate Hearings of 1931 Concerning 1929

109

10. Dispelling the Myths of 1929

115

11. The U.S. Government Accuses . . .

141

12. The Prime Cause of the 1929 Crash: The Public Utility Sector

153

viii

CONTENTS

13. Lessons to Be Learned

167

14. Post-Crash Investment Strategies: Beating the Bear Market

179

Notes

185

Bibliography

193

Index

199

ACKNOWLEDGMENTS

Many people contributed to this project. Among those who were especially helpful were: Betsy Ann Olive and Don Schedeker of CornellÊs Johnson Graduate School of ManagementÊs library staff; Rosemary A. Lazenby of the archives division of the Federal Reserve Bank of New York; Seymour Smidt, Jerome Hass, and Maureen OÊHara, faculty colleagues at Cornell made useful suggestions. Barb Drake typed untold revisions. Dick Conway called my attention to the article that motivated my initial research efforts. Sections of this book were written during a study leave spent at the Judge Institute of Management, University of Cambridge. The leave and the research were financed by the Arthur Andersen Foundation and CornellÊs Johnson Graduate School of Management. Richard Barker, Sandra Dawson, Gishan Dissanaike, Geoff Meeks, Christopher Pratt, and Geoff Wittington all facilitated my visit and made it a very pleasant experience. At Cornell, Sheri Hastings kept my faxes flowing. Above all, I want to thank the people at the University of Cambridge Library, especially Ann Toseland; Ann kept me supplied with film of the newspapers of 1929 to 1950, and did not complain of my repetitive requests. While the others are unnamed by me (unfortunately), their helpfulness is well remembered. I also want to thank Burton Malkiel, who offered a friendly intellectual challenge that led to my initial interest in the events of 1929.

INTRODUCTION

Senator Glass: „Mr. Whitney, right on that point may I ask you a question: What percentage of the public is [sic] speculating in stocks of the stock exchange understand the real intrinsic value of the stocks in which they deal?‰ Hearings before the U.S. Senate Committee on Banking and Currency on stock exchange practices Admittedly, it is preposterous to suggest that stock speculation is like coin flipping. I know that there is more skill to stock speculation. What I have never been able to determine is·how much more? ·Fred Schwed, Jr., Where Are the CustomersÊ Yachts? The year 1929 stands out as the most significant year of the decade of the 1920s. In the minds of most people, the year 1929 marks the crash of the stock market, the beginning of the Great Depression, and the end of a 10-year period of prosperity that exceeded anything the United States had ever known. In 1955, John Kenneth Galbraith published his very readable and enjoyable classic The Great Crash, 1929. A reader of that popular book might well conclude that it would be foolhardy for someone to retrace the same path. And it would be; but I will follow a different path and arrive at a different set of conclusions.

xii

INTRODUCTION

What actually was the economic situation in 1929? How does it compare to the economic situation in 2008 – 2009? To better illuminate the current dark financial picture, I take a fresh look at the Crash of 1929 and then compare that period to the stock crash of 2008 – 2009. I challenge the facts „everyone knows‰ and overturn previously held assumptions concerning the catastrophic events that led to 10 years of economic depression. Likewise, todayÊs news is filled with stories about what is happening and why. While itÊs still too soon to come to rock-solid conclusions about the financial market meltdown of 2008 – 2009, much of what has happened could have been foreseen and even avoided · just as it could have been in 1929. By accurately assessing the causes behind the 1929 stock market crash that led to the Great Depression, and the causes that led to the decline of 2008 – 2009, readers can better grasp the present market situation and more wisely make financial decisions. This book considers the economic situation in 1929 and the events leading up to the stock price declines in October of that year. It concludes that the 1920s were a wondrous period of economic prosperity for the United States, and that in 1929 it was far from obvious that the stock market was in trouble. But something very serious happened in 1929 to stock prices, and we should try to understand it. There are many myths about 1929 that are incorrect. The myth that is most relevant to this book is „Stocks were obviously overpriced (the evidence suggests stocks were reasonably priced.)‰ While stocks were not obviously overpriced in general, there was one sector of the market, public utilities, that can be shown to have been overpriced. This book is an attempt to refute unjustified myths and to define the causes of the 1929 stock market crash. There were several factors that combined in October 1929 to bring about the crash. It is important that the causes be properly understood, because the 1929 stock market was not that much different from the market today or different from what the market could be at any time in the future. The 2008 – 2009 stock market crash was actually more severe than the 1929 – 1930 crash, and it is equally important to understand that event. During the 1920s, commerce in the United States attracted truly outstanding individuals who achieved successes of an international nature. The stories and achievements of such business people as Benjamin Strong, Owen D. Young, and Alfred P. Sloan are inspirational. What went wrong and caused the stock market to crash in October 1929? What did happen in 1929? Herbert Hoover, the president of the United States, saw increasing stock market prices as a speculative bubble manufactured by the mistakes of the Federal Reserve Board: „One of these clouds was an American wave of optimism, born of continued progress

INTRODUCTION

xiii

over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississipi Bubble.‰1 But the optimism was justified. The „bubble‰ did not have to burst. The Federal Reserve Board did not create the bubble, but it may have contributed to the destruction of stock market values. During 1928, in hearings before the Senate Committee on Banking and Currency, Senator Glass asked Whitney to reveal the percentage of investors who were speculators and who understood the real intrinsic value of the stocks they bought. Whitney (and others) could not distinguish between a speculator and an investor. Also, no one in 1929 knew how to determine, with any degree of confidence, the real intrinsic value of stocks (in fact, the determination of stock value still remains a challenge). Stock picking requires more skill than coin flipping, as Fred Schwed maintains, but it is not clear how much more skill we have to pick stocks or to determine when the market is too high (when it becomes necessary to make the sell decision) or too low (when it becomes necessary to make the buy decision). Overconfidence on the part of investors who „know‰ that the market is too high or too low is very dangerous, as the following conversation suggests: Investor: „I am developing a feel for the market.‰ Friend: „Take an aspirin. You are probably just catching a cold.‰

Many financial decisions made today are heavily influenced by what we understand to have happened in the past. It is important that we try to understand what the actual economic situation was in 1929 and what happened to the stock market. In 2008, the stock market again crashed. The 2008–2009 crash was actually more severe than the 1929–1930 crash. We should look to the events of 1929 in order to better understand the events of 2008–2009. The first lesson for an investor is that even in a normal year, the stock market can fall 50 percent in a matter of months. The investor who does not recognize that fact is vulnerable to unnecessarily large losses. The stock market is volatile and always will be. Diversify!

Chapter 1

HOW HIGH IS HIGH? THE STOCK MARKETS IN 1929 AND 2008

However, contemporary and historical accounts have failed to find even a smoking gun, let alone a culprit. ·Rappoport and White (1993, p. 570) On Black Thursday, October 24, 1929, the stock market (New York Stock Exchange) fell 34 points, a 9 percent drop for the day. The trading volume was approximately three times the normal daily volume for the first nine months of the year. There was a selling panic. But the series of events leading to the crash actually started before that date. THE STOCK MARKET 1922–1932 Table 1.1 shows the average of the highs and lows of the Dow Jones Industrial Stock Index for 1922 to 1932. Using the information of Table 1.1, from 1922 to 1929 stocks rose in value by 218.7 percent. This is equivalent to an 18 percent annual growth rate in value for the seven years. From the low of 245.6 in 1928 to the high of 386 in 1929, there was a 57 percent growth; but using the 290.0 measure for 1929, the increase for 1929 was only 15 percent. From 1929 to 1932, stocks lost 73 percent of their value (different indices measured at different times would give different measures of the increases and decreases). The price increases were large but not beyond comprehension, given the real prosperity taking place in the United States. The price decreases from 1929 to 1932 were consistent with the fact that by 1932,

2

BEATING THE BEAR Table 1.1 Dow-Jones Industrials Index,* Average of the Highs and Lows Index 1922

91.0

1923

95.6

1924

104.4

1925

137.2

1926

150.9

1927

177.6

1928

245.6

1929

290.0

1930

225.8

1931

134.1

1932

79.4

*1922 –1929 measures are from the Stock Market Study, U.S. Senate, 1955, pp. 40, 49, 110, and 111. 1930 –1932 average of the lows and highs for the years, Wigmore, 1985, pp. 637–39.

there was a worldwide depression, and stock price expectations were not optimistic. If we take the 386 high of September 1929 and the 1929 year-end value of 248.48, the market lost 36 percent of its value during that four-month period. John Kenneth Galbraith apparently would have had no difficulty forecasting the crash: „On the first of January of 1929, as a matter of probability, it was most likely that the boom would end before the year was out‰ (1961, p. 29). Paul A. Samuelson, on the other hand, admits that „playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught by the 1929 debacle‰ (1979, p. 9). Most of us, if we held stock in September 1929, would not have sold early in October. In fact, if I had liquidity, I would have purchased stocks after the major break on Black Thursday, October 24. For the next 10 years, I would have been sorry, since Black Thursday was not the end of the decline. The 1929 stock market, for many reasons, was like a large boulder on top of a hill. Given enough pushes to get it started, the boulder would roll down the hill, accelerating as it went. We want to consider why the market was in such a sensitive position and what factors acted to start its downward fall. We will find that there were many contributing factors leading up to the crash. Each of them is small taken individually, but together they helped create the right situation for the debacle.

HOW HIGH IS HIGH?

3

Observers were not pleased with the severity of the crash. Thus John Maynard Keynes (Moggridge 1981, p. 1, and 1992, p. 480), in a letter to his wife, Lydia (October 25, 1929), wrote, „Wall Street did have a go yesterday . . . The biggest crash ever recorded . . . I have been in a thoroughly financial and disgusting state of mind all day.‰ Before the events played out, many others would share KeynesÊs despondency. There is evidence that the stone on the hill is an apt description of the market in 1929. In a recent study, Rappoport and White (1994) treat brokersÊ loans as options written by the lender and bought by the borrowers. They conclude ( p. 271), „The sharp rise in implied volatility coincident with the stock-market boom suggests the fear of a crash.‰ This conclusion, that there was fear of a market crash, is easily acceptable given the statements and positions of the Federal Reserve Board and the U.S. Senate, to be described later. One position is that the stock market was too high; thus a crash was inevitable. Reasons will be given to justify the level of prices. I conclude that the market was not too high in 1929. There are two basic but naïve and incorrect methods of „proving‰ that the stock market was too high in September–October 1929, using only stock prices. One is to compare the stock market prices for some prior period, say 1925, with those of September 1929. The stock price increases for this time period are impressive. Balke and Gordon (1986) show a 155 percent increase (the third-quarter 1929 stock prices are 2.55 times as large as the 1925 prices). During the first nine months of 1929, the increase was 15 percent. The market did go up dramatically from 1925 to October 1929. The second popular method of „proving‰ that the market was too high is to compare the September 1929 prices with those in November 1929 or, more impressively, with prices in 1932. In 1932, prices were 32 percent of the year-end 1929 prices. They went down. Malkiel (1996, p. 50) uses the following stock prices (Table 1.2) to illustrate the excessive heights that stocks reached in September 1929. Obviously, either the September prices are too high, the November prices are too low, or the world changed. But comparing stock prices merely shows that changes took place. There is a plausible explanation for the high prices of September 3, 1929. In evaluating the P/EÊs of firms in 1929, it is useful to estimate the costs of capital. Long-term debt was yielding approximately 5 percent and preferred stock 6 percent. Dividend yield on the average stock was 3.19 percent in August, and the dividend payout rate was 0.64. For comparison, U.S. Treasuries in August of 1929 yielded 3.7 percent. With a retention rate of b = 0.36 and a return on new investment of r = 0.14, the expected growth rate is g = rb = 0.14(.36) = 0.05. Assume that

4

BEATING THE BEAR

Table 1.2 Selected Stock Prices in 1929 High Price September 3, 1929

Low Price November 12, 1929

American Telephone & Telegraph

304

1971Î4¼

Bethlehem Steel

140

781Î4¼

General Electric

3931Î4¼ 7

1681Î8

Montgomery Ward

137 Î8

491Î4¼

National Cash Register

1271Î2

59

Radio Corporation of America

101

28

the cost of equity is approximately 8.2 percent. With these assumptions and facts, a P/ E of 20 is justified for the average firm. P (1 − b ) 0.64 = = 20 = E k − g 0.082 − 0.05

With a growth rate of 0.06, a P/ E of 29 would be justified. Adding growth from the use of debt and from issuing new equity capital, a larger P/ E than 20 would be justified. There is a wide range of calculations of actual average P/ EÊs for 1929. One estimate in Bierman (1991, p. 59, based on statistics from MoodyÊs) is an average P/ E of 16.3, which is low compared with the 20 computed above. Wigmore (1985, p. 572) found a P/ E of 29.8 using the high stock prices and 12.4 using the low prices of 1929. These P/ EÊs are based on the data of 135 companies. Irving Fisher estimated the P/ E ratio to be 13 for the market as of August 1929 (Commercial and Financial Chronicle, October 26, 1929) The use of different companies and data from different times results in different measures of the P/ E ratio in 1929, but the range of estimates seems to be from 12.4 to 29.8, with 16.3 being a reasonable estimate. Let us consider (Table 1.3) the price – earnings ratios of the same six companies that were included by Malkiel, using the high and low prices of 1929 (numbers from Wigmore, 1985, pp. 34 – 87). Using the low 1929 prices for all the stocks, we have very reasonable P/ E ratios ranging from 7 to 18. If anything, given the low cost of equity and high expected growth rate, these P/ EÊs are too low. Using the high prices in the numerators, the ratios are somewhat high, especially RCA, with an indicated P/ E of 73.

HOW HIGH IS HIGH?

5

Table 1.3 Price – Earning Ratios for the Corporations of Table 1.2 Using the High Price for 1929

Using the Low Price for 1929

American Telephone & Telegraph

20

13

Bethlehem Steel

13

7

General Electric

43

18

Montgomery Ward

60

16

National Cash Register

28

11

Radio Corporation of America (RCA)

73

17

The Wall Street Journal on October 9, 1929 (p. 17), had an article with the heading „Rails Sell 11.9 Times Earnings.‰ This multiple was before the October 24 crash, but it reflected the stock price decreases of September and the first week of October. The P/E measure was for 27 dividend-paying railroads. During October, the Dow Jones railroad index dropped from 173 to 159, a drop of only 8.1 percent. Railroads were not a bubble on October 1. On October 22 the Journal ( p. 3) reported „Utilities Sell at 24 Times Net.‰ The net was for the 12 months ending June 30, and the multiple was for 20 representative companies (6 were below 20 times earnings). At the end of July, they had been selling for 35 times earnings. A day later, the Journal ( p. 1) reported that aviation issues were selling at 12 times net after their market value was reduced 56 percent (the P/ E had been 23). The earnings used were the estimated 1929 earnings. The above P/EÊs were all before Black Thursday. THE REAL ECONOMY The 1920s were a period of real growth and prosperity. Real income rose 10.5 percent per year from 1921 to 1923 and 3.4 percent from 1923 to 1929. The gross national product (GNP) increased in real terms from 296.22 in 1928 to 315.69 in 1929 (Balke and Gordon, 1986, p. 782). The year 1929 was the best year ever for the U.S. economy. The Federal Reserve Bulletin showed production at 119 in July; in August it increased to 121, and in September to 123. In October, it dropped to 120, but this level of production was still higher than JulyÊs level. There was a widespread feeling that real business activity was in good shape. For example, consider the following from the Economist, October 5, 1929 ( p. 616): „Meanwhile, business news continues rather good,

6

BEATING THE BEAR

with exceptionally high rate of production during the summer months. . . . Excellent autumn and holiday trade is anticipated.‰ During the period 1919–1929, total factory productivity increased at an annual rate of 5.3 percent for the manufacturing sector. This was twice the rate for the entire period studied (the last year studied was 1953 [Kendrick, 1961]). Farming, mining, transportation, communications, and public utilities all did well. Across all industries the period 1919–1929 was the period of most productivity improvement. The Federal Reserve Bulletin (1930, p. 494) showed total industrial production at 83 in 1919 and 118 in 1929 (the maximum was 125 in May and June). This was an annual growth rate of 3.6 percent. There were warning signs, not necessarily observed in October 1929, that real economic activity was slowing. Steel output in September was 416,000 tons below August, and „automobile production decline[d] 82,000 cars practically to level of 1928.‰ These observations were from the New York Times, December 31, 1929 (p. 30). They were not likely to be widely known in October. Balancing these belated negative reports were two front-page headlines in October from the Wall Street Journal (October 2): „Steel Activity in Sharp Rise‰ and (October 7) „Motor Output Above Normal.‰ The majority of the economic news reports in October were very favorable. On October 4, the Wall Street Journal (p. 1) had a major headline: „Best September in Typewriters.‰ The article went on to say that sales of typewriters were regarded as a reliable index of business activity. The Journal editor concluded that there was little chance of a recession. All of the following measures for September – October 1929 were above the 1923 –1926 index measure of 100: Total production Manufacture Building contracts awarded Factory employment Factory payrolls Freight car loadings

Commodity prices were less than 100 and the prices of farm products were at 105. The business news during the summer and fall of 1929 was very good. On May 24, the Magazine of Wall Street carried an article describing the expansion possibilities for electricity in rural areas. The October 1, 1929, issue of Forbes described record-breaking rail earnings. The June 15

HOW HIGH IS HIGH?

7

issue of the Magazine of Wall Street stated, „Business so far this year has astonished even the perennial optimists.‰ When the stock market price break came on Thursday, October 24, the Economist (p. 805) observed, „The final collapse of the Wall Street Boom . . . has confounded optimists and pessimists alike.‰ And an important point that is frequently ignored (p. 824): „The share boom of 1926–29 originated in a period of industrial prosperity which has never been surpassed in the worldÊs history.‰ Thus the business news immediately prior to October 24 was extremely positive (except for the regulatory news applicable to the utility sector). As the Economist states, it was a period of industrial prosperity that had never been surpassed. Of course, stock prices went up. They went up not because of speculators but primarily because of economic facts. If this had not been true, the speculators would have sold the market (or more exactly its components) short and put an end to the boom long before October 24, 1929. Cecchetti (1992, p. 576) writes, „We will never know exactly what caused the stock market to fall by nearly 30 percent in late October 1929.‰ He is correct, but there is more to be learned. He also states, „First, there was no reason to believe a priori that stock prices were too high before the crash.‰ He identifies (p. 574) as causes the „Federal Reserve behavior, together with the public statements of numerous government officials.‰ The research conducted for this book allows us to agree with and expand on these thoughts.

Chapter 2

THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES

However, if the attitude of the Federal Reserve officials can be properly construed from statements of its friends, there are those who are just as apprehensive that the market may go up as the average small investor is afraid that it might go down. ·The Magazine of Wall Street, May 18, 1929 From 1925 to the first three quarters of 1929, the stock market increased dramatically. Table 2.1 shows an index of all common stock prices and the changes in value from 1925 to 1929. The fact that common stocks increased in value by 120 percent in four years (1925–1929) implies a compound annual growth rate of 0.218. Although this is a large rate of appreciation, it is not obvious proof of an orgy of speculation. The decade of the 1920s was extremely prosperous in real terms, and the stock market, with its rising prices, reflected this prosperity as well as the expectation that the prosperity would continue. But Congress and the Federal Reserve Board worried about the speculation taking place in New York. The hearings held by the Senate Committee on Banking and Currency on broker loans in February and March 1928 and the hearings on stabilization held by the House Committee on Banking and Currency in March, April, and May 1928 are very helpful in understanding the subsequent actions of the Federal Reserve Board in 1929. The Senate committee was concerned because total loans secured by stocks and bonds of the member banks of the New York federal reserve

10

BEATING THE BEAR

Table 2.1 Common Stock Prices, 1925–1929

Year

Index of All Common Stock (1941– 42 = 10)

Growth Rate

Cumulative Change from 1925

1925, first quarter

11.01

1926, first quarter

12.94

0.18

0.175

1927, first quarter

13.94

0.08

0.266

1928, first quarter

17.49

0.25

0.589

1929, first quarter

24.24

0.39

1.202

1929, second quarter

24.43

0.01

1.219

1929, third quarter

28.12

0.15

1.554

1929, fourth quarter

21.90

0.22

0.989

Source: N. S. Balke and R. J. Gordon, „Historical Data,‰ in The American Business Cycle (Chicago: University of Chicago Press, 1986), p. 802.

district on January 11, 1928, exceeded $3.8 billion, and „the largest part of this sum is used for speculation in the New York Stock Exchange.‰1 The desire to control the speculation taking place in the New York Stock Exchange (NYSE) was primary. The senators did not define speculation, but they knew it was evil and had to be controlled. Senator Robert LaFollette of Wisconsin led off the 1928 hearings by quoting H. Parker Willis, an ex-secretary of the Federal Reserve Board: „it remains a fact that our reserve system has excited no real remedial influence upon the great American evil of stock-exchange gambling.‰2 Roy Young, the newly appointed governor of the Federal Reserve Board (he had been the governor of the Minneapolis Reserve Bank), defended the reserve system and pointed out that the increase in broker loans between January 6, 1926, and February 29, 1928, „came about entirely in the advances that were made by corporations and individuals‰ and was not the result of actions taken by the Federal Reserve or by New York banks.3 Young asked the rhetorical question: „Is this volume of credit that is going to the stock market denying commerce and industry credit?‰4 He concluded that he could find „ no evidence of credit being denied to commerce or productive industry.‰5 Young concluded by stating, „Now, I am not prepared to say whether the brokersÊ loans are too high or too low. I do not think anybody else can say so. I am satisfied they are safely and conservatively made.‰6 Senator Carter Glass responded by asking, „Would you not modify that and say they are safely made?‰7

THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES

11

Young did not object to the elimination of the word „conservatively.‰ He stated, „Yes, I am; however, speaking from the Federal Reserve Bank standpoint, I do not think the Federal Reserve should say whether they are too high or too low. Now if there is a further expansion of this brokersÊ loan account and it gets to the place where it is dangerous and borders on unwarranted speculation, I have enough confidence in the American banking fraternity to believe they can correct that situation themselves.‰8 This positive statement is important, since it separated Young from the other members of the board. The five other members of the board concluded that there was excessive speculation and the board had to take action. Edmund Platt, vice-governor of the Federal Reserve Board ( Platt was an ex-newspaper editor from Poughkeepsie, New York), also testified that he did not know that the market was too high.9 Mr. Platt: It looks as if it was an inflation in the price of securities. On the other hand, I do not believe anybody can positively and definitely say that a security like United States Steel, for instance, should not sell on a 5 percent basis. . . . With all the saving of capital that Professor Sprague has told you about and everything, maybe there is so much capital seeking investment that securities that appear to be reasonably sound, with a future prospect perhaps ought to sell on a 5 percent or even a 4½ percent basis. I do not see how anybody can tell positively. Senator Glass: Do you think that bets are always made with reference to the soundness of the security? Mr. Platt: Not always; but I think that is pretty generally true with relation to the higher grade ones · such securities, for instance, as the investment trusts all buy. There is another thing injected into the situation. We have had a tremendous growth in investment trusts lately by which the smaller investor can put in a thousand dollars and have his investment scattered among such stock as American Telephone and Telegraph, United States Steel, etc. His thousand dollars are spread among the whole lot of them so there is not very much risk of loss in the long run.

Platt failed to realize that investment trusts could not protect the investor from changes in the level of the stock market. He also did not realize that some of the trusts were using large amounts of borrowed funds to leverage the returns on equity investment and thus had large amounts of risk. Glass then „established‰ the presence of gambling in the market. Senator Glass: I have in mind just a single security right now among many others that occupy a similar position. It was quoted in last January at 1081Î4¼. There has been no change in the management of the corporation, there has been no

12

BEATING THE BEAR

approximate increase or diminution in the supply and sale of the product. The same security is selling on the market, or was yesterday, at 69. Mr. Platt: It was selling at 108? Senator Glass: It was selling at 108 in January. It was selling on the market yesterday at 69. Now, what is that but gambling?10

Glass seemed to suggest that buying a stock that decreased in value was gambling. Platt was correct about „not much risk of loss in the long run,‰ if „long run‰ is defined to be in excess of 20 years. In the short run, the risk prospects are much different. Charles Hamlin of the board (a lawyer from Boston) declined the invitation to testify, but E. H. Cunningham of the Federal Reserve Board (an ex-Iowa farmer) did offer some comments. He made clear that he was against the use of credit for speculative purposes: „I do feel, however, that the rapid increase of the past three years in the use of credit for speculative purposes is a tendency in the wrong direction. Credit used for such purposes is a part of the credit availability of the country, and in the event that the credit supply should become or limited, the amount invested in stock loans will naturally have the effect of limiting credit availability, and might possibly, if some measure of control is not provided, reach such proportions as to seriously embarrass the credit requirements of business and commerce.‰11 The inability of the board to distinguish between credit being used to finance security purchases and credit used to finance the purchase of real goods and services was to cost the country dearly. In March, April, and May of 1928, the House Committee on Banking and Currency held hearings on stabilization. These hearings were relative to the consideration of an act that would amend the Federal Reserve Act of 1913 to have the federal reserve system promote the stability of commerce and a more stable purchasing power for the dollar. The first person to testify was Adolph Miller of the Federal Reserve Board, a former economics professor. He quoted extensively from The Behavior of Prices by Frederick C. Mills. There followed an interesting exchange between Miller and Otis Wingo, a congressman from Arkansas: Mr. Miller: Well, I have had this book in my hands only a couple of days, so I cannot tell you all that is contained in the volume. Mr. Wingo: I think you will find when you read it clear through that he says that the behavior of prices is largely like the behavior of individuals. That is his theme.12

Wingo later asked a series of questions that anticipated perfectly the misguided actions of the board in 1929.

THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES

13

Mr. Wingo: IsnÊt this the major question that governs your board in deciding such questions? DonÊt you consider what your policies should be in regard to meeting the needs of legitimate business in the country, and not the effect on the stock market? If the needs of legitimate business require easy money, then you will meet that need and not be scared off because perchance there is an attendant evil that there may be a lot of speculation in the stock market? Mr. Miller: How do you propose to reconcile those two purposes? We have a securities market in this country that generally is ready to take advantage of easy and cheap credit. Mr. Wingo: I donÊt think you caught my point. My point is this. The factor that should control in fixing the rediscount rates and in determining whether or not you will put more money in the market or take money out is not what is going on in the stock market · that is not the prime consideration · but what are the necessities of legitimate business? Mr. Miller: Yes. Mr. Wingo: And the fact that in meeting the necessities of legitimate business you happen to stimulate a little bit the amount of speculation in the stock market should not deter you from meeting the major needs of business?13

Miller kept responding and Wingo kept pointing out to Miller that „You still donÊt get my question.‰14 If Miller had understood Wingo, the course of history might well have been changed. Wingo was intelligent and knowledgeable. He was even a fine pragmatic teacher (as evidenced by his questions). Unfortunately, Miller and four other members of the board did not understand the difference between the stock market and the real economy. Wingo finally declared: „That is, you cannot always determine when a brokerÊs loan or a stock loan is one for speculative purposes.‰15 Miller did not speak directly to that statement but he did finally state, „ I am of the opinion that for the purposes of good administration in the federal reserve system a tight control over the diverting of its credit into any kind of speculative loans is necessary.‰16 When one of the congressmen asked „As a matter of practical banking, you would know where the money went to, wouldnÊt you?‰17 Miller responded „It is not always easy to know it. But it can be sensed.‰18 Remember, Miller was the intellectual leader of the board in 1929 and the most forceful of its members. The board was in deep trouble. Hamlin, who declined to testify in earlier hearings, testified at this hearing and revealed that he thought the board had a right to act when „speculation so threatens business, threatens to curtail, perhaps, business credits that may be demanded.‰ But he also stated „I should always be reluctant to act.‰19 Young, governor of the Federal Reserve Board, also testified, but his testimony can be summarized by his statement that „stability is a big question and a big problem. It is one that I am not capable of talking about

14

BEATING THE BEAR

definitely at this time.‰20 Miller thereby became the de facto leader of the board. No one can support or contradict conclusively the conclusions resulting from „ what if ‰ statements. But we should ask, what if a healthy Otis Wingo of Arkansas had been the governor of the Federal Reserve Board in 1929? His questions during the hearings indicated a knowledge of economics and finance exceeding that of all members of the board. Unfortunately, the cards were not dealt that way, and Adolph Miller was the guiding force behind the actions of the board in 1929. Wingo deserves more than a few words of praise. He was admitted to the bar in 1900 and practiced law in Sevier County, Arkansas. He was elected to Congress nine times and served in Congress from 1913 until his death in 1930. He was one of the prime authors of the Federal Reserve Act. When he died on October 21, 1930, he was replaced in Congress by his wife, Effiegene Loeke Wingo, who then ran for Congress, was elected, and served in Congress from 1930 to 1933. She did not offer herself as a candidate for renomination in 1932 but proceeded on to other activities. A contemporary offered the following description of Wingo: „A man of commanding appearance, self-confident, fearless, and aggressive, Mr. Wingo was a natural leader. His ideals were high, his emotions deep, and in all relations he was loyal, kind and considerate.‰21 Despite the fact that he was suffering from ill health during the hearings, his questions were unusual in their consistent fairness, insightfulness, and intelligence. It is a tragedy that Miller did not listen more carefully to the congressman from Arkansas. The congressman did well. We are in his debt. He effectively dispelled the myth that credit given to brokers kept credit from being given to the real economy. Unfortunately, Miller did not learn the lesson. We cannot be sure of cause and effect in 1929. But we can be sure that Miller did not understand the lesson being taught by Wingo in 1928. In 1929 the Federal Reserve Board, with Miller as the intellectual leader, tried by several significant actions to stop stock market speculation. By August it had succeeded. We will not be able to conclude that the board caused the stock market price declines in the fall of 1929, but there is evidence that the stock market price increases (arising from speculation) were a major concern of the board, which took actions to stop them. On Sunday, October 13, 1929, the Times ( p. 7) reported that Professor C. A. Dice of Ohio State, an economist, had declared, „Stock Prices Will Stay at High Level for Years to Come.‰ He gave the following justifications ( p. 7): „the great economic developments in wealth, in efficiency of production and transportation, in cheapness and adequacy of distribution, in invention and engineering and in public good-will and confidence.‰

THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES

15

He concluded „The day of the small investor is here.‰ Dice was an advocate for the „new era.‰ Consider the following information regarding performance of U.S. corporations, which was readily available in 1929: 1. In the first nine months of 1929, a total of 1,436 firms announced increased dividends (Forbes, October 15, 1925, p. 95). In 1928, only 955 announced an increase. 2. In the first nine months, cash dividends were $3.1 billion, up from $2.4 billion in 1928 (a 29 percent increase). 3. In September 1929, dividends were $399 million compared with $278 million in 1928, an increase of 44percent. 4. The dividend payout was 64percent in September 1929, compared with 75 percent for September 1928, reflecting increased earnings. 5. Earnings compiled for 650 firms showed a 24.4 percent increase versus 1928 for the first six months (National City Bank of New York Newsletter, August 1929). The earnings for the third quarter for 638 firms were 14.1 percent larger than for 1928. For the first nine months of 1929, the earnings of the 638 firms had increased 20.3 percent compared with 1928 (November 1929, p. 154). The March 1930 issue showed that for 1,509 firms, annual earnings had increased by 13.5 percent for 1929 compared with 1928.

It is not difficult to see why the market was using high expectations of earnings growth. With reasonable (for the time period) estimates of growth, most of the industrial stock prices for September 1929 can be justified with a dividend growth valuation model. It is important that we more fully understand the causes of the 1929 stock market crash and correct some of the widely held misconceptions. If stock prices were too high because of speculative buying and the crash was inevitable, then the lesson to be preached is simple, if not easily executed. One should not invest in stocks if stock prices are too high. The conventional wisdom is that speculation was the cause of stock prices being too high. Thus Malkiel (1996) writes ( p. 51) about a speculative boom: „Perhaps the best summary of the debacle was given by Variety, the show-business weekly, which headlined the story, ÂWall Street Lays an Egg.Ê The speculative boom was dead and billions of dollars of share values · as well as the dreams of millions · were wiped out.‰ Laying the blame for the „boom‰ on speculators was even more common in 1929. Thus, immediately upon learning of the crash of October 24, Keynes wrote in the New York Evening Post (October 25, 1929): „The extraordinary speculation on Wall Street in past months has driven up

16

BEATING THE BEAR

the rate of interest to an unprecedented level‰ (Moggridge, 1981, p. 2 of vol. xx). And the Economist, when stock prices reached their low for the year, repeated the theme that the U.S. stock market had been too high (November 2, 1929, p. 806): „There is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world.‰ The key phrases in the above quotations are „exaggerated balloon of American stock values‰ and „extraordinary speculation on Wall Street.‰ The common viewpoint was that the U.S. stock market was too high. But if the conventional view of history is not correct and if U.S. stocks were not universally too high, then what did cause the great crash? The stock market index hit a high of 386 in September 1929; by November, it had dropped to 230, a drop of 40 percent. By the time the crash was completed in 1932 · and thanks to the oncoming of the real economic depression · stocks had lost in excess of 70 percent of their value. The results of the crash were devastating to individuals and to nations. The crash helped bring on the depression of the thirties and the depression helped to extend the period of low stock prices, thus „proving‰ that the prices had been too high. This book reviews a small set of possible causes of the crash and reaches specific conclusions that might cast some light on this important event. The lessons for investors and students of history are important. Although I cannot prove that I know the exact specific causes of the crash, I present some reasonable evidence supporting my hypotheses. A CATALOGUE OF EIGHT CAUSES Consider the eight „suspects‰ that may or may not have caused the crash. The identified possible causes include the following: 1. The stock market was too high in September 1929 (values did not justify the prices) because of excessive speculation, making the crash inevitable. 2. There was a real downturn in business activity. 3. Actions of the Federal Reserve Board excessively restricted growth of the money supply. 4. On both sides of the Atlantic, a message was being sounded by both the media and important governmental figures that the U.S. stock market was too high; hence there was a „war‰ against the speculators. 5. There was excessive buying on margin and excessive buying of investment trusts; relative returns and costs of buying on margin are relevant to evaluating margin buying.

THE EVENTS PRIOR TO THE 1929 AND 2008 CRASHES

17

6. There was excessive leverage when the debt of operating utilities, holding companies, investment trusts, and margin buying are all considered. 7. There was a setback in the public utility market arising from an adverse decision for utilities in Massachusetts combined with an aggressively priced utility market segment. 8. The market overreacted.

We will choose number 7 as the triggering event. The leverage (number 6) and the repetitive statements that the market was too high were also major factors. THE 2008–2009 MARKET CRASH When real estate prices started to go down in 2007 and homeowners found that their mortgages were larger than the value of their houses, many borrowers stopped making their mortgage payments. The mortgage defaults spread to the default on collateralized mortgage obligations held by financial institutions financed with over $30 of debt for each dollar of equity. This led to a string of financial institutions having more debts than assets, resulting in a drastic restriction of credit available to industry. The stocks of the financial sector were battered; then, as business activity slowed, other stocks tumbled. With falling operating results, the lower stock prices observed in the fall of 2008 were soon justified, given the lower operating earnings. The problems in the financial sector led to an inability of these firms to lend. The drying up of credit led to a decrease in business activity, which led, in turn, to a worldwide recession in 2008 – 2009. In 1929, the stock market crash led to a decrease in business activity in 1930 –1932. In 2008, financial events (house prices decreased in value, subprime mortgages defaulted, and business activity decreased) triggered stock price decreases, which were rapidly validated by poor income measures in the fourth quarter of 2008. The stock price decline in 2008 was more severe than that in 1929. Alan Greenspan wrote in The Wall Street Journal (March 11, 2009) that: „There are at least two broad and competing explanations of the origins of this crisis. The first is that the Âeasy moneyÊ policies of the Federal Reserve produced the U.S. housing bubble that is at the core of todayÊs financial mess. The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.‰

18

BEATING THE BEAR

The long-term fixed rate was more relevant, since it is the rate that should be used to value long-lived real estate. Thus we have low long-term interest rates fueling a vigorous real estate market. Wall Street encouraged the real estate boom by packaging the mortgages so that even segments with the worst credit were given a triple-A rating. In addition, the buyers of risky components seemed to be able to divest themselves of the risk by engaging in credit default swaps. All seemed to be going well until 2008, when real estate prices stopped going up and borrowers lost the incentive to pay on mortgages that were larger than the value of the real estate. Credit default swaps (CDSs) grew from a market of a few billion dollars in 2001 to $60 trillion in 2007. Banks bought subprime mortgages and then engaged in swaps, where they paid the risk taker in good years, but the banks were paid if the borrower did not pay the mortgage in a timely fashion. Since the bank unloaded its risk to the swap counterparty, it could buy additional risky mortgages. Unfortunately, the risk still existed. If the counterparty who promised to pay in case of mortgage default accepted too many swaps in a bad year, it would be unable to pay. The banks that had purchased protection would (and did) find that the losses were not effectively hedged. Why were credit default swaps a reasonable strategy for the banks buying the subprime mortgages? The mortgage originators were lending money to real estate buyers with a low probability of being able to make their mortgage payments and with little incentive to pay if the value of the real estate was less than the value of the mortgage obligation. In a letter to the editor (The New York Times, May 10, 2009), Ian Jarvis makes the point that if a real estate investor „would have walked down Main Street just once pretending to be a homebuyer and spent one day having liarsÊ loans thrust at him, he would have met the real estate agents selling overpriced merchandise to underinformed dreamers and heard the agentsÊ pitch ·„Investors like you, sir, are making a fortune.‰ If he had done his homework, Mr. ________ might not have played the part he did in devastating our economy.‰

Chapter 3

MARKET MYTHS IN 1929 AND 2008–2009

WHO KILLED COCK ROBIN? Are the Prophets of Disaster Now Satisfied? ·The Magazine of Wall Street, November 16, 1929 There is a great deal wrong with our understanding of the 1929 stock market crash. Even the name is inexact. The largest losses to the market did not come in October 1929 or the winter of 1930 but rather in the following two years. In the calendar year 1929, the market lost only 11.9 percent of its value, after having gained 37.9 percent in the previous year. In December 1929, many expert economists, including John Maynard Keynes and Irving Fisher, felt that the financial crisis had ended, and by April 1930 the Dow Jones Industrial Average had recovered a large percentage of the October losses. By contrast, from September 2008 to March 2009, the stock market lost in excess of 50 percent of its value. Our misconceptions about the events of the fall of 1929 have been fed by the easy generalizations of authors more interested in being dramatically clever than in analyzing the facts. We will show that there are good reasons for thinking that the stock market was not obviously overvalued in 1929 and that it was sensible to hold stocks in the fall of 1929 and to buy stocks in December 1929 (admittedly this investment strategy would have been terribly wrong). We want to consider two basic questions in this book: Was the stock market unreasonably high in October 1929? Was a crash inevitable? We will present explanations for the initial decline in stock market value which are

20

BEATING THE BEAR

not dependent upon an assumption of overvaluation. But we will not fully explain why the market turned down in the fall of 1929. Changes in market psychology are not perfectly explained by reference to specific events. The objective of this book is not to determine whether the fall in stock prices triggered the Great Depression of the 1930s but to describe more accurately the stock market crash of 1929–1932 so that we can better understand the present stock market situation and better predict the future. It is normal practice to describe the 1929 stock market prior to October as a bubble or speculative orgy. Throughout economic history many events have been defined as bubbles. Historically, the existence of price bubbles (large price increases followed by large price decreases) in financial markets has been explained, in part, by the assumption of irrationality on the part of traders. For example, C. R. Kindleberger explains bubbles in the following way: „speculation for profit leads away from normal, rational behavior to what have been described as manias or bubbles. The word mania emphasizes the irrationality; bubble foreshadows the bursting.‰1 In 2008, the real estate bubble burst. How do we now there was a bubble in 2008? Prices went down in 2008 and 2009.2 One empirical investigation of the existence of a price bubble was performed by R. R. Flood and R. M. Garber.3 They were unable to reject the hypothesis that bubbles were absent from the German hyperinflation of the 1920s. Since their research dealt with rates of changes associated with an overall price level, they are appropriately circumspect in making claims about more specialized asset markets: „The professionÊs folklore on the existence of bubbles emphasizes such markets, for example, the Tulip Bubble, the South Sea Bubble, the Mississippi Bubble, the crash of 1929. However, no one has verified that a bubble of the type defined in the current rational-expectations literature has ever existed.‰4 Many of the so-called bubbles are actually interesting economic ventures that failed or well-managed scams that were vigorously sold by expert con artists. The famous „South Sea Bubble‰ was a combination of the above two factors. The South Sea Bubble (1711–1721) occurred in England. It started out as a legitimate business enterprise (the South Sea Company with a charter for monopoly of trade with Latin American countries) but ended up being the high-pressured selling of nearly worthless securities. The South Sea CompanyÊs first ship to approach Latin America was driven off by the Spaniards in 1717. In 1718, England was at war with Spain and the companyÊs original charter lost its value. Faced with the loss of its reason for existence, the company then proceeded to repackage the debt securities of the English government. The firmÊs stock tremendously increased in value as new capital was used to pay old capital and more government debt securities were

MARKET MYTHS IN 1929 AND 2008–2009

21

purchased. Before concluding that only fools get taken in by such bubbles, consider the fact that Isaac Newton in a single month sold his £7,000 of South Sea Company stock at a profit of 100 percent; several months later, however, he lost £20,000 after making further investments in the company.5 It has been said of John Blunt, a director of the South Sea Company and the prime promoter of its securities from 1717 to 1721, that „he continued to live his life with a prayer-book in his right hand and a prospectus in his left, never letting his right hand know what his left hand was doing.‰6 The 1929 stock market situation was intrinsically different from the classic examples of bubbles, including the South Sea Bubble. The 1929 stock market crash was more the result of the misjudgments and bad decisions of good people than the evil actions of a few profiteers. There were solid reasons for buying stock in October 1929, but the market sentiment soon shifted from optimism to pessimism, and the negative psychology of the market became more important than the underlying economic facts. BEFORE 1929 It is important to understand some of the most significant events that led to the 1929 stock market decline. In 1920, Warren G. Harding was elected president of the United States, and in 1924, Calvin Coolidge was elected. These two presidents do not rank high in performance, and their appointees left something to be desired. At the beginning of 1929, the Federal Reserve Board consisted of Harding – Coolidge appointees or reappointees (three members of the board · Edmund Platt, Charles S. Hamlin, and Adolph C. Miller · had originally been appointed by Wilson). Unfortunately, these appointees were not the most talented or best prepared for controlling the U.S. banking system. The Federal Reserve Board in January 1929 consisted of the following six members (omitting the two ex-officio members: Secretary of the Treasury A. W. Mellon and Comptroller of the Currency J. W. Pole): Roy A. Young, Governor. Young had been governor of the Minneapolis Reserve Bank before joining the board. Edmund Platt, Vice-Governor. Platt was an ex-newspaper editor and ex-congressman from Poughkeepsie, New York. Adolph C. Miller. Miller had been a professor of economics at Harvard, the University of Chicago, and Cornell. Charles S. Hamlin. Hamlin was a Boston lawyer who had been an assistant secretary of the treasury with Cleveland and Wilson. He was the first governor of the Federal Reserve Board. George R. James. James was a Memphis merchant. Edward H. Cunningham. Cunningham was an Iowa farmer.

22

BEATING THE BEAR

Young, Hamlin, and Miller had relevant experience or academic qualifications, but the other members of the board required on-the-job training. Neither Young nor Hamlin were very insightful or forceful and did not supply the leadership needed by the board, although Young actually opposed many of the boardÊs actions in the first six months of 1929. Miller was by far the most decisive member of the board and became the de facto intellectual leader. Although he had an academic background, his style was that of an autocrat. Hamlin kept a diary that is an important source of our understanding of what happened in the meetings of the Federal Reserve Board. Benjamin Strong, the most respected (internationally) of U.S. bankers, was the head of the New York Federal Reserve Bank from 1914 until the fall of 1928. In 1925, when direct pressure on banks to control speculation was recommended by the board as a strategy, „Governor Strong disagreed, pointing out that direct pressure could not succeed in New York unless the Federal Reserve Bank refused to discount for banks carrying speculative loans, and that it would mean rationing of credit, Âwhich would be disastrous.ʉ7 Although he died in 1928, StrongÊs influence extended to 1929. From 1921 to August 1928, the real financial genius and power in the United States was Benjamin Strong, governor of the New York Federal Reserve Bank. Lester V. Chandler has written the definitive biography of Strong.8 Strong was an acknowledged leader of international finance and truly a giant in U.S. banking. Most important, StrongÊs intellect and personality (including a great sense of humor) led to New York being the power center of U.S. banking from 1921 to 1928. This frustrated several members of the Federal Reserve Board, especially Young and Miller. In the summer of 1927, the United States was on the verge of a recession. Productivity had dipped down and significant economic signs were negative. In addition, Europe was losing gold to the United States and European bankers feared an international disaster. Strong led a move to reduce the discount rate and increase the reserve banksÊ holdings of U.S. securities. This easy money policy succeeded and the recession was avoided. Later Miller would blame the resurgence of stock speculation in 1928 on StrongÊs easy money policy of 1927. Miller was very influential in leading the board to avoid this „mistake‰ in 1929. STOCK SPECULATION Throughout the 1920s, New York banks had financed broker loans. The „speculation‰ being financed by the New York banks became increasingly distasteful to members of the Federal Reserve Board. The board

MARKET MYTHS IN 1929 AND 2008–2009

23

advocated „direct pressure‰ on New York banks to limit borrowing by member banks from the Fed, which was then used to finance broker loans. Strong disagreed with the Federal Reserve Board. He successfully argued that penalizing banks that carried speculative loans would be a disastrous policy. In October 1928, Strong died after a long illness. After his death, the dispute between the board and the New York Reserve Bank accelerated, with the board advocating restricting broker loans and the New York Bank wanting to increase the rediscount rate. The Federal Reserve Bulletin of February 1929 made it clear that the federal reserve banks would take steps to decrease the flow of credit to „speculators.‰ The bulletin stated that the Fed „means to restrain the use, either directly or indirectly, of Federal reserve credit facilities in aid of the growth of speculative credit.‰ By early 1929, the board had sent out a clear signal that it believed there was excessive speculation in stock, and that it wanted the banks to decrease their broker loans. Over the next several months, there evolved a series of explicit conflicts between the board (wanting to control speculation by direct pressure) and the New York City Reserve Bank (wanting to avoid an arbitrary tightening of credit · with the banks deciding who would get credit). Beginning in February 1929, the Reserve Bank of New York wanted to increase the rediscount rate from 5 to 6 percent. The Federal Reserve Board refused the repeated requests until August 1929. A commercial bank that had made a loan, wanting to expand its ability to make more loans, would send the loan to the reserve bank in its district and receive in return federal reserve notes or the accounting entry equivalent. The rate paid by the commercial bank to the federal reserve bank is called the rediscount rate; it represents a cost to the bank and defines the rate it must charge. (This bank loan rate must be larger than the rediscount rate.) An increase in the rediscount rate translates immediately into an increase in the rate the banks charge their customers. The U.S. Senate reacted immediately to the boardÊs public condemnation of the bankÊs practices of fueling the „speculative boom‰; it adopted the following resolution in support of the board: Whereas in press dispatches recently, the Federal Reserve Board has complained that money is being drawn from the channels of business and used for speculative purposes, and that some of said speculation is illegitimate and harmful: Therefore, be it Resolved, That the Federal Reserve Board is hereby requested to give to the Senate any information and suggestions that it feels would be helpful in securing legislation necessary to correct the evil complained of and prevent illegitimate and harmful speculation.9

24

BEATING THE BEAR

The mood was firmly established that the levels of 1929 stock market prices were the result of unthinking, evil speculation. The investing community was bombarded with statements from both financial experts and policy makers at the highest levels that there was excessive speculation, resulting in stock prices that were too high. Even Trowbridge Callaway, president of the Investment Bankers Association of America, spoke of „the orgy of speculation which clouded the countryÊs vision.‰10 M. Friedman and A. J. Schwartz describe the situation at the end of the 1920s as follows: „The bull market brought the objective of promoting business activity into conflict with the desire to restrain stock market speculation. The conflict resolved in 1928 and 1929 by adoption of a monetary policy, not restrictive enough to halt the bull market yet too restrictive to foster vigorous business expansion.‰11 The FedÊs restrictive credit policy on speculative loans started to affect broker loan rates early in 1929. Broker call loan rates were 6.94 percent in January 1929, but they were reported by the Fed to have increased to 14.40 percent by the end of March 1929.12 Rates on commercial paper had also increased, although not as much (from 51Î4 to 6 percent). The difference between the rates on broker loans and rates charged for other commercial activities was dramatic. Although the Fed expressed concern regarding excessive speculation in stocks, the real economy as measured by published statistics was fundamentally sound. But it is important to remember that while the Fed was implicitly fighting speculation and price increases in the stock market, there was a deflation in the prices of goods and services. As described by Friedman and Schwartz, „The stock of money, too, failed to rise and even fell slightly during most of the expansion · a phenomenon not matched in any prior or subsequent cyclical expansion. Far from being an inflationary decade, the twenties were the reverse.‰13 By March 1929, the tight money policy of the Federal Reserve Board was successful in increasing the price of credit. The normal credit demands (income tax payments, quarterly payments of dividends and interest, and spring agricultural requirements) resulted in a withdrawal of funds from the New York call loan market; call rates were reported by National City Bank to reach a maximum of 20 percent.14 There was a drop in stock prices, but the New York City banks provided funds for broker loans and the stock price decrease was very small. The rates on call loans fluctuated violently in April and May. In May alone the call loan rates ranged from 6 to 15 percent.15 The National City Bank of New York Newsletter reported that there was a „growing reluctance of the banks to extend their loans on collateral ineligible for rediscount at the Reserve Banks.‰16

MARKET MYTHS IN 1929 AND 2008–2009

25

The July 15, 1929, issue of Forbes reported (quoting R. W. McNeel) that the policy of the Federal Reserve Board was destroying the confidence of investors and that a continuation of the policy would undoubtedly stop the free flow of capital into American industry. There was a growing feeling among business writers that the Fed did not want the market to go up further. The war against the New York speculators had begun. MYTHS AND FABLES A myth exists only in imagination. We know, using historical data, that stocks actually decreased in value in the fourth quarter of 1929. But other things that we „know‰ about 1929 are less clearly based on fact. There are seven great myths about 1929: 1. Stocks were obviously overpriced (the evidence suggests stocks were reasonably priced). 2. The crash was inevitable. ( It was just as likely to observers at the time that stocks would go up as down.) 3. The Great Crash occurred in October 1929. (Most of the losses took place in 1930 –1932.) 4. Speculators deserved to be taught a lesson. ( It was very difficult to distinguish good investors from bad speculators.) 5. Dishonest manipulation drove stock prices up. (There is evidence of some bothersome but not significant manipulation; there is no evidence that the level of the market was materially affected by these actions.) 6. Credit given to brokers kept credit from being given to the real economy (this would be true only if Federal Reserve actions rationed the total credit; it certainly does not have to be valid.) 7. The high level of stock market prices jeopardized the nationÊs prosperity. ( It was not stock prices but the action of the Federal Reserve to bring down stock prices that jeopardized prosperity.)

Gerald Sirkin also takes the position that descriptions of 1929 as a period of „speculative orgy‰ are misleading. He concludes that „some showed signs of over-indulgence. But, by the usual standards for such things, the conclusions would have to be: not much of an orgy.‰17 The following fable is typical of the stories told about promoters and speculators in 1929: Consider the story of the oil promoter who appeared before Saint Peter and presented his credentials for admission to Paradise. He was informed by Saint Peter that the quota for promoters was filled and no more of

26

BEATING THE BEAR his profession could enter for the time being at least. Not dismayed, the promoter queried, „As I understand it then, the only condition under which I can gain admission is that a vacancy be created?‰ „Precisely,‰ replied Peter. A faint smile appeared on the candidateÊs face; it was apparent that he could meet that situation. He asked for the privilege of making an announcement to his former colleagues. Directed to the celestial microphone he delivered himself of a brief message. „Fellow promoters, oil has been discovered on Jupiter!‰ The words were no sooner spoken than several thousand of the tribe stormed out through the gates. Peter, somewhat surprised by the exodus, turned to the candidate, „Well, I guess you may come in now.‰ The reply: „Saint Peter, IÊve changed my mind . . . IÊm going too. . . . There may be some truth in that report.‰18

HAWLEY–SMOOT ACT (1930) In 1930, the Hawley – Smoot Act was passed, fixing the average rate of duties at about 41 percent.19 Given that the first major stock market decline occurred in October 1929 and the act passed in 1930, it is difficult to conclude that this act was a major contributing factor to the October stock price declines (there had been considerable hope that the president would veto the bill), but it probably did contribute to the subsequent stock price declines and the Great Depression. One hypothesis is that the stock market was not excessively high in 1929 but that there were effective efforts by the Federal Reserve Board, Congress, and the president of the United States to bring the stock market speculators to their knees. The constant attack on the New York speculators and the „overpriced‰ stock market created a situation where any negative news or a combination of relatively minor events could generate a psychological reaction that would lead to a market decline. „Who killed cock robin?‰ remains a valid question. It was not the New York speculators. From reading articles and books, everyone knows that in 1929, bathroom attendants and bellhops were speculating in stocks. But no one knows how many people lacking the necessary qualifications (whatever they were) were in the market (speculating or possibly even investing). F. L. Allen writes: „Unquestionably there were far more people speculating than ever before; unquestionably there were great numbers of clerks, stenographers, janitors, chauffeurs, and waiters in the market. Yet probably not much more than one person in a hundred in the American population was playing stocks on margin.‰20 Most of us are in favor of broad-based ownership of U.S. industry. But in 1929 the ownership of stock by nonprofessionals was looked at as a bad act, called speculation.

MARKET MYTHS IN 1929 AND 2008–2009

27

THE GREAT MYTH OF 2009 The great myth of 2009 is the administrationÊs stimulus plan passed in March 2009. Rather than a pure stimulus plan, it was a grab bag of the projects Democratic congressmen and senators had wanted to implement for the previous eight years and were not able to obtain because of the eight years of President George W. Bush and a Republican Congress. I do not mean to imply that all the projected spending under the stimulus bill is bad. But much of it cannot be justified as part of a stimulus plan. Hardly anyone knows what spending has been approved for specific projects, since few persons have read the stimulus bill as passed. I know Cornell University gets a chunk for projects, few of which were high priority for the United States. Does this mean that the $800 billion of stimulus spending will not stimulate the economy? This is not the issue. The correct question is whether, with a month of careful evaluation, a better set of projects and strategies to create jobs and increase economic activity could not have been approved. Consider the $250 grant each recipient of Social Security received in the spring of 2009. That $250 was not subject to federal income taxes and the amount did not depend on the income or wealth of the recipient. If husband and wife both received Social Security, the family would have received $500 in total. Not exactly a carefully targeted award.

Chapter 4

THE FED’S ROLE IN GOOD TIMES AND BAD

At home high wages and little unemployment have promoted industrial peace and excepting the issues of prohibition, farm relief, the crime wave and the policies of the Federal Reserve Board there is little to disturb the even tenor of our commercial ways. ·Joseph Stagg Lawrence, Wall Street and Washington By the beginning of 1929, both the Federal Reserve Bank of New York and the Federal Reserve Board believed that speculation in stocks was excessive and had to be controlled. The New York bank thought the best method to control credit was to increase its rediscount rate. The board did not want to increase interest rates but rather to take „direct action.‰ This referred to the utilization of publicity to make the boardÊs position known and then moral persuasion (threats?) to convince banks that they should go along with the boardÊs desire to restrict stock market speculation. In the first half of 1929, this meant that the banks should divert credit from loans financing stocks to loans to be used for normal business activity. Although the difference in the desired course of action could be described as an intellectual one, there were other more important factors that contributed to the lack of cooperation: „The close of the period was marked by open conflict between the Federal Reserve Board and the Federal Reserve Banks over the technique for controlling stock market speculation. This was the crucial engagement in a struggle for power within the system that had always been potential and that was to lead in the course of the next few

30

BEATING THE BEAR

years to a near-complete shift of power from the Banks in general and the New York Bank in particular to the Board.‰1 To understand the hostility of the Federal Reserve Board toward the Federal Reserve Bank of New York, one has to go back to the years 1914 –1928, when Benjamin Strong was governor of the Federal Reserve Bank of New York. By 1921, Strong was the dominant U.S. central banker of this era. From 1921 to 1928, Washington was a side show compared with New York when it came to issues of national and international finance. Strong believed that credit should not be restricted solely to prevent of stock speculation and feared the consequences of the credit restriction policy: I think the conclusion is inescapable that any policy directed solely to forcing liquidation in the stock loan account and concurrently in the prices of securities will be found to have a widespread and somewhat similar effect in other directions, mostly to the detriment of the healthy prosperity of this country. Some of our critics damn us vigorously and constantly for not tackling the stock speculations. I am wondering what will be the consequences of such a policy if it is undertaken and who will assume the responsibility for it.2

When the fall in stock prices came, no one claimed responsibility. In 1927, business activity was relatively flat and the Federal Reserve Board, at the urging of Strong, decided on an easy money policy. Adolph Miller, a very influential member of the board, blamed this policy for the bad events of 1929 and subsequent years and stated that Strong was its originator: „The policy . . . was originated by the New York Federal Reserve Bank, or more particularly by its distinguished Governor, the late Benjamin Strong. Brilliant of mind, engaging of personality, fertile of resource, strong of will, ambitious of spirit, he had extraordinary skill in impressing his views and purposes on his associates in the Federal Reserve System.‰3 Miller felt that the federal reserve system during 1927 and 1928 had followed policies of easy credit with disastrous results. Stock prices went up in 1927, 1928, and the first nine months of 1929. It was not until February 2, 1929, that the Federal Reserve Board acted in a manner Miller approved. He blamed the Federal Reserve Bank of New York for not supplying the necessary leadership: „But it is abundantly clear that acceptance by the Board of aggressive easing action proposed by the New York Federal Reserve Bank in 1927 and of complete abandonment of restraining action in the second half of 1928 proves that the Board, under the established tradition, was first too quick to fall in with a daring

THE FEDÊS ROLE IN GOOD TIMES AND BAD

31

and dangerous proposal and later too slow to assume the leadership which was needed and was lacking at a most critical time. . . . And New YorkÊs leadership proved to be unequal to the situation.‰4 Adolph Casper Miller had been a member of the Federal Reserve Board from its beginning. For 24 years before joining the Department of the Interior and then the Federal Reserve Board, he had taught economics at Harvard, Cornell, the University of Chicago, and the University of California. William Hard described Miller as the „brains of the Board.‰5 As early as 1925 in a speech to the Boston Commercial Club, Miller declared war on speculation: „It is clear therefore that no bank has a proper status as an applicant for reserve-bank accommodation which is supplying credit for speculative purposes.‰6 This radical view of banking and the function of the Federal Reserve was held in check by Benjamin Strong. With StrongÊs death in October 1928 and the election of Herbert Hoover in November 1928, Miller was able to impose his philosophy on the board and on the country. Miller lived on S Street in Washington; Herbert Hoover lived on the same block. Hoover and Miller became fast friends and undoubtedly HooverÊs economic policies were heavily influenced by his friend (or Miller was influenced by Hoover).7 When Hoover moved into the White House in 1929, Miller was finally in a position of tremendous influence. Miller was never able to shift his focus from the speculation taking place on the New York Stock Exchange to the real economy. The fact that the monetary policies of 1927 advocated by Strong helped to avoid a recession and resulted in the prosperous years of 1928 and 1929 did not enter his thinking. His obsessive goal was to put an end to speculation. Finally, in February 1929, he convinced the Federal Reserve Board that direct action was appropriate: „In this period of optimism gone wild and cupidity gone drunk . . . the Federal Reserve Board was growing more and more anxious at the course of developments. Ultimately its anxiety reached a point where it felt that it must itself assume the responsibility of intervening in the dangerously expanded and expanding speculative situation menacing the welfare of the country. This it did early in February, 1929.‰8 Before 1929 Strong and President Coolidge stood between Miller and control of the Federal Reserve. The persuasive power and leadership capabilities of Strong are further illustrated by a story told by Chandler concerning the Kansas City Reserve Bank. Governor Bailey of that bank was addressing the Reserve Bank Governors Conference: Hardly had he begun to speak when one of his colleagues shouted: „Tell us Governor, why your Federal Reserve Bank led off in the reduction of the discount rate?‰

32

BEATING THE BEAR „I donÊt mind telling you,‰ said the Governor, „I did it because Ben Strong wanted me to.‰ At this remark there was much laughter. When Governor Bailey resumed, he said with some show of feeling: „IÊm not afraid to follow the lead, in financial matters, of such men as Ben Strong and Andrew Mellon.‰9

In October 1928 Strong died. On November 23, 1928, George Harrison was appointed as governor of the Federal Reserve Bank of New York. However, „StrongÊs death left the system with no center of enterprising and acceptable leadership. The Federal Reserve Board was determined that the New York Bank should no longer play that role.‰10 The election of Hoover also ensured that the restrictive credit policies of the Federal Reserve Board would be supported by the White House starting in March 1929. Harrison was the son of a U.S. Army career officer. He graduated from Yale in 1910 and from the Harvard Law School in 1913. He served for a year as legal secretary to Justice Oliver Wendell Holmes of the U.S. Supreme Court. At the formation of the federal reserve system, he was appointed assistant general counsel of the Federal Reserve Board. After a tour of duty with the American Red Cross in France during World War I, he served as general counsel of the Federal Reserve Board. In 1920 he became a deputy governor of the Federal Reserve Bank of New York and accompanied Governor Strong on his last trip to Europe in the summer of 1928. Harrison was a very intelligent and competent leader with a high sense of morality, but he was not an effective political strategist. He would have trouble with the Federal Reserve Board. The Federal Reserve Board waited until the beginning of 1929 to fling down the gauntlet and challenge the New York bank. Hoover had been elected president of the United States and had already spoken out against speculation. With Hoover about to be inaugurated, the board acted. On January 3, 1929, Harrison called Governor Young of the Federal Reserve Board to advise him that the New York directors had increased the minimum buying rate for bankersÊ bills (a bill in this context is a bankerÊs acceptance). The rate increase was to be effective the next morning. This was the normal procedure followed by reserve banks for changing the minimum buying rate for bills. The banks voted to change the rate and then informed the board of their actions. That evening a telegram was received by Harrison from the board indicating that the board was not prepared to approve of the increase. Harrison was shocked by the telegram. Young had been governor of the Federal Reserve Board for well over a year and should have understood the accepted process for changing the bill rate. In three telephone calls that afternoon Young had not indicated that the board was displeased with

THE FEDÊS ROLE IN GOOD TIMES AND BAD

33

New YorkÊs raising the bill rate. In fact, a week previously Harrison had told Young that the bill rate might be raised. Young had not indicated that he disapproved or that the Reserve Board would have to approve such an increase. Harrison did not realize that Young was only nominally in charge of the Federal Reserve Board. Adolph Miller wielded the effective power, and he strongly disapproved of a rate increase. Harrison tried to call Young at his home and finally made connection at seven oÊclock that evening. He told Young that he was sorry that there was any misunderstanding as to procedure and that the New York bank had followed the same procedure it had followed for many years in the past without any question or disapproval by the board. But Young was „very much put out‰ and said that „he did not intend any longer to be a rubber stamp.‰ Harrison added that „he seemed very much out of temper‰· this about a man described by contemporaries as „jovial.‰ Young was frustrated by the fact that the New York Federal Reserve Bank raised the bill rate and that an activist majority of his board would not accept the increase. He was in the middle. C. S. Hamlin reports in his diary that Young was furious at not having been consulted by New York for his approval and that he wanted to order the rate suspended. „Platt said that would seem like a slap in the face; that Governor Young said that was what he wanted.‰ Young thought Harrison had not treated him courteously. Pent up emotions were being released. Harrison received the blasts that were intended for Benjamin Strong but were never delivered. Hamlin writes that the board tried unsuccessfully to find a regulation that showed New York had acted illegally. Miller thought a new regulation was needed that „henceforth all acceptance rates must be approved by the Board before being effective.‰ At 10:00 A.M. on January 4, Harrison telephoned Young and tried to be a peacemaker: I told him again that, as I saw the matter, we had acted in complete good faith in accordance with what we understood to be the established procedure for a number of years; . . . we have from time to time changed our buying rate merely advising the Board that we had done so, never asking their approval; that our action on yesterday was quite in accordance with this procedure; and that, having discussed the matter with him from time to time in the past, more particularly only last Monday, without any intimation on his part that he wanted a different procedure to be followed, I assumed that we were acting quite in accordance with the BoardÊs understanding and wishes.

That afternoon Young called Harrison and told him that since New York had already made the rate effective, that the board had just noted the

34

BEATING THE BEAR

action without approval or disapproval. Young also said that the board was preparing new regulations. The new regulations never surfaced. The events of January 3 and 4 clearly indicate that Young and the Federal Reserve Board intended to reaffirm their control of the Federal Reserve Board over the Federal Reserve Bank of New York. Harrison went to Washington and met with Young on January 6. „We discussed all sorts of matters, especially all those matters likely to come up for consideration at the Open Market Investment Committee meeting. He made no mention, however, about bill rates or prospective regulations. I did not bring up the subject myself until just about as Governor Young was to leave for lunch. I then asked him how his regulations were progressing. He smiled and said not very well, since each proposal that he had made had not met with the approval of the Board.‰ This is the end of the bill incident. But when Young said to Harrison that „he did not intend any longer to be a rubber stamp,‰ it is likely that he was not reacting to the polite-to-a-fault Harrison but rather to the years of StrongÊs administration and to YoungÊs personal relationships with the other board members. The incident reflected attitudes that were to become more evident in subsequent events. Not only was the board sensitive to actions of the New York Fed, but there was internal strife. Hamlin reports that there were violent discussions between Young, James, and Cunningham. Miller wanted to issue a statement that would help, according to Hamlin, „prevent seepage into Wall Street.‰ Young did not agree with the preparation of a statement and said that the board could not issue a statement in favor of direct action and restraint of broker loans. In February, the board did just that. There was extensive discord within the board. In a conversation with Alexander of the National Bank of Commerce on January 9, Harrison emphasized his philosophy regarding what federal reserve banks could and would not do. He described a federal reserve bank that had in the past adopted a policy of not making loans to any member banks that had outstanding loans to finance automobiles. That direct action drew a great deal of criticism, and the policy was soon changed. Harrison made the point that the same objection „might apply · though, perhaps, in different degree · to brokersÊ loans.‰ He then made a stronger statement regarding his opposition to direct action against broker loans: „We were not the ones to determine whether the Stock Exchange was a legitimate part of the economic life of the country; that we must assume, so long as it exists, that it is, and that, if so, brokers are a necessary part of the machinery, and loans to brokers are a necessary incident to their business and the business of the banks with whom they carry balances.‰

THE FEDÊS ROLE IN GOOD TIMES AND BAD

35

Harrison then applied direct action (before the BoardÊs letter of February 2 was sent or published): I referred to the fact that since April 1, 1928, the National Bank of Commerce has been out of our debt only 28 days, and that since July 1, 1928, they have been out of our debt only six days · those during October; that both with respect to the continuity and frequency and average of their borrowings, they were pretty much out of line with other banks in New York; that I thought he was entitled to know this fact in order that he, as well as we, might avoid the possibility of criticism both here and in Washington. . . . I added again that he would know better than we just how best to make the adjustment.

This was an effective illustration of direct action at work. The events of January 3 and 4 prepared the foundation for Harrison being inclined to implement the boardÊs direct action campaign even before the board had announced its policies. Harrison clearly did not relish conflict and would attempt to avoid it by anticipating the actions of the board. The war on speculation had begun. Banks were being told to restrict loans to brokers. On January 21, Miller offered the board members a draft of a letter defining the direct actions to be taken. YoungÊs objective was to „put MillerÊs draft in the least objectionable form.‰ Young did not think direct pressure on federal reserve banks would be successful and was not in favor of the letter. The paradox was that Young and the New York Bank were in agreement. Both did not believe in direct action ( pressure on banks to direct their loans away from speculative loans). The New York Bank believed that the way to control loans was through an increase in interest rates, letting the market price determine resource allocation. MillerÊs proposed letter was discussed at great length. Young feared „it would be construed as an attack on the stock market and cause trouble‰ ( Hamlin, January 25). On January 25, Miller telephoned Hamlin to say that the banking system had gone to pieces and that the appointment of Harrison in New York was a „severe disaster‰ ( Hamlin, January 25). On January 31, Young went to New York to attend the meeting of the New York board of directors. Governor Montagu Norman, governor of the Bank of England, was also in New York visiting the Federal Reserve Bank of New York. Young and Norman talked in New York and Norman interpreted that conversation to eliminate the need for a trip to Washington. Harrison, wanting to avoid difficulties with Young, suggested that this might be misunderstood and strongly urged that he visit Washington. Norman said this was agreeable to him and he went to Washington.11

36

BEATING THE BEAR

On February 2, MillerÊs draft was again considered by the board. A motion that would insert „no desire for drastic action‰ in the letter was put to a vote, and it lost. On the letter itself, all members voted yes except Young. „Platt said he hoped the public would construe it as a recommendation for drastic action as to existing speculative loans and James and Miller agreed with him‰ (Hamlin, February 2). Hamlin states that „evidently these three are oblivious or reckless of the dangerous consequences which might ensue if the letter were so construed.‰ But Hamlin voted to send out the letter despite these anticipated dangerous consequences. (Appendix 1 to this chapter is a copy of the February 2 letter.) Not only was there a battle between the board and the New York Bank but there were also disagreements within the board. These were described in 1935 by Miller: „In the six months following the BoardÊs declaration of its position of February 2, 1929, the five members of the Board who took the responsibility of formulating the attitude and policy for the federal reserve system were opposed by a minority of their own members, including the Secretary of the Treasury, the governor and the vice-governor, by the twelve federal reserve banks and, finally, by the Federal Advisory Council and many, but by no means all, of the largest member banks. This was a formidable opposition.‰12 Despite the massive opposition, Miller failed to consider the possibility that he was in error. The Federal Reserve Bank of New York believed that direct action (as typified by the boardÊs letter of February 2, written by Miller) was ineffective and would lead to problems of implementation. New York favored increasing the discount rate. Eleven times, from February 14 to May 23, the New York directors voted to raise the discount rate of their bank from 5 to 6 percent. Eleven times the board voted down the increase. It was only on August 9, 1929, that the board approved the increase to 6 percent. On February 5, Harrison was in Washington explaining the position of the New York directors on the discount rate. He spoke to Young for two hours in the morning and joined the board in the afternoon. According to Hamlin, Harrison stated „that speculative activity was steadily increasing; that in last year speculation loans of all banks increased 8 billion‰ (Hamlin, Feb. 5). Under questioning, Harrison agreed that a 6 percent rate would be „injurious to small manufacturers‰ and would „interfere with building operations.‰ Harrison said direct pressure had failed and „if 6 percent could not control speculation, higher rates must be resorted to.‰ There was no disagreement between the New York Fed and the Washington board that speculation must be controlled. They only differed as to method.

THE FEDÊS ROLE IN GOOD TIMES AND BAD

37

HarrisonÊs report of the February 2 meeting is somewhat different than HamlinÊs: In the end I told the Board that we had no recommendations to make at this time; that we considered it a very serious period in our credit history; that I thought our meeting of the day before was of sufficient importance to report to the Board; that I would be glad to get their reactions and to discuss with them System policy, especially with a view of determining whether they had anything in mind that we might be doing that we have not been doing. Very little was said by members of the Board, although when I asked Dr. Miller what he thought about an increase of one percent in the event that we should have to increase at all, he said that he thought that was a very important matter that should be determined at the time we would have to act.

The New York bank thought that time had already arrived. Harrison then discussed the letter of February 2 sent from the board to the reserve banks: I then discussed with the Board at some length their letter to us of February 2, saying that I believed that the New York bank had already done practically as much as was in its power to do through so-called direct action; that we believed it was our right and our duty to inform individual member banks when they were out of line either in the point of continuity or amount of borrowings; that we never had any difficulty in securing their cooperation in this regard; but that whenever we did discuss this matter with our member banks we pointed out that the method of correcting their position with us was a matter of internal management for them to decide; that we could not undertake to manage their institutions; but that we could indicate to them that we thought they had been borrowing too long or too much from us, either in relation to other comparable member banks or in relation to the character of their own business, having in mind the possibility that a bank might at times be borrowing the equivalent of capital funds from us as a result of a deliberate investment, also out of which the bank would be making a profit represented by the spread between our rate and the return on the investments.

The differences between the positions of the board and the New York bank are well defined by an exchange between Harrison and Miller (as described by Harrison): There were no specific suggestions made by anyone other than Dr. Miller who said that if he were running the Federal Reserve Bank of New York and received such a letter as that written by the Board, he would either write a letter to each of the principal member banks in New York or else

38

BEATING THE BEAR call them into conference to say that he had been to Washington and had learned that the Federal Reserve Board was opposed to the use of Federal Reserve credit to support speculative credit and that, in those circumstances he would tell them to do „thus and so.‰ I told him that that was just the point. The difficulty is to determine what is „thus and so.‰

Later on the afternoon of February 5 the board considered a proposed insert for The Federal Reserve Bulletin. Hamlin notes that „in discussing its effect, Miller said he did not think it would cause any drastic liquidation of speculative loans, that nothing we could do would have that effect; that he personally would like to see a sudden liquidation and crash.‰ In October, Miller would get his wish. According to Hamlin, E. A. Goldenweiser, director of the Division of Research and Statistics of the Federal Reserve, warned against the insert: „Dr. Goldenweiser, who happened to be there, said he would not be true to himself if he did not say that it would be a great mistake to include in the Bulletin a copy of our letter to the chairman; that it would reveal a difference of opinion between the Board and the banks and would be washing dirty linen.‰ Miller agreed to include only the first page of the letter. Only Young voted against publication of the letter. The February 1929 issue of The Federal Reserve Bulletin included the following statements: During the last year or more, however, the functioning of the Federal Reserve system has encountered interference by reason of the excessive amount of the countryÊs credit absorbed in speculative security loans. The credit situation since the opening of the new year indicates that some of the factors which occasioned untoward developments during the year 1928 are still at work. The volume of speculative credits is still working. . . . The extraordinary absorption of funds in speculative security loans, which has characterized the credit movement during the past year or more, in the judgment of the Federal Reserve Board, deserves particular attention lest it become a decisive factor working toward a still further firming of money rates to the prejudice of the countryÊs commercial interests. The Federal Reserve Act does not, in the opinion of the Federal Reserve Board, contemplate the use of the resources of the Federal Reserve banks for the creation of extension of speculative credit. A member bank is not within its reasonable claims for rediscount facilities at its Federal Reserve bank when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans.

The March issue of The Federal Reserve Bulletin contained the following statements: „In last monthÊs Bulletin, the Federal Reserve Board

THE FEDÊS ROLE IN GOOD TIMES AND BAD

39

defined its attitude toward the rapid growth of loans on securities in recent years and toward the present high level of this class of loans. The Board said that Âthe extraordinary absorption of funds in speculative security loans, which has characterized the credit movement during the past year or more, deserves particular attention lest it becomes a decisive factor working toward a still further firming of money rates to the prejudice of the countryÊs commercial interests.ʉ The bulletin then gave a brief lecture on banking policy and credit policy: Credit policy is essentially impersonal and finds expression chiefly through the influence that the Federal Reserve system may exert on the volume and cost of bank credit through its policy of sales or purchases in the open market and through discount rates on member-bank borrowings and buying rates on acceptances. In determining upon credit policy the Federal Reserve system is always under the necessity of balancing the advantages and disadvantages that are likely to follow a given course of action. Low money rates may have a favorable effect on domestic business, but at the same time may stimulate speculation in securities, commodities, or real estate. High money rates, on the other hand, may exert a moderating influence on speculation, but at the same time may result in a higher cost of credit to all lines of business, and thus be detrimental to commerce and industry; ultimately they may draw gold from abroad, which would tend to ease the domestic situation.

On February 6, Harrison briefly visited the board and expressed his regrets that the board had released its statement calling for „direct action‰ to limit speculative loans. Harrison returned to New York, and on February 7, Hamlin reports that „Harrison called up and said his directors were considering advancing their discount rate. Governor Y. told him it would be better not to act today. If it raises the rate I think every member except Governor Y. and possibly Platt would refuse to approve it.‰ On February 8, the board tabled New YorkÊs request to increase the discount rate (Platt voted against the tabling). The board feared that if it approved, it would be concluded that „what it meant in its letter was simply to increase rates · while the opposite was the fact as to most of the Board‰ (Hamlin, Feb. 8). On the same day an interesting exchange took place between Miller and Young (as reported by Hamlin). Miller was a good friend (and ex-neighbor) of Herbert Hoover: During the discussion Miller spoke of Hoover as one who would back up the Board, that he knew Wall Street well, and he seemed to act as if Hoover knew and approved of the BoardÊs action; and that if the Board weakened, he faintly intimated, Hoover might take position in the matter.

40

BEATING THE BEAR Young asked if this was a threat. Miller evidently abashed, said „No. Not at all!‰ YoungÊs defense of the FedÊs independence is praiseworthy. Miller later stated that he would never vote for higher discount rates unless it were clearly demonstrated that direct action was a failure.

On February 14, the directors of the Federal Reserve Bank of New York unanimously voted to increase the rediscount rate to 6 percent. Harrison immediately (at 3:40 P.M.) telephoned Young in Washington and requested a decision, „one way or another today.‰ At 4:20 P.M. Young telephoned Harrison and read the following statement: „The Federal Reserve Board has instructed me to call you and advise you that the Board has received the verbal advice of the Federal Reserve Bank of New York having established a rate of six percent and that the Federal Reserve Board will hold the matter for review and during the interim has determined that the rate of the Federal Reserve Bank of New York shall be five percent.‰ Harrison explained why a review and a decision was needed that day. Young said he had not understood the need for urgency and said he would speak to the board again. At 5:20 P.M., not having received a call from Young, Harrison again telephoned Young and explained the problems with not knowing whether the board might approve a higher discount rate already approved by New York (the directors, some of whom managed banks, had inside information). At 5:30 P.M., McGarrah (chairman of the New York Bank) called Young and extended HarrisonÊs concerns. At 5:45 P.M., McGarrah again called Young. Young read the following statement to McGarrah: „The members of the Board present have agreed, informally, that they will take no action to change the rediscount rate of the Federal Reserve Bank of New York before the next regular meeting date of the directors of that bank, to wit, next Thursday, unless advised in the interim that there is no objection to the Board acting earlier should it so desire.‰ At 5:30 P.M., C. E. Mitchell (a director of the New York Federal Reserve Bank and president of the First National Bank) talked with Young about the problems of leaving the issue unresolved. At 6:01 P.M., Harrison explained to Young the vote establishing a rate of 6 percent. He stated „if the Federal Reserve Board did not act that day the action would lapse‰ (this lapsing would seem to solve one of HarrisonÊs problems, but this fact was ignored by all). Young said the board wanted to think it over and needed time. At 6:23 P.M., there was a „lapse in conversation‰ while Young talked with

THE FEDÊS ROLE IN GOOD TIMES AND BAD

41

other members of the board. At 6:40 P.M., Young read the following motions to Harrison: 1. In view of the incomplete report of the rediscount rate action taken by the directors of the Federal Reserve Bank of New York as furnished over the telephone by the Federal Reserve Bank of New York, and in view of the fact that the Board now has the resolution before it as passed by the New York directors, it moves that the previous action of the Federal Reserve Board in reference to the rediscount rate of the Federal Reserve Bank of New York be reconsidered. Motion carried. 2. Moved that the Board disapprove of the action of the directors of the Federal Reserve Bank of New York and determine the rate of that bank to be five percent.

Thus, the board agreed to review New YorkÊs decision, but then voted to disapprove New YorkÊs decision to increase interest rates. Harrison, trying to reopen the issue, offered to supply more information if the board desired it. Mitchell accepted defeat more gracefully. He talked with Young and told him „he was glad the Board had taken definite action.‰ Governor Harrison then informed Governor Young that he would, in accordance with our usual custom, announce to the newspaper men that there was no announcement to make. At 9:10 A.M. on February 28, Young telephoned Harrison to discuss the form of a report of call loans made for the account of others. After completion of that topic, Harrison shifted to the rate situation. Young explained that the board wanted to give direct action a trial and that the board would vote 7 to 1 against any rate increase request from New York. On March 16, 1929, Young spoke before the Commercial Club of Cincinnati. The speech was released for publication the next day. Aside from offering a variety of solutions without recommending any of them, Young stated: Financing business through shares or bonds can be on a sound basis and when it is sound is entitled to credit, but it is not entitled to all the credit or to an unreasonable proportion of the total. It seems to me that it would be the part of prudence for all who are lenders to see first that business gets credit at reasonable rates and let the others get what is left.

These are the carefully thought out comments of the governor of the Federal Reserve Board in March 1929.

42

BEATING THE BEAR

On March 21, Harrison had a telephone conversation with Andrew Mellon. Mellon agreed that rates had to go up sooner or later but, as Harrison wrote, „I never heard anything further from Mr. Mellon.‰ On March 26, call money started at 12 percent; but by noon, call money had risen to 20 percent. Stock prices were down drastically. C. E. Mitchell of the First National Bank described the situation in the exchange to Harrison as „panicky.‰ The New York Fed supplied the liquidity necessary to stem the decline. Mitchell also took steps (making loans to brokers) that helped stop the fall in prices. Mitchell was not to be thanked for his efforts. The action by Harrison is significant, since he directed the resources of his bank and the New York member banks toward stemming the panic. This was a dry run for the October crash. Harrison wrote: I then mentioned, however, that in circumstances such as these which he described as bordering on the „panicky,‰ the Federal Reserve Bank did not want and could not be in the position of arbitrarily refusing loans on eligible paper to member banks, that the impression should not be spread about that we were refusing loans and that I had advised the officers of the bank that if inquiry should come to them they should not imply that we would refuse loans. In other words, as I explained to Mr. Mitchell, my opinion was that in a period of great stress the Federal Reserve Bank should be in the position of freely lending money at its going rate in order that there might not be any charge that it had arbitrarily refused or rationed credit.

Harrison then called Jackson Reynolds, chairman of the Clearing House Committee, and had a similar conversation with him. Reynolds saw some benefits from the decrease in stock prices: He repeated that he thought it was „fine‰ and that „these fellows were getting what they ought to get.‰ I told him, however, that I did not want him to feel that the Federal Reserve Bank, because of all of its efforts to seek cooperation of the member banks in the past to avoid unnecessary uses of its credit, should be understood as refusing to grant credit on eligible paper.

One has to wonder who „these fellows‰ were who were „getting what they ought to get.‰ Harrison also called Young: „At about 12:45 I telephoned Governor Young of the Federal Reserve Board to tell him of conditions in the money market, mentioning that the call rate was then 20 percent, that $60 million was wanted, that stock prices had declined drastically, and that conditions

THE FEDÊS ROLE IN GOOD TIMES AND BAD

43

on the Exchange were very actively depressed. He said that he had already been advised of those facts.‰ Young stated that HarrisonÊs actions were „100 percent right.‰ March 26, 1929, is not a historical day compared with the black days of October. The actions of the New York Fed and the National City Bank and „luck‰ turned the day. However, on March 26, the low of the Dow Jones Index was 281.51, compared with the previous dayÊs high of 311.55 · a drop of 9.6 percent. The volume on March 26 was 8,246,000 shares, compared with 5,860,000 shares the day before and 5,619,000 the day after. The actions of the New York Fed and the National City Bank helped prevent the panic from becoming historic. The April issue of The Federal Reserve Bulletin makes no reference to the panic of March 26. It does state that „The liquidation of brokersÊ loans by banks since the BoardÊs statement of February 7 indicates an effort by the banks to comply with the desire of the Board to restrain the diversion of bank credit into speculative channels. This liquidation has been accompanied by a further rise in money rates, which has attracted funds from corporations and individuals in this country and abroad.‰ On March 26, Mitchell had announced that the National City Bank „was ready to lend $25 million on the call market, whatever might be the attitude of the Federal Reserve Board.‰13 One might think that history would thank Mitchell for helping to prevent a collapse of the stock market. Appendix 2 to this chapter contains MitchellÊs 1933 testimony before a Senate committee on stock exchange practices. Mitchell is not thanked for preventing a March crash but rather is accused of encouraging the speculation that led to the October fall in prices. The New York Times on March 29, 1929, carried the following statement made by Senator Carter Glass regarding Mitchell: He avows his superior obligation to a frantic stock market over against the obligations of his oath as a director of the New York Federal Reserve Bank. Mr. MitchellÊs proclamation is a challenge to the authority and the announced policy of the Federal Reserve Board. The challenge ought to be promptly met and courageously dealt with. The Board should ask for the immediate resignation of Mr. Mitchell as Class A director of the New York Federal Reserve Bank. . . . The whole country has been aghast for months and months at the menacing spectacle of excessive stock gambling, and when the Federal Reserve Board mildly seeks to abate the danger by an administrative policy

44

BEATING THE BEAR fully sanctioned by law, rather than by a prohibitive advance in rediscount rates, which might penalize the legitimate business of the entire country, an officer of the System issues a defiance and engages in an attempt to vitiate the policy of the Federal Reserve Board.14

Hoover approved of the statement by Glass. The stage was set for the October crash. The New York banks had learned that massive actions to prevent stock market panic would not be thanked by the president, Congress, or the Federal Reserve Board. On March 28, Miller was in New York to attend a meeting of the directors of the New York Federal Reserve Bank. At 12:45 he informed Harrison „that he did not feel he could be present at our meeting of directors this afternoon in view of the reported statement of Mr. Mitchell in the morning newspapers concerning Âloans on callÊ and ÂFederal Reserve Board warningsÊ without expressing his views in the matter, that to say nothing would imply possibly that he agreed with what Mr. Mitchell had said.‰ Mitchell was a director of the New York Federal Reserve Bank. Harrison then notes: „I suggested the possibility of Mr. Miller sitting next to Mr. Mitchell at lunch and discussing privately and quietly with him what he had in mind. Mr. Miller said that he did not want to discuss the matter with him Âpersonally.Ê I asked him whether he wanted to discuss the question ÂofficiallyÊ at the board meeting, stating that perhaps the Federal Reserve board had not given him any mandate with respect to the matter. Mr. Miller said that, of course, that was true and that he would therefore not mention it at the meeting.‰ Harrison continued to try to act as a peacemaker: „I then told Mr. Miller that I hoped he would not persist in his intention not to join our meeting, that he had come here to discuss the Federal Reserve BoardÊs policy with our directors, that that matter was of paramount importance and that I hoped he would discuss the matter with Governor Young before he decided not to attend our meeting.‰ After a phone call to Young, Miller indicated that „he would be glad to join our meeting and say nothing with respect to Mr. MitchellÊs statement. I told him I was very glad of this result.‰ The Banking Act of 1933 states, „to prevent a repetition of the incident in March 1929, when, despite the express warning of the Federal Reserve Board to the contrary, the National City Bank poured $25,000,000 into the call-loan market, the Banking Act of 1933 fortifies the Board with power to call in immediately all advances made to any member bank which disregards a warning against increasing its stock market loans.‰15

THE FEDÊS ROLE IN GOOD TIMES AND BAD

45

Thus an action by a member bank, made with the full knowledge and approval of the Federal Reserve Bank of New York and the governor of the Federal Reserve Board, led Congress to pass an unnecessary law. On Thursday, April 11, 1929, the directors of the New York Federal Reserve Bank voted to establish a discount rate of 6 percent. Harrison phoned Edmund Platt of the Federal Reserve Board to advise him of that fact and to tell him in some detail of the nature of the discussion of the bankÊs directors. Platt indicated that the board had acted on the rate increase that morning and had disapproved it. Harrison requested that the board „reconsider the matter.‰ About an hour after the request, Platt telephoned to say that the board had voted to disapprove the rate increase. On the afternoon on April 18, 1929, Harrison telephoned Platt to advise him that the directors of the New York Bank had again voted to establish a discount rate of 6 percent. Platt again reported that the board had rejected the rate increase. On the afternoon of April 25, 1929, Harrison telephoned Platt to advise him that the directors of the New York Bank had voted unanimously to establish a rate of 6 percent. Harrison advised Platt that the directors would await word from him as to the decision of the board. Platt telephoned at about 4:15 to say that the board had voted not to approve the increase. This meeting was different from past meetings, since Secretary Mellon presided and argued the case for an increase. On April 26, 1929, Harrison called Mellon. They first discussed the foreign exchange situation and then the discount rate situation. Harrison stated his position regarding the availability of credit: I referred to the episode on Tuesday, March 26, when money rates went to 20 percent and said that our position now was the same as it was then, that is, that the problem of providing funds for the call loan market or determining the rates for call loans was with the New York banks and bankers, not with the Federal Reserve Bank; that we could not request or suggest that they should or should not cut funds in a period of severe pinch; that that was their problem, but that the necessary corollary of that position was that we should be prepared to lend freely, if necessary, to provide reserves against loans taken over by New York City banks, Mr. Mellon said he thought that that was absolutely the right position and an unavoidable one.

On May 13, Harrison spoke with William C. Potter, president of Guaranty Trust Company. Harrison related the January 2 bill rate incident (proudly stating that New York still had authority to change rates

46

BEATING THE BEAR

without getting approval from the Federal Reserve Board). He then complained that „we have not only been denied the right to increase our rate but have been in a measure subjected to the test of so-called direct action.‰ Harrison gave Potter a copy of McGarrahÊs May 10 letter to read (the letter was in reply to the boardÊs letter of May 1; G. W. McGarrah was chairman of the Federal Reserve Bank of New York). Mr. Potter read the letter through; said that in his opinion our position was precisely correct; that the situation was such that it would be impossible for us to deal with banks on the basis suggested by the Board, and that he hoped our letter would have the effect of raising a definite final issue with the Board on which this whole problem could be fought out; that it is becoming more and more impossible as things are going now. He said that they obviously do not understand the operation of the New York money market and that he was glad we had taken the position that we did.

Having established that the Federal Reserve Board was the common enemy, Harrison then proceeded to explore direct action. During the course of the conversation, I mentioned to Mr. Potter incidentally that the Guaranty Trust Company was one of the banks listed in the BoardÊs letter. He said then that he wanted to discuss their problem with me and said that their difficulties were due largely to a loss of deposits which always takes place at the time of a merger, and also to some heavy demands quite frequently by some of their best customers for loans on securities. . . . As he was leaving my room, he said he hoped that they would be out of our debt inside of ten days or two weeks even though it meant a large loss to them to do so; that he was just as anxious as the Federal Reserve Bank to be in a position to take care of the increased demand that will arise during the fall.

Later Harrison called George Baker, Jr., of the First National Bank to discuss the credit policies of the First National Bank. The First National Bank wanted cheap money and Harrison did not want an easy money policy. Harrison also thought it was unfortunate that people were saying that First National was „defying the Federal Reserve Bank.‰ Harrison then dropped the other shoe: I said I thought it was most unfortunate that institutions of the standing and importance of the First National and the Federal Reserve were so obviously going in different directions. I then mentioned, putting all the

THE FEDÊS ROLE IN GOOD TIMES AND BAD

47

cards on the table as to our position, that, regardless of any difference of opinion about legal rights, we consider clearly that we have the right, in the case of a bank which has been borrowing as much and as long as the First National is borrowing, to deny credit, but that I saw very considerable difficulty in our exercising that right; that we had never had to do so in the case of any of our member banks and that I hoped we never would have to do so.

The direct action mandate was clear (although not stated without ambiguity): „At one time during the discussion I made it very clear to him that we had not asked and that we were not then asking him to reduce his call loans, that I was merely pointing out the fact that his bank has been borrowing continuously in sums wholly out of line with other banks in New York, and that I still hoped that within a reasonable time they might find it convenient to get their bank more in line with other banks.‰ In June 1929, the board relaxed (but did not abandon) its direct action campaign. Miller described in 1935 the change in June 1929 to be a relaxing of the direct pressure: By the middle of June it became apparent that in the then existing psychological and economic situation continuance of unremitting pressure on the market, particularly with the known heavy financial requirements of many leading industrial undertakings at the approaching end of the fiscal year, might precipitate a catastrophe. The Board, after a conference with a delegation of New York reserve bank directors, decided to relax for the time being but not to abandon its Âdirect pressure.Ê It was moreover then becoming evident that the stock market was reaching a point where it would collapse of its own weight, and that the principal concern of the federal reserve system should be to prepare itself to help the banks and the country to absorb the imminent shock as soon as it occurred.16

The Federal Reserve Bulletin of October 1930 clearly shows the downward slope of the money in circulation during the period 1926 –1930. At the beginning of 1926, $5,200 million was in circulation. At the beginning of 1929 there was only $5,100 million. The real economy was growing in a robust manner, but money in circulation was shrinking. The Federal Reserve Board had focused on stock market speculation to the neglect of the need of the real economy for money. And it received bad press for its restrictive practices: „Undoubtedly a good deal of the restricted buying interest of the public may be attributed to the uncertainties of the credit situation and the Federal Reserve Board.‰17

48

BEATING THE BEAR

In September 1930, Young resigned his $12,000-a-year job as governor of the Federal Reserve Board to accept a $30,000-a-year position as governor of the Boston Reserve Board. Other Federal Reserve Board members received $10,000 per year. While $10,000 a year was not an attractive temptation to a highly successful person in commerce in 1929, it was a very tempting political payoff (the job carried 12 years of security, with a good chance of reappointment). Paul M. Warburg, a member of the first Federal Reserve Board and a very successful investment banker, described the boardÊs position as follows: There is no desire to fasten blame on any individual who took part in fashioning the SystemÊs policies in this trying period. No doubt, everybody concerned acted to the best of his knowledge and ability, and the keener his realization of the gravity of his responsibilities, the greater, of course, was the persistency with which he held to his own views. The fact remains, however, that in the face of a most critical situation · possibly the gravest with which the Federal Reserve Board widely divided within itself and unable to agree upon a definite and effective plan. We find this Board, as rumor has it, at variance with leading Federal reserve banks and, against the advice of the Advisory Council, blocking timely rate increases urged by the Federal reserve banks most concerned.

Warburg would have preferred that the board raise interest rates early in 1929. However, he recognized that others wanted the board to minimize its control of the market.18 Throughout 1928 and 1929, both the Federal Reserve Board and the Federal Reserve Bank of New York acted aggressively to control stock speculation. In fact, „there is no doubt that the desire to curb the stock market boom was a major if not dominating factor in Reserve actions during 1928 and 1929. Those actions clearly failed to stop the market boom. But they did exert steady deflationary pressure on the economy.‰19 The tragedy of 1929 was that the Federal Reserve focused on stock market speculation rather than the real commercial activities that were taking place. On August 2, 1929, Harrison met with the Federal Reserve Board and again suggested an increase in the discount rate to 6 percent. Harrison was authorized to invite the governors of all the federal reserve banks to meet with the board on August 7. On August 9, the directors voted to increase the discount rate to 6 percent. This time the board approved the increase. The major difference between the Federal Reserve Bank of New York and the Federal Reserve Board had

THE FEDÊS ROLE IN GOOD TIMES AND BAD

49

ended. Soon there would be substantive real problems to occupy their attention. The high level of stock market prices did not jeopardize the nationÊs prosperity. These prices could be justified given the bright future expected for the U.S. economy. The actions of the Federal Reserve Board to bring down stock prices, however, jeopardized prosperity in ways that few predicted. THE FED IN 2000–2009 In the years preceding the 2008 crash, the Federal Reserve Bank facilitated the booming real estate market by making sure that long-term interest rates (real and nominal) were very low. The 10-year treasuries from 2002 to 2008 had average interest rates that were less than 4.79; in 2008, they were 3.78. The buying of U.S. bonds by China helped the Fed achieve its low interest rate goal. Ex post the pre-2008 real estate market has been described as a bubble. If one defined the pre-2008 real estate market as a bubble, then the Fed was guilty of encouraging the real estate price increases to be higher than desirable. However, during the pre-2008 period there was no general outcry against the FedÊs policies. It was only when real estate prices stopped going up that the extent of subprime mortgages was revealed. And the FedÊs faulty practices with regard to interest rates were identified only when the high risk borrowers stopped paying on the mortgages (decreases in real estate prices gave the borrowers an incentive to walk away from debts that were larger than the value of the assets underlying the loans). In early 2009, the Federal Reserve Bank bought $250 billion of low-interest-rate (less than 5 percent) mortgages guaranteed by Fannie Mae and Freddie Mac. These purchases drove mortgage rates to below 5 percent. Also, as mortgage prices went up, banks recorded gains on the sale of mortgages and also the fair value gains on mortgages held. The Fed, of course, can print money.

Appendix 1

LETTER SENT TO ALL FEDERAL RESERVE BANKS FEBRUARY 2, 1929 The firming tendencies of the money market which have been in evidence since the beginning of the year · contrary to the usual trend at this season · make it incumbent upon the Federal Reserve banks to give constant and close attention to the situation in order that no influence adverse to the trade and industry of the country shall be exercised by the trend of money conditions, beyond what may develop as inevitable. The extraordinary absorption of funds in speculative security loans which has characterized the credit movement during the past year or more, in the judgment of the Federal Reserve Board, deserves particular attention lest it become a decisive factor working toward a still further firming of money rates to the prejudice of the countryÊs commercial interests. The resources of the Federal Reserve system are ample for meeting the growth of the countryÊs commercial needs for credit, provided they are competently administered and protected against seepage into uses not contemplated by the Federal Reserve Act. The Federal Reserve Act does not, in the opinion of the Federal Reserve Board, contemplate the use of the resources of the Federal Reserve banks for the creation or extension of speculative credit. A member bank is not within its reasonable claims for rediscount facilities at its Federal Reserve bank when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans. The board has no disposition to assume authority to interfere with the loan practices of member banks so long as they do not involve the Federal Reserve banks. It has, however, a grave responsibility whenever there is evidence that member banks are maintaining speculative security loans with the aid of Federal Reserve credit. When such is the case the Federal reserve bank becomes either a contributing or a sustaining factor in the current volume of speculative security credit. This is not in harmony with the intent of the Federal reserve act nor is it conducive to the wholesome operation of the banking and credit system of the country. You are desired to bring this letter to the attention of the directors of your bank in order that they may be advised of the attitude of the Federal Reserve Board with respect to this situation and the problem confronting the administration of Federal Reserve banks. The board would like to

THE FEDÊS ROLE IN GOOD TIMES AND BAD

51

have from them an expression as to (a) how they keep themselves fully informed of the use made of borrowings by their member banks, (b) what methods they employ to protect their institution against the improper use of its credit facilities by member banks, and (c) how effective these methods have been. The board realizes that the problem of protecting the credit situation from strain because of excessive absorption of credit in speculative security loans is attended with difficulties. It also realizes that there are elements in the situation which are not readily amendable to recognized methods of banking control. The board, nevertheless, believes that, however difficult, the problem can be more completely met and that the existing situation admits of improvement. The Federal Reserve Board awaits the reply of your directors to this letter and bespeaks their prompt attention in order that it may have their reply at an early date. By direction of the Federal Reserve Board.

Appendix 2

Mr. Pecora: Do you recall that at the same time the National City Bank threw $25,000,000 into the call-loan money market at rates of 16 percent and more. Mr. Mitchell: Yes, sir. Mr. Pecora: And that that was regarded as a flaunt on the warning sounded by the Federal Reserve Board? Mr. Mitchell: It was regarded as that in certain quarters, yes. Mr. Pecora: In certain responsible quarters? Mr. Mitchell: Yes, sir. Mr. Pecora: In other words, at the time when the Federal Reserve Board was seeking to apply the brakes to this inflationary process the National City Bank was nullifying that to the extent that it threw this $25,000,000 into the call-loan money market. Mr. Mitchell: That I deny, Mr. Pecora. Mr. Pecora: Well, didnÊt it have the opposite effect from that which was intended by the Federal Reserve Board in raising its rediscount rate at that time? Mr. Mitchell: I think not. Mr. Pecora: DidnÊt it contribute to the opposite effect? Mr. Mitchell: I think not. What happened · and since the question has been brought up I think I should be permitted to reply to it · was this: We had not been borrowing from the Federal Reserve Bank at all. The Federal Reserve BoardÊs warning was a warning against banks leaning on Federal Reserve credit to support speculation. We were not leaning upon Federal Reserve credit to support speculation. There developed in New York, at a time when we were not borrowing a penny from the Federal Reserve Bank, and not rediscounting, when we had plenty of government bonds and eligible loans for discount at the Federal Reserve Bank· as I say, there developed one day at the money post on the exchange a period when there was no money to lend. The rate had gone up, I think, to 15 or 16 percent. We stepped in there to allay what was becoming a money panic, an inability of the legitimate borrower to borrow for his day contracts the money that was essential if they should be maintained. (Some testimony omitted) Senator Brookhart: Who were those honest borrowers? WerenÊt they speculators? Mr. Mitchell: No. Those were brokers who had to make good the contract that day, for overnight. We went in and loaned . . . Senator Brookhart: (Interposing) That was a speculative contract. It was one of those gambling deals, wasnÊt it?

THE FEDÊS ROLE IN GOOD TIMES AND BAD

53

Mr. Mitchell: This was not in support of the speculative market. This was to prevent a money panic, which was sudden, and developed overnight, and we went to the Federal Reserve Bank for two days only. I take the opportunity of asking if you will just let me read a paragraph from our bulletin? This pertains to what occurred in March of 1929. It wonÊt take but a moment. And four days later . . . Mr. Pecora: (Interposing) Four days after what date? Mr. Mitchell: After the date when we made these loans, which I think was about March 26 or 27, 1929. On the 1st day of April our monthly bulletin was issued, and I caused this paragraph to be put in: During the last week of March these large credit demands, including shifting of balances in connection with income-tax payments and in preparation of quarterly disbursements of dividends and interest, combined with the substantial withdrawal of funds from the New York call-loan market, resulted in a scarcity of call money that sent the rates up to 20 percent and caused a sharp reaction in stock prices. Prompt action by New York City banks, however, in offering to provide funds to take care of the marketÊs requirements, served to avert any fears of a money panic. The National City Bank fully recognizes the dangers of overspeculation and endorses the desire of the Federal reserve authorities to restrain excessive credit expansion for this purpose. At the same time, the bank business generally, and it may be assumed the Federal reserve banks, whose policies over the past year have been marked by moderation, wish to avoid a general collapse of the securities markets such as would have a disastrous effect on business. It is evident from the way money has acted here in the past few days that the crisis has passed and the incident is a closed book. At the same time it would be unfortunate that any action taken by this bank during the emergency should have created the thought that our views, again and again expressed, as to undue expansion of the credit structure have changed. That there has been a most unusual expansion in credit is a fact that is generally admitted and that the largest element in that expansion is so-called speculative loans must also be, and is, recognized. With this crisis past, the people of the country would be generally well advised to bear in mind the condition of the credit structure and voluntarily see to it that in their loan accounts they maintain wider margins and lean less heavily on borrowed money. Mr. Pecora: Now, this expansion of the credit structure that is referred to in that bulletin, Mr. Mitchell, was due primarily, wasnÊt it, to the unprecedented amount of speculation in the stock market over a period of two or three years prior to March of 1929? Mr. Mitchell: It was the development of excessive speculation. Senator Brookhart: If you had let it collapse in March that would have saved hundreds of thousands of dollars to people who invested later on, prevented them from buying, and the collapse would not have suffered such purchases to mean a loss; it not that a fact? Mr. Mitchell: I do not believe that any man who has it within his power to stop a money panic is going to take the responsibility of seeing the money panic develop.

54

BEATING THE BEAR

Senator Brookhart: That is what is wrong with our financial system; nobody is going to stop this speculation. Mr. Mitchell: I may be an inferior banker, but so long as I am in the banking business and can find a way to stop a money or a credit panic every bit of the weight I can put into the situation is going to be put in. (Some testimony omitted) Senator Fletcher: The depreciation in securities that resulted in October in a drop of some $25,000,000, as I recall, would not have been as great . . . Senator Brookhart: (Interposing) Would not have been at all, would it? Senator Fletcher: Would not have been as great if this collapse had occurred in March, would it? If that collapse had occurred in March 1929, what would have been the situation? Mr. Mitchell: The banker could not see a panic occurring because of a money squeeze that was minor in its character. Security prices were high, speculators and investors everywhere were borrowing more money than they should; that was a fact that we all appreciated and that we were trying to preach against and educate the public in regard to. (Some testimony omitted) The Chairman: It has been repeatedly interpreted by Senator Glass as your saying to the Federal Reserve Board to go to hell. IsnÊt that so? Mr. Mitchell: Senator Glass took that attitude at that time, and it was an exaggerated statement made as the result, not of any statement made by me, but as the result of the newspaper article. I was not . . . (Some testimony omitted)20

Chapter 5

PRACTICE FOR THE OCTOBER CRASH: THE WEEK OF MARCH 25, 1929

Secretary of the Treasury Mellon opened 1929 with a statement for the January 1 newspapers. The New York Times ( p. 26) headed a column with „Mellon Optimistic on Business Trend.‰ His comments were eagerly awaited by the investment community. Mellon did not make frequent announcements. The New York Times said the comments were awaited „with unusual interest because of the unprecedented speculative activities on the Stock Exchange.‰ The closest Mellon came to commenting on the state of the stock market was in reference to interest rates: „High interest rates in the open market, due to the speculation on the Stock Exchange, forced the Treasury during the year to pay 43Î4¾ percent in selling one of its short-term issues.‰ In February, the Federal Reserve Board sent out its letter dated February 2, 1929, to all Federal Reserve banks (see chapter 4, Appendix 1). The objective was to tell all member banks that a bank could not use the rediscount facilities at its Federal Reserve Bank „when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans.‰ This letter alerted the participants of the New York Stock Exchange that the board believed there was too much stock market speculation. Member banks were urged not to borrow from the Federal Reserve Bank to finance stock market speculation. On the afternoon of February 14, the Federal Reserve Bank of New York voted, on its own initiative, to increase the rediscount rate from 5 to 6 percent. By 6:40 P.M., the Federal Reserve Board had passed a resolution that „moved that the Board disapprove of the action of the directors of the

56

BEATING THE BEAR

Federal Reserve Bank of New York and determine the rate of that bank to be five percent.‰ The board did not want borrowers (borrowing to finance speculative loans) who could pay the increased rate to have access to bank funds. It wanted the loans to be rejected because they were speculative and not accepted because the borrowers could pay the higher interest rate. The New York Fed wanted the cost of the funds to regulate who borrowed the funds and did not want to distinguish between investment and speculative purposes. On March 12, the New York Times had an important article regarding an announcement from the Treasury Department: „Mellon Not to Act in Speculation Ban.‰ The „ban‰ referred to the February letter from the board. The rumor on Wall Street was that Mellon opposed the distribution of the letter. Now, the announcement indicated that the Treasury would not „revise FedÊs war on speculation‰ ( p. 44). There was no reference to the availability of credit. This announcement was good news for Wall Street, since Mellon did not reinforce the FedÊs war against speculators. On the other hand, neither did Mellon repudiate it. The Mellon announcement triggered a classic letter from a concerned lawyer ( I. M. Levy). In a letter dated March 12 (in the New York Times, March 28, p. 20) Levy wrote, „Prosperity is very much a matter of psychology and if the Federal Reserve Board continues its pessimistic note, it may create a panic.‰ MellonÊs response a couple of days later was not up to his normal standards. He made the point to Levy that Levy probably meant newspapers and others were pessimistic, but not the Federal Reserve Board. To top it off he sent a copy of the Federal Reserve BoardÊs letter to Levy to prove his point. I fear that Mr. Levy was not reassured by the secretaryÊs letter. It is interesting how perceptive LevyÊs was. This letter was before both the March and October crashes. In fairness, Mellon responded as well as he could, given his sensitive position. It was reasonable for him to deny that any federal government employee or body was pessimistic. Of course, the culprit being attacked by the board was speculation. The board was not obviously pessimistic from MellonÊs viewpoint, which focused on economic activity. On March 15, the New York Times ( p. 1) had a headline reading „Mellon Advises Buying of Bonds by Investors.‰ Mellon cited the relatively high bond yields and low prices compared with high stock prices. „This does not mean that many stocks are not good investments. Some, however, are too high in price to be good buys.‰ He then said, „For prudent investors . . . now is the time to buy good bonds.‰ The article then went on to explain

PRACTICE FOR THE OCTOBER CRASH

57

why MellonÊs mild statement with regard to the investment climate was important. The Federal Reserve Board had declared „warfare against the excessive use of Federal Reserve credit for speculative activities on the Stock Exchange,‰ and Mellon had said only that some stocks were too high in price. The news article revealed that Mellon „would not enter into a general discussion of present-day speculation in stocks‰ and that he had a long conference with Hoover on the day before his statement. Some cynics suggested that MellonÊs recommendation to buy bonds was related to the TreasuryÊs efforts to sell low-yielding treasuries, but this is unfair, and we can assume that it was MellonÊs way of saying that some, but not all, stocks were too high. Given that we know HooverÊs position with regard to speculation during 1929 (he wanted it checked), we can conjecture what types of statements Hoover requested from Mellon. At a minimum he wanted a statement describing the evils of stock market speculation. Instead, he got a reasoned statement that, with hindsight, we can conclude was very good investment advice. The next day the editorial in the New York Times ( March 16, p. 18) led off with „ The most significant thing in Secretary MellonÊs comment on stock market prices is the fact that he made any comment at all.‰ The New York Times would also have liked a blast at speculation, but not having received it, the editor evaluated MellonÊs comments to be „a weighty statement‰ that described the „dangers of excessive speculation.‰ If Mellon had wanted to say this, his statement would have included these words or something close to them. Rather, Mellon gave an intelligent evaluation and sensible recommendations. On March 16, Roy Young, governor of the Federal Reserve Bank and chairman of the Federal Reserve Board, spoke before the Commercial Club of Cincinnati. His speech made clear that the Federal Reserve Board advocated the rationing of credit for buying stock securities: „It seems to me that it would be the part of prudence for all who are lenders to see first that business gets credit at reasonable rates and let the others get what is left.‰ The „others‰ were the financial community, including the buyers of the stocks and bonds issued by the business that Young wants to help. On Tuesday, March 26, there was a New York Times major first-page headline, „Stock Prices Break Heavily as Money Soars to 14 Percent.‰ The Times conjectured that the market crash on Monday was caused by an expectation of drastic action by the Federal Reserve Board, including the possibility of an increase in the rediscount rate. The 14 percent cost of call money was very high (in October 1929 the cost of call money was 5 percent).

58

BEATING THE BEAR

There was an interesting footnote to the dayÊs trading. Radio Corporation of America (RCA) went up 41Î4 points as the market went down. International Telephone and Telegraph also went „against the tide,‰ increasing by 67Î8 points. The analyst of the Times offered three reasons for the March 26 crash: 1. The tight money. The increase in the cost of call money from 9 percent to 14 percent shocked the market. The 14 percent was the highest rate since July 1, 1920. 2. The fear that the Fed would increase the rediscount rate or do something else to dry up credit to finance securities. 3. There were too many speculative positions.

The article said the speculators were „prone to do the wrong thing at the right time, or the right thing at the wrong time.‰ One suspects that the reporter was actually thinking of investors new to the stock market rather than the conventional expert manipulators that Washington looked at as speculators. The article on the price break referred to „Hundreds of Margins‰ being called. In the past, the margin calls had been sent by the mail, but in March 1929, in the new high-tech world, they were sent by telegraph. This reference to margin calls highlights the fact that the lenders intended to either get additional cash backing for the margin loans or sell the securities. One has to assume that many securities were sold as a result of the margin calls, since not all the investors had additional cash. The next dayÊs market performance ( Tuesday, March 26) was even worse than that of Monday. The Wednesday Times ( p. 1), in its right-hand headline, exclaimed, „Stocks Crash and Then Rally in 8,246,740 Share Day: Money Goes to 20 Per Cent.‰ The volume of trading beat the previous dayÊs record by 1,292,700 shares. The average market price dropped 9.6 percent. At an interest cost of 20 percent, few or no rational investors could maintain a margin account. In fact, some broker loans were at 22 percent. In addition, there was a shortage of available loan funds even at these interest rates. Funds to finance securities were not available. Bond prices were lower on March 26. This was partially the result of convertible bonds selling at lower prices, reflecting lower stock prices, but it was also the result of investors being in a state of shock regarding securities in general. During the day, 300 stock issues hit new lows for the year. Interestingly, in this down market, RCA was up 11Î8 points, closing at $93 (the high for the year to this date was 1093Î8 and the low was 681Î4). Obviously, RCA was a stock immune to market fluctuations because of its underlying strength (in October this obvious conclusion would turn out to be wrong).

PRACTICE FOR THE OCTOBER CRASH

59

One of the subheadlines on page 1 (New York Times, Wednesday, March 27) was „Bankers Aid Recovery.‰ The assistance of the bankers had occurred toward the end of the day (Tuesday, March 26). On Wednesday, March 27, the market recovered some of its losses. In a left-hand front-page headline on Thursday, March 28 („recoveries‰ are not as important as „crashes,‰ thus the recovery had a downgraded headline), the New York Times had „Stocks Rally Vigorously As Bankers Aid Market; All Needed Funds Ready,‰ „Call Money 15 Per Cent,‰ and „National City Bank Offers $25,000,000 in 5 Lots.‰ The National City BankÊs offer to lend $25 million is very interesting. The bank was part white knight and part profit-maximizing bank. It offered to lend $5 million at 16 percent. If more funds were needed, it would lend $5 million more at 17 percent. For the fifth $5 million unit, it would charge 20 percent. The bank was acting as a lender of last resort, but at these high rates it was not exactly encouraging investment in stocks. The chairman of National City Bank was Charles Mitchell. As a result of MitchellÊs actions or because of good fortune, the market did not continue its drop on March 27. In fact, the events of March 25 and 26 pale in comparison with the events of October. But still the sequence of events in March is very important. Mitchell was castigated by congressmen of both houses for his actions that were said to indicate contempt of the Federal Reserve Board. Mitchell was not the only banker who took steps to stem the fall in stock prices. The New York Federal Reserve Bank (under Governor George Harrison) also supplied liquidity to member banks so that they could finance brokers. Harrison wanted the New York Federal Reserve Bank to be „in the position of freely lending money at its going rate in order that there might not be any charge that it had arbitrarily refused or rationed credit.‰ But rationing credit is exactly what the Federal Reserve Board wanted the Federal Reserve banks to do. HarrisonÊs position was that the Federal Reserve Bank should „grant credit on eligible paper.‰ Obviously, he did not want to analyze whether the purpose of the borrowing was for investment or speculation. Rightly or wrongly, Mitchell was blamed by the Federal Reserve Board (especially board member Adolph Miller), the press, and Congress for reversing the stock market crash of March. On page one, the headline of the Times ( March 29) was „Glass Assails Mitchell For BankÊs Aid to Market; Stocks Up in Buying Rush.‰ „Glass‰ was Senator Carter Glass of Virginia. Glass called for MitchellÊs resignation as a director of the New York Federal Reserve Bank. He denounced MitchellÊs „contempt of [the] Board.‰ GlassÊs position was heartily supported by other senators.

60

BEATING THE BEAR

When informed of GlassÊs denouncement of him and his bankÊs actions, Mitchell said, „ThatÊs very interesting, but I have no comment to make.‰ On the same day (Friday, March 29) the Times reported that RCA was up to 1061Î2 and that the cost of call money had dropped from 15 to 8 percent. Obviously, the National City BankÊs offer to lend at 16 to 20 percent did not cause this drop. On March 28, Adolph Miller, a senior member of the Federal Reserve Board, was in New York to have lunch and attend a meeting with the board of directors of the New York Federal Reserve Bank. Mitchell was a board member. Miller did not want to have lunch with Mitchell, nor did he want to meet with him. After persuasion from George Harrison and after Miller called Governor Young, Miller went to the meeting (we assume he also went to lunch). On Friday, March 29, Congress announced that an inquiry would take place. The New York TimesÊs right-hand headline ( March 30, p. 1) said, „Congress Inquiry Likely Into Stock Speculation; Mitchell Explains Stand.‰ It was not clear whether Congress was more upset about stocks going up, the existence of speculators, or the thought that MitchellÊs bank stopped the price decline. Senator Brookhart of Iowa made page 2 of the Times with the statement that he „would forbid the widespread use of banking resources in speculation.‰ MitchellÊs explanation of why he thought the Federal Reserve BoardÊs February letter did not apply to his bank in March was that the National City Bank, at the time, was not in debt to the Fed and thus not restricted in its actions. The April issue of the Federal Reserve Bulletin describes the ongoing policy of restraining the diversion of bank credit into speculative uses but does not mention the stock market drop of March 25 and March 26. THE BANKING ACT OF 1933 The Banking Act of 1933 is a law of the United States. It includes the words „to prevent a repetition of the incident in March 1929, when despite the express warning of the Federal Reserve Board to the contrary, the National City Bank poured $25,000,000 into the call-loan market.‰ The act gives the Federal Reserve Board the power to prevent member banks from disregarding the wishes of the board (Stock Exchange Practices, 1934, p. 18). Of course, National City Bank did not „pour‰ $25 million into the callloan market. It offered to make loans at very high rates. Since National City Bank had not borrowed from the Fed, the Banking Act of 1933, if in place, would not have stopped National City Bank from acting just as

PRACTICE FOR THE OCTOBER CRASH

61

it acted. Also, it is not clear that we would want to prevent National City Bank from taking the actions it took in March 1929. THE 1931 SENATE HEARINGS In hearings conducted by the U.S. Senate Committee on Banking and Currency in 1931 to review the performance of the Federal Reserve system, Governor Harrison of Federal Reserve Bank of New York said he had never asked member banks in New York to reduce their loans to brokers. The Federal Reserve Bank used interest rates to ration capital rather than to give „a particular admonition to particular banks.‰ While not exactly accurate, since elements of „direct action‰ can be found in the actions of the New York Fed in 1929, it does describe how Harrison wished to operate his bank. Harrison, in turn, would not try to tell MitchellÊs National City Bank whom to lend to and at what rate. THE 1933 STOCK EXCHANGE PRACTICES HEARINGS (1933) Mitchell was questioned extensively by Ferdinand Pecora, counsel for the committee, at the 1933 stock exchange practices hearings conducted by the subcommittee of the U.S. Senate Committee on Banking and Currency. Pecora wanted to establish that MitchellÊs action in March 1929 was „a flaunt [sic] on the warning sounded by the Federal Reserve Board.‰ Mitchell pointed out that at the time that „We were not borrowing a penny from the Federal Reserve Bank, and not rediscounting . . .‰ and that rates had gone up to „15 or 16 percent. We stopped them to allay what was becoming a money panic, an inability of the legitimate borrower to borrow for his day contracts the money that was essential.‰ Senator Brookhart then asked, „Who were those honest borrowers? WerenÊt they speculators?‰ Mitchell explained that they were brokers. Brookhart interrupted to say, „That was a speculative contract. It was one of those gambling deals, wasnÊt it?‰ Mitchell then explained the purpose of a bankÊs lending to a broker and that National City Bank wished „to avoid a general collapse of the securities market.‰ Pecora then placed the blame on Mitchell: „If you had let it collapse in March that would have saved hundreds of thousands of dollars to people who invested later on.‰ Mitchell said he wanted „to stop a money panic.‰ Brookhart modified his thought to „Nobody is going to stop this speculation.‰

62

BEATING THE BEAR

The misconceptions of the senators were immense. The chairman (Senator Norbeck) asked of Mitchell, „How much higher did they go before they broke off · by three or four times, some of them, didnÊt they?‰ This unrealistic view of the market was not uncommon, but it is shocking. Mitchell was asked by the chairman, „It has been repeatedly interpreted by Senator Glass as your saying to the Federal Reserve Board to go to hell. IsnÊt that so?‰ Mitchell agreed that Senator Glass „took that attitude,‰ but it was not the result „of any statement made by me, but as the result of the newspaper article.‰ Mitchell pointed out that the Federal Reserve Bank of New York was kept informed of the actions of National City Bank and did not object to its actions. For more detail, see the appendices to chapter 4. CONCLUSIONS The stock market price declines of March 25–26, 1929, were a dry run for October. The March declines were probably triggered by the high cost of call money. Mitchell and National City Bank received blame for stopping the selling panic and saving the day, but we cannot be sure of the effect of National CityÊs offer to lend $25 million. The bank loans were to be at 16 to 20 percent interest cost. At these rates, investors could not use the bank financing to hold stocks with confidence. The turnabout in stock market prices might have resulted from MitchellÊs offer to lend, or it could be that the good business news could not be ignored and, at the lower prices, investors stepped in and bought. There is one thing that the New York bankers learned. Washington would be very upset if the banks repeated the actions of National City Bank in any future crash. Not surprisingly, in October the New York banks did not stop the crash. After March, the stock market resumed its climb, reaching its peak in September. This was looked at by Washington as the result of more speculation. Washington thought the additional speculation was made feasible by Mitchell (actually Harrison and the New York Federal Reserve Bank deserved a large share of the credit). By September, the market had risen above the March level; thus it had further to fall and the consequences would be more severe. Mitchell was blamed by some for the more severe consequences. In October, when the real crash happened, the actions taken by the New York banks were not effective in stopping it. It is not obvious that National City Bank acted decisively or effectively in March, but many people (especially those in Washington) thought it did. They also thought the action was ill considered. In October 1929, they would learn that not even the powerful Wall Street bankers could stem the tide of a selling panic.

Chapter 6

THE 1929 MARKET IN DEPTH: THE UPS AND DOWNS OF THE 1929 STOCK MARKET

Someone is said to have asked Newton what he thought of the prospects of the stock, and received the reply that he could calculate the motions of the bodies, but not the madness of the people. ·John Carswell, The South Sea Bubble During 1929, the public was bombarded with statements of outrage regarding the speculative orgy taking place on the New York Stock Exchange. If the media and respected people in authority say something often enough, a large percentage of the investing public is likely to believe it. By October 1929, the overall revealed opinion in the federal government was that there was excessive speculation in stocks and the market was too high. Galbraith (1961), Kindleberger (1978), and Malkiel (1996) all clearly accept the assumption that the market was too high. The Federal Reserve Bulletin of February 1929 stated that the Federal Reserve would restrain the use of „credit facilities in aid of the growth of speculative credit.‰ The U.S. Senate adopted a resolution stating that the Senate would support legislation „necessary to correct the evil complained of and prevent illegitimate and harmful speculation.‰ Trowbridge Callaway, president of the Investment Bankers Association of America, gave a talk in which he spoke of „the orgy of speculation which clouded the countryÊs vision.‰ John Kenneth Galbraith wrote (1961, pp. 16–19), „The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.‰

64

BEATING THE BEAR

Adolph Casper Miller, an outspoken member of the Federal Reserve Board from its beginning and an influential member in 1929, described 1929 as „this period of optimism gone wild and cupidity gone drunk.‰ Senator Carter Glass asked, „What percentage of the public is [sic] speculating in the stocks of the stock exchange understand the real intrinsic value of the stocks in which they deal?‰ (Hearings of Senate Committee on Banking and Currency on BrokersÊ Loans, 1928). A Senate committee (in reference to $3.8 billion of loans of the member banks of the New York Federal Reserve district on January 11, 1928) stated, „The largest part of this sum is used for speculation in the New York Stock Exchange‰ (Hearings of Senate Committee on Banking and Currency on BrokersÊ Loans, 1928). Senator Robert LaFollette described „the great American evil of stock exchange gambling‰ (Hearings of Senate Committee on Banking and Currency on BrokersÊ Loans, p. 2). Senator Glass „proved‰ the speculative aspect: „It was selling at 108 in January. It was selling in the market yesterday at 69. Now what is that but gambling?‰ (Hearings of Senate Committee on Banking and Currency on BrokersÊ Loans, p. 80). National City Bank seemed to recommend a recession to solve the speculation problem: „A temporary slackening of the business pace, which would have as its effect a sobering influence on speculative sentiment, should be the very thing to keep business on a sound and enduring basis‰ (National City Bank of New York Newsletter, October 1929, p. 197). An important letter from the Federal Reserve Board ( February 2, 1929) to the member banks described „the extraordinary absorption of funds in speculative security loans.‰ (See chapter 4, appendix 1.) Ferdinand Pecora asked, „What is the difference between speculation in stock and gambling in stock, to your notion?‰ Albert Henry Wiggin responded, „Investments that turn out wrong are speculations‰ (Committee on Banking and Currency, Stock Exchange Practices, 1933, pp. 2327 and 2418 –19). A Senate committee defined speculation as follows: „Margin purchasing is speculation in securities with borrowed money‰ (Committee on Banking and Currency, Stock Exchange Practices, 1934, p. 9). Myron C. Taylor, head of the U.S. Steel Corporation, described „the folly of the speculative frenzy that lifted securities to levels far beyond any warrant of supporting profits‰ (Forbes, December 15, 1929, p. 26). The attacks on speculation were not limited to the United States. In England, both the Economist (October 8, 1929, p. 774) and the Financial Times (October 4, 1929, p. 7) reported that the remarks of Philip Snowden, EnglandÊs chancellor of the exchequer, on speculation were

THE 1929 MARKET IN DEPTH

65

widely quoted in the United States. They were reported by the New York Times, the Wall Street Journal, and the Washington Post. Snowden had referred to the „speculative orgy‰ in the United States. Herbert HooverÊs election to the presidency was a very significant event. He was a neighbor and good friend of Adolph Miller (see p. 31), and Miller reinforced HooverÊs fears. President Hoover was an aggressive foe of speculation. For example, he later wrote, „I sent individually for the editors and publishers of major newspapers and magazines and requested them systematically to warn the country against speculation and the unduly high price of stocks.‰ Hoover then pressured Secretary of the Treasury Mellon and Roy Young, governor of the Federal Reserve Board, „to strangle the speculative movement.‰ In his memoirs (1952), Hoover titled his second chapter „We Attempt to Stop the Orgy of Speculation,‰ his use of the specific words reflecting SnowdenÊs influence. The speculative enemy was not clearly defined. The following groups are possibilities implied by the above quotations: 1. 2. 3. 4. 5.

„Gamblers‰ and „speculators‰ (neither term was well defined) Buyers of stock on margin Buyers of any stock in 1928 or 1929 Buyers of risky stock Buyers of stock who sold at a gain after holding for a short period of time 6. Anyone who did business on Wall Street

Before placing blame on Hoover, consider the position of his rival for the 1932 presidency. Franklin Delano Roosevelt, in his 1930 campaign for the New York State governorship, unfairly attacked HooverÊs administration (New York Times, October 21, 1930) thus: „During the final period of inflation and stock market plunging not one single step was taken by the responsible officials of the National Administration to put on the brakes or to suggest even that the situation was economically false and unsound.‰ Thus Roosevelt would have taken (or would have intended to take) even stronger action to stop the „inflation‰ of stock prices than did Herbert Hoover. THE INVESTMENT ENVIRONMENT IN 1929 The Dow Jones Industrial Average was 203 at the beginning of 1928, and it closed at 300 · a 48 percent increase.1 This was also the high for the year. During 1929 the market continued upward, reaching 380 on August 30 · a 27 percent increase for the first eight months of 1929. Fears of excessive speculation also grew throughout this period.

66

BEATING THE BEAR

Secretary of the Treasury Andrew W. Mellon, who had been quiet regarding the state of the stock market, finally, in March 1929, declared that „the time was opportune for the prudent investor to buy bonds.‰2 Privately Mellon made clear that there was excessive speculation, but publicly · except for the bit of investment advice · he was quiet. On the other hand, the New York Times Magazine declared in May 1929 that Andrew Carnegie, in insisting on bonds rather than common stock, „made one of the most colossal mistakes in market history when the Carnegie Steel CorporationÊs plants were taken into the United States Steel Corporation.‰3 In July 1929, The Commercial and Financial Chronicle reported that not only stocks but also New York real estate was enjoying a boom. While the Chronicle reported that prices had doubled and even trebled within 12 or 18 months, it also raised the specter of excess supply of rental space, given the massive construction activity. The Financial Chronicle of August 3, 1929, reported with shock and apprehension the increase in broker loans, stating that „the record is one that should make the most confirmed optimist pause and ponder whether we are drifting.‰4 It cited the numbers of the Federal Reserve Bank of New York, showing an increase from $4.259 billion on August 1, 1928, to $5.960 billion on August 1, 1929. This was even more impressive given that the Stock Exchange–reported broker loans at $7.474 billion on July 31, 1929, and the exchange had only reported $4.838 billion on July 31, 1928 · a 54 percent increase. The same issue of the Chronicle carried the following news article on the stock market activity for the week: On Tuesday, U.S. Steel started a new revival and carried the whole market with it, covering of shorts, of course, aiding the rally, and, as a matter of fact, U.S. Steel on that day established a new high record for the year. After the close of business on Tuesday, the quarterly statement of the Steel Corporation appeared, and it was of such a strikingly favorable character that it led to very extensive buying of all the different steel stocks; and, aided by the aggressive rise in the steel shares, it was easy to stage bullish demonstrations all along the line.

In August 1929, the fundamentals underlying the stock market were still strong, but they were receiving less attention than the growth in broker loans and the „excessive speculation.‰ B. C. Forbes illustrated the difficulties of forecasting accurately and the foolishness of putting unambiguous forecasts in print: „The position of the Federal Reserve Banks has improved to such an extent that all talk of an advance in the 5 percent rediscount rate has disappeared. The feeling

THE 1929 MARKET IN DEPTH

67

is that money rates will rule appreciably lower between now and the end of the year.‰5 In July, the bill rate had been lowered to 51Î4 percent; when the discount rate was increased to 6 percent in August, the bill rate was further decreased to 51Î8 percent. The board probably thought that bill money flowed to commerce and money raised by discounting of securities flowed into securities. It is not clear that the discount rate should have been increased in 1929, but history indicates that August 1929 was too late for the increase. After the increase in the rediscount rate to 6 percent, The Magazine of Wall Street reported that „prices broke sharply, as they always do in the face of unexpected adverse news. But after the first shock, the major portion of the list recovered under the leadership of the Âinvestment issues,Ê and the market has since conducted itself pretty much as if nothing had happened.‰6 On Thursday, August 8, the Federal Reserve Bank of New York increased the rediscount rate from 5 to 6 percent, and the increase that was first requested in February was finally approved by the Federal Reserve Board. The volume on Thursday, August 8, was 2.8 million shares; on Friday, it was 5.0 million. On August 10, The Financial Chronicle reported that „the stock market yesterday suffered a tremendous collapse.‰7 Interestingly, call loans on the exchange were renewed at 10 percent on Monday, while after the rate increase on Friday, the rate was only 8 percent. On August 10, the market rebounded. On August 24, the Chronicle reported that the increase in the discount rate had not checked stock speculation and that there was a new bull movement in which the bears had been scattered to the winds. A feeling has again grown up that there is no limit to the upward surge of Stock Exchange values. Day after day the story has been the same and spectacular and sensational advances have become a mere matter of routine. For over a year the object of Reserve policy has been to prevent the further absorption of bank credit in speculative channels. Has this been accomplished, or has this step of raising the rediscount rate · which step, by the way, should have been taken long ago · contributed in any way to bring such a result about? The answer is furnished in the course of brokersÊ loans, which have been recording new high totals, week after week, with only an occasional interruption to the expansion. The rate of expansion, indeed, has latterly been increasing.

On August 31, 1929, the Chronicle reported that prices had been moving up almost without interruption and that many new high records for the year had been established. Call loan rates were up to 9 percent, but this did not

68

BEATING THE BEAR

seem to deter the market. A 9 percent annual cost does not deter investment if the investor thinks the stock will increase by 40 percent in a year. On September 4, Roger W. Babson addressed the National Business Conference at Babson Park, Massachusetts. He maintained that „forced accounting has probably been the greatest factor in prolonging the present period of prosperity.‰8 He warned businessmen to watch their steps and listen to the advice of the accountant or the result could be a serious business depression. He warned that borrowing for speculation could lead to trouble. The market took little note of BabsonÊs pessimism, reaching a high of 381.44 on September 7. Babson also discussed the investment outlook. He identified two factors keeping the market up: foreign buying and investment trusts. He predicted that sooner or later the stock market boom would collapse, like the Florida boom. This prediction received a lot of attention in the press, but Babson had long predicted a collapse and the market took little note. BabsonÊs basic investment advice was good in 1929 and is good now: „We advise investors to keep always a certain amount of money in stocks and a certain amount of money in bonds and a certain amount of money liquid, to take advantage of special opportunities as they arise. Hence, today, instead of attempting to guess what the market will do, I advise you to keep in a position so that you will be safe whatever happens, and be in a position to take advantage of bargains when, as, and if they appear.‰ Irving Fisher of Yale University responded to BabsonÊs forecast of doom. Prefacing his remarks with the statement that no one was infallible, Fisher admitted that „there may be a recession of stock prices, but not anything in the nature of a crash,‰ and proceeded to explain the reasons for his view: „The present high levels of stock prices and corresponding low levels of dividend returns are due largely to two factors. One, the anticipation of large dividend returns in the immediate future; and, two, reduction of risk to investors largely brought about through investment diversification made possible for the investor by investment trusts.‰9 This was reported on September 6, 1929 (see Note 9). Fisher was bullish, but The Evening World sided with Babson: „We are thus obliged to regard his advice to investors as wiser than Professor FisherÊs.‰ The September 14 issue of the Chronicle hinted that there was weakness in the economy but that the weakness was minor: Much has been made of the fact that the monthly statement of the United States Steel Corporation, issued on Tuesday, showed a reduction during August in the aggregate of unfilled orders on the books of the subsidiary

THE 1929 MARKET IN DEPTH

69

companies in the large amount of 429,966 tons, or far in excess of general expectations. But the precise significance of this remains to be seen. Granting that it may mean a slackening in the pace of activity which has characterized the iron and steel trades for so long, there is nothing particularly harmful in that, and it has its compensating advantages in that it will permit the overhauling of furnaces and mills, so much needed and so long delayed. For many weeks the plants of the Steel Corporation were turning out products in excess of the theoretical capacity of the works, and even now, according to this weekÊs issue of the „Iron Age,‰ these plants are engaged at 91% of capacity, which is a pretty good rate, even in the rush times like those through which the country has recently been passing.

The same issue of the Chronicle identified speculation in the stock market as the number one problem. „Nothing could be more harmful at such a period than a continuation of the unbridled speculation in the stock market with serious menace that this will involve if it is allowed to go on unchecked. The fact that these speculative excesses are now in process of correction is most assuring on that point.‰ Contemporary observers identified the increase as the result of excess speculation, failing to note that fundamental economic conditions had justified a rise in prices. The Chronicle of September 21 predicted that a crash was near, blaming speculation and inflation in security values. The flow of loan funds from the rest of the United States to New York was impressive. The high rate of return that could be earned on call loans to brokers was difficult to resist. The loans had very little risk of default: „Our members are withdrawing their deposits, and so we have no money to lend for home building,‰ says the president of an Illinois building and loan association, and a thousand other building and loan officials echo his remarks. „The cause of the withdrawals,‰ continued the Illinois man, „is Wall Street. Our money has gone into stocks or into brokersÊ loans. What chance has 5 percent against anywhere from 6 to 20 percent for call money in Wall Street, with absolute security; or against the lure of speculation and its golden rewards for audacity? Only second and third mortgages can compete with the stock market. There is no first mortgage money.‰10

Table 6.1 shows broker loans for 1929 as reported by the New York Stock Exchange. The increase from January to September was 27 percent. The increase in the loans of New York banks was 25 percent and from „others‰ was 37 percent.

70

BEATING THE BEAR

Table 6.1 Broker Loans Reported by the New York Stock Exchange

Total

From New York Banks and Trust Companies

From Private Banks, Brokers, Foreign Banking Agencies, etc.

1929

1929

1929

January

6,735

5,664

1,071

February

6,679

5,619

1,060

March

6,804

5,713

1,091

April

6,775

5,580

1,194

May

6,665

5,482

1,183

June

7,071

5,797

1,275

July

7,474

6,154

1,320

August

7,882

6,492

1,390

September

8,549

7,077

1,472

October

6,109

5,313

796

November

4,017

3,432

585

December

3,990

3,370

620

End of month

Source: Adapted from The Federal Reserve Bulletin, October 1930, p. 621. Net borrowings on demand and on time. In millions of dollars.

The October 1 issue of Forbes had a long article describing how Babe Ruth invested his money. Ruth had a trust fund of approximately $150,000, which paid him $12,000 a year.11 The trust was set up so that Ruth could not touch the principal (Ruth had allegedly lost $100,000 on horse races in Cuba on one visit). Only his „side‰ income went into the trust. Ruth spent his salary. The article did not describe the portfolio mix of the trust, but with an 8 percent current yield, it was probably not heavy in common stocks. In mid-September, the New York market closed at 343.45 · down 10 percent from the September high of 386.10. During the week of October 21, the first major break in stock prices occurred. Stocks closed at 320.91 on Monday, 326.51 on Tuesday, and 305.85 on Wednesday. On Black Thursday, October 24, the low was 272.32, but the close was not too bad at 299.47. On Friday and Saturday, the market held steady. On Monday, October 28, the market dropped to a low of 256.75; on Black Tuesday, October 29, the low was 212.33. From the monthÊs high of 358.77 to the monthÊs low of 212.33 there was a drop of 41 percent in the market index. The drop was 44 percent from the 380 level reached on August 30.

THE 1929 MARKET IN DEPTH

71

The October 26 Chronicle carried an address by Irving Fisher made on October 21. FisherÊs position was that stocks, even at their peak in August, were selling at only 13 times the total earnings as compared with 14 times the total earnings in August of the preceding year. According to Fisher, stocks were underpriced, not overpriced. Fisher also spoke in Washington, D.C., on October 23, stating that the stock market slump was only temporary. Broker loans, which were $6.8 billion on October 16, had contracted to $3.6 billion by the middle of November. Call money could be obtained in November at 3 percent.12 Attempts were made to engender enthusiasm. The U.S. Steel Corporation and American Can Company both declared extra dividends. The Bank of England reduced its discount rate from 6 1Î2 to 6 percent. On November 21, the Federal Reserve Bank of New York reduced its discount rate from 6 to 5 percent (the 11 other reserve banks were already charging 5 percent). Interestingly, the Chronicle questioned the reduction. Resumption of speculative fever was still the main fear. The Federal Reserve Bank of New York bought $160 million in government bonds on the open market in October 1929 and $210 million in November.13 At least the actions were in the right direction (although too small to have a significant effect). By the end of October, the market had recovered to 273.51. During November, it drifted downward to 238.95 but recovered in December to close the year at 248.48 (it reached a high in December of 267.56). Since the beginning of the year, value was 300; the market had lost only 17 percent of its value from the beginning of the year to the end of the year. The Magazine of Wall Street estimated the loss in stock value during October to be $50 billion. It properly noted that „there has been no loss of the sum total of tangible property, as when in the war we shot away $20,000,000,000 worth of it.‰ It even anticipated one of the most famous lines in U.S. movies. After stating „But in America imagination is deathless,‰ the article closed with „Tomorrow is another day!‰ Could Margaret Mitchell (or Scarlett OÊHara) have read The Magazine of Wall Street?14 INVESTMENT TRUSTS In the late stages of the market rise, investment trusts became a very popular investment vehicle. They offered professional management and, more importantly, relatively cheap diversification. Unfortunately, there was no way to be diversified against a market crash and to invest 100 percent in

72

BEATING THE BEAR

the stock market. The October crash was too extensive, and diversification could not offer investors much solace. The equity investor in the typical British investment trust fund fared even less well. The British trust was normally leveraged with debentures and preference shares. A slight drop in the market and the common or founder shares would be wiped out. A more severe drop and the preference sharesÊ value would be eliminated. The debenture holders would always get something (although not necessarily their contractual amount). Although the American investment trusts could borrow, most did not. Many had invested funds in the call money market and thus earned a high, essentially riskless return. Some analysts attributed the market rise to the existence of the investment trusts. This is very unlikely, but they were probably a positive factor for the market, since their availability encouraged relatively risk-averse investors to enter the market. John Kenneth Galbraith discusses investment trusts in detail.15 He focuses on the Goldman Sachs Trading Corporation, an investment corporation that was formed by Goldman, Sachs and Company in December 1929 with investors paying $104 a share. The corporation was highly leveraged. The stock value dropped to $1.75 after the succession of market crashes in 1930 to 1932. This illustrates the destiny of the stock price of a leveraged investment company during a down market. W. Z. Ripley of Harvard University made a very interesting observation regarding the operation of investment trusts: „One of the cardinal weaknesses of the investment-trust plan is that when tied in any way with banking institutions · bankers or brokers · it offers a very great temptation to use the trusts, so to say, as a wastebasket in which to put the things which cannot be successfully placed in the hands of the public. I have seen that happen a number of times.‰16 Investment trusts were a good idea in that they offered the average investor diversification, but there were major faults in execution. WHEN YOU KNOW THE FUTURE Irving FisherÊs academic accomplishments were impressive. He also had good reasons for thinking in 1929 that stocks were not overvalued. Thus in November 1929 he wrote, „stocks will soon recover a considerable part of lost ground‰ and „business prospects are excellent.‰17 But he ignored the virtues of diversification either among stocks or between stocks and other assets. He obviously felt he could forecast the future based on logic. He was wrong. His son wrote:

THE 1929 MARKET IN DEPTH

73

His wire to me in California, replying to my inquiry about the advisability of selling some of my Remington Rand in order to diversify, reflects his current state of mind: November 17, 1928 SUGGEST YOU MIGHT RISK HALF YOUR PRESENT HOLDINGS BY BORROWING ON IT AS COLLATERAL AND USING PROCEEDS OF LOAN FOR BUYING MORE. SIX MONTHS OR A YEAR LATER YOU COULD PROBABLY SELL AT SUBSTANTIAL ADVANCE AND THEN DIVERSIFY. I disregarded this advice, but we would each have fared much better if we had followed it to the letter. At the peak of the boom Father could have liquidated enough of his Remington Rand stock to pay off all his heavy bank loans, and still have retained a net of between eight and ten million dollars. Instead, he waited for that elusive rise which never came, and lost his proverbial shirt. Just before the crash Remington Rand was selling for $58 per share. A year later it was still worth $28 per share. This seemed like a dizzy figure in comparison with its ultimate nadir, when it sank to one dollar.18

Table 6.2 shows the drop in common stock prices in October 1929, the partial recovery from November 1929 to April 1930, and then the Table 6.2 Security Prices

Month or Date Number of issues

Bonds 60

Preferred Stocks

Common Stocks (1925–1930) Total Industrial Railroad Public Utility

20

404

337

33

34

1929, August

95.0

126.3

218

210

165

304

September

94.8

126.8

225

216

168

321

October

95.1

126.4

202

194

157

277

November

95.7

123.9

151

145

135

195

December

96.5

126.4

154

147

136

201

1930, January

96.5

126.5

156

149

137

209

February

96.4

126.9

166

156

143

231

March

97.8

127.8

172

163

143

242

April

97.9

128.2

181

171

142

264

May

97.9

127.6

171

160

136

250

June

98.2

126.8

153

143

125

224

July

98.7

125.9

149

140

124

215

Source: Adapted from The Federal Reserve Bulletin, October 1930, p. 622. Index numbers of Standard Statistics Company. Monthly data are averages of weekly figures.

74

BEATING THE BEAR

resumption of the fall. Note that high-grade bond and preferred stock values actually increased in 1930 compared with 1929. THE SMOOT–HAWLEY TARIFF J. Wanniski argues vigorously that „the stock market crash of 1929 and the Great Depression ensued because of the passage of the Smoot–Hawley Tariff Act of 1930.‰19 Wanniski is on stronger grounds in arguing that the act helped bring on and prolong the depression than in maintaining that it triggered the 1929 crash. The financial press in 1929 was much less occupied with foreign trade than perhaps it should have been, but the fact is that in 1929 the proposed tariff act was not a major issue with the business news media and not likely to have significantly influenced the level of the market. Although the bill was signed into law on June 16, 1930, Wanniski states that „the stock market anticipated the act and crashed in the last days of October, 1929.‰20 However, from November to April 1930, the market rebounded, even though during that period it became more apparent that the Smoot – Hawley Tariff bill would become law. THE 1929–1932 CRASH Despite the relatively sound fundamentals of the U.S. economy, the stock market crash beginning on October 24, 1929, is a reality. We know that from the high point on September 1, 1929, to the low point on July 1, 1932, the loss was 82.6 percent. The market values of all stock securities listed on the New York Stock Exchange was $89.7 billion on September 1, 1929, but it fell to $71.8 billion on November 1, 1929. By July 1, 1932, the market had fallen to a value of $15.6 billion.21 Not only did the stock market value decrease in 1929 but trading activity was reduced to about one-third of its former level. The trading activity on organized U.S. exchanges went from 1.8 billion shares in 1929 to .6 billion in 1932.22 Although stocks may have been reasonably valued in September 1929, the market was vulnerable. Unlike the great Chicago fire, it was not one kick that triggered the disaster but rather a set of events that amplified the consequences. The result was a drastic decline in stock prices in 1929 and an even larger decline over the next three years. CONCLUSIONS It is clear that the Federal Reserve Board in 1929 thought that the use of bank credit for speculation was bad and that the stock market was too high.

THE 1929 MARKET IN DEPTH

75

But the board did not do anything in September or October 1929 that can be pointed to as a trigger of the 1929 crash. They would have liked to have had stock prices decline a bit, but except for Adolph Miller (described by Hamlin as wanting a „sudden liquidation and crash‰), they did not seek a crash. Regarding the February 2 letter of the board, Hamlin stated: „The board did not desire by that warning to bring about any radical deflation of speculative loans. It wanted gradually to attempt to put federal reserve credit back where it belonged, and take it out as a basis of these excessive speculative loans‰ (U.S. Senate Committee on Banking and Currency Hearings, January 1931, and HamlinÊs diary of February 5, 1929). My position is that the efforts to stop the stock speculation created a climate that merely required a slight push or a spark to set off the selling panic. Thus, the smoking gun that caused the start of the crash might comprise events that were relatively minor in themselves but that were major in their consequences.

Chapter 7

The Great Crash of 2008: The 2008–2009 Market in Depth

As we enter 2008 we are proud of how far we have come and excited about the opportunities ahead. —Richard S. Fuld, Jr., and Joseph M. Gregory Lehman Brothers 2007 Annual Report In the Spring of 2008, the Dow Jones Industrial Index reached a high for the year of 13,058. In less than a year, the index fell to 6,470 (on March 9, 2009), a drop of over 50 percent. This fall in stock prices resulted in a ­trailing P/ E of 9.91 (see New York Times, March 9, 2008, p. C4). Government Policies 2002–2009 There were two important government policies during the period 2002– 2008 that contributed to the economic boom (some would call the economy of 2002 – 2008 a bubble). The first policy of the Federal Reserve to capture attention after the crash was the low interest rates that made it possible for real estate buyers to buy bigger, more costly properties. Second, members of Congress wanted to make home ownership available to a wider segment of the U.S. population and encouraged banks to make loans available to people without adequate resources. Frequently, the buyers did not have to make any initial payment (no money down). This spreading home ownership may be considered to be a worthy social objective; but when banks lowered the financial requirements for obtaining a mortgage, the consequences were a much larger number of subprime mortgages equal to or larger than the value

78

Beating the Bear

of the property being purchased. This loan expansion was too often combined with more generous ratings by the bond rating agencies and ­acceptance of these ratings by too many investors in mortgages, who then leveraged their investment in very risky real estate loans with too much debt. The Panic and Crash As the world entered a new millennium, lenders approved loans that were unlikely to be repaid unless real estate values continued to increase and the economy prospered. When the inflation of real estate prices ended, many borrowers ran away from their loans and securitized mortgage securities rapidly lost value. The beginning of the credit debacle occurred. As job losses increased, increasing numbers of borrowers were unable to pay interest and principal. Job losses, supplemented by real estate price declines, added to the reasons for borrowers to fail to pay. By the fourth quarter of 2008, the credit markets in the United States were paralyzed as financial institutions failed or contracted. The commercial credit market all but disappeared. Companies were unable to obtain credit for investing in plant, equipment, and inventories. Naturally a drop in business activity followed, so that the falling profits in the financial sector were soon reported in other business sectors. The falling corporate profits soon justified the falling stock prices and even justified another round of stock price reductions. Unlike the October 1929 stock market crash, where the business indicators were still good, in 2008, as stock prices fell, the stock market crash could be justified by statistical indicators that reflected a severe business recession. The Financial Markets: 2008 Daniel Gross writes that1 “Subprime origination rose to $625 billion in 2005, up from $210 billion in 2001.” By 2008, the magnitude of the subprime mortgage market was in excess of $1 trillion. The credit default swap market was in excess of $60 trillion. The opportunity for large losses when home buyers stopped paying their mortgages was immense. Among the causes of the financial sector’s difficulties in 2008–2009 were: 1. Government efforts to promote home ownership among a subset of the population who could not afford home ownership. This effort was ­reinforced by banks willing to make the loans and bond rating agencies to give inflated ratings. 2. Management of Wall Street firms that did not fully understand the risk of risky assets financed to an excessive extent by debt. Or, alternatively,

The Great Crash of 2008

79

they understood and were driven by greed and competition to follow these financial strategies. 3. Some criminal activity (e.g., B. Madoff ), but this was not central to the relevant economic events. 4. The lending by banks to private equity firms. This had the potential to be a major cause of the 2008 stock market crash, but it was not. Except for the private equity firms Fortress and Blackstone, which initially made public offerings of their overpriced stock, there were few tie-ins of ­private equity and the 2008 stock market collapse.

A list of those factors that were unlikely to have caused the financial crisis of 2008 is interesting. 1.  The actions of the eight-year Bush administration (a failure to take action can be cited) 2.  Corrupt CEOs 3.  Wall Street crime 4.  Private equity activities 5.  Insufficient regulation (some of the proposed regulations are likely to cause as many problems as they solve)

Since house prices and real estate in general dropped in value before the stock market crash, the popping of the real estate bubble was identified as the major cause of the 2008 stock market crash. But we know only that real estate values increased until the summer of 2008 and then decreased. We do not know that real estate values were too high in 2008. They were a few exceptional scholars (e.g., Robert J. Shiller) who knew that real estate values were too high prior to 2008, but most of us did not. When real estate values started to decrease, the owners of the real ­estate increased the rate on which they failed to pay their mortgages. The ­mortgage defaults had a drastic effect on the health of those financial ­institutions that had purchased the mortgages or had insured the investors against losses. As these events unfolded, the public found out that bond rating firms had been too generous in the ratings they gave to collections of mortgages. AAA ratings and the like were given to collateralized bond tranches, where the probability of default was much larger than with the AAA securities of the past (with practically zero probability of default). Confounding the problem was the fact that banks originating ­mortgages were being less demanding in their loan requirements. They offered mortgages to people who could meet the mortgage payments only with a very low probability and with very low or zero initial payments. Profits

80

Beating the Bear

and ­bonuses were the normal incentives leading the banks to offer these ­generous lending terms. The Basel banking standards (mandated by the Fed) established that bank assets be valued using the credit ratings awarded by approved credit agencies. Thus banks frequently relied excessively on the credit agency scores rather than conducting credit research of their own. The banks were vulnerable to credit risk if the credit rating firms too readily awarded ­investment grade ratings to less worthy paper. Also affecting the lending institutions were the encouragements of Congress to make house buying available to a sector of society that had formerly been excluded by economic considerations from the opportunity to buy a house. Freddie Mac and Fannie Mae, two firms sponsored by the federal government, were encouraged to commit their resources to ­making house buying more widely feasible. The growth in real estate debt was facilitated by Wall Street’s clever packaging of mortgages, especially subprime mortgages, so that even the more risky collection of loans could be sliced up in such a way that part of the investment set was rated AAA, even though the entire mortgage ­collection was not of investment grade. Obviously, some of the risk of subprime mortgages could not be eliminated, but the lenders could still engage in credit default swaps or the equivalent. This was a form of insurance where a counterparty who could afford to take risk (or thought it could take on more risk) did so in ­exchange for a fee. The swap counterparty promised to pay if the borrower defaulted on the mortgage payment. With no defaults, it would ­collect a fee. Unfortunately, as the borrowers’ ability to pay went down, the volume of loans to risky borrowers went up. You can weight the factors described above as you wish (or based on your political inclinations), but the fact is that as house prices stopped going up, the number of defaults on mortgages increased immensely. First, in 2008, the financial market was shocked by the collapse of Bear Stearns. American International Group, Inc. (AIG) was the counterparty accepting the risk on too many mortgages by being the payor on the credit default swaps. While AIG was rescued from bankruptcy by the $122.8 billion line of credit given by the Federal Reserve, the Fed merely watched as ­Lehman Brothers went under. Earlier, the Fed did broker a deal where J.  P. ­Morgan Chase absorbed the profitable remainder of Bear Stearns when Bear Stearns was headed for bankruptcy. The rescue of Citigroup by the Federal Reserve was done in order to prevent a horrible financial situation from ­developing into an unbearable financial mess that would more or less ­destroy the U.S. economy.

The Great Crash of 2008

81

The next decade will be spent analyzing what went wrong and how to prevent it from happening again. Unfortunately, many of the causes of a ­financial melt-down are very difficult to identify as they are happening. We will always have real estate values go up and then slip downward. When the prices start going down, there will be economic incentives for owners of real estate to default on their mortgages. Although many of the factors contributing to the 2008 stock market crash can be avoided in the future, it is not reasonable to assume that the path of stock prices or real estate values will always be upward. Troubled Asset Relief Program The Troubled Asset Relief Program ( TARP) was created in 2008 to ­unfreeze the credit markets. The U.S. government (via the Department of the Treasury) would purchase troubled assets and equity from financial institutions and offer loans in order to strengthen the weakened financial sector. A total of $244.4 billion was given to banks, accompanied by tight ­federal restrictions. These included curbs on executive pay, dividend increases, and spending on corporate jets and conferences. The government also received preferred stock and warrants to buy common stock. By June 10, 2009, ten banks returned $68.3 billion of the government’s money in order to avoid the restrictions. These banks included J. P. ­Morgan, Goldman Sachs, and Morgan Stanley. The government still held ­warrants to buy the common stock of the banks (the warrants were worth between $3 and $5 billion). New York Attorney General Andrew Cuomo revealed that nine banks that received TARP assistance paid $33 billion in bonuses in 2008 to their employees. Each of 5,000 employees received at least $1 million (Wall Street Journal, July 31, 2009, p. 1). The TARP funding was $175 billion. For those banks that repaid $50 billion of TARP loans in 2009, the bonuses for 2008 were $23 billion (of the total $33 billion). Bear Stearns In March 2008, Bear Stearns collapsed under the burden of too large an inventory of subprime mortgages and too much debt. To avoid the financial havoc that would result from a bankruptcy, the Federal Reserve gave J. P. Morgan Chase a $30 billion credit to buy Bear. Bear stock, which had sold for $172 in 2007, was sold for $10 per share on May 30, 2008 (it was initially sold for $2 per share, but the price was increased to $10). Why did the Fed arrange the transfer of Bear Stearns to J. P. Morgan Chase but two months later allow Lehman Brothers to sink under its burden

82

Beating the Bear

of debt and assets that had rapidly fallen in value? There are many who think that Lehman’s fall triggered the world’s financial crisis in 2008. They believe that the Federal Reserve made a major error in allowing Lehman to fail. Bear Stearns in 2008 had $395 billion of assets, $384 billion of debt, and $11.1 billion of equity. It had a debt ratio of 384/11.1 = 34.6 to 1 of equity. This was a large amount of debt, especially given the large amount of subprime debt (risky assets) owned by the firm. This was a gamble with at best a very low probability of success. Those who want a more complete telling of the collapse of Bear Stearns may wish to read Kelly’s Street Fighters2 and Cohan’s House of Cards.3

The Audit of the Consolidated Supervised Entity Program (2008) The audit was of the SEC’s oversight of Bear Stearns and six other f­ inancial holding companies in the SEC’s Consolidated Supervised ­Entity (CSE) program.4 It was conducted by the SEC’s Office of Inspector ­General. The report is over 120 pages long and should be required reading for anyone who thinks that federal government’s supervision and Federal regulations will guarantee against financial shocks like those that occurred in 2008. In the week of March 10, 2008, rumors about liquidity problems at the Bear Stearns Companies prevented Bear from securing financing and pushed it to the verge of bankruptcy. On March 14, 2008, the Federal Reserve Bank of New York offered J. P. Morgan Chase $30 billion of financing if it would buy Bear. Chase ­initially offered $2 per share and then, to avoid possible lawsuits, raised its offer to $10 per share. Chase, unlike Bear, could borrow money from the New York Fed. Bear was one of seven firms in the SEC’s Consolidated Supervised ­Entity (CSE) program. (Merrill Lynch and Lehman Brothers were also in the program.) A broker–dealer could apply to the SEC to become a CSE. It was a ­voluntary act. If accepted as a CSE, the firm was exempt from the SEC’s standard net capital rule and could use an alternative, more flexible method of computing the firm’s required capital. Thus Bear, Merrill, and Lehman were all CSEs. The crucial word is “supervised.” The SEC accepted the function of ensuring that these firms (each a CSE) had an appropriate amount of capital.

The Great Crash of 2008

83

The audit report ( p. 2) states “Bear Stearns was highly leveraged with a large exposure (i.e., concentration of assets) in mortgage-backed securities.” Although accurate, this statement understates the failure of Bear’s asset and liability structures. The SEC’s oversight of Bear (as well as Merrill and Lehman) failed ­miserably. The idea of oversight was excellent and foresighted. The ­execution of the oversight failed. This audit stated ( p. viii) “Thus it is ­undisputable that the CSE program failed to carry out its mission in its oversight of Bear Stearns. . . .” Deficiencies are explained in the audit in more detail. Oversight by a federal agency did not prevent Bear Stearns, Merrill, and Lehman from making disastrous financial decisions. Lehman Brothers (2007–2008) The 2007 fiscal year of Lehman Brothers ended on November 30. On November 30, 2007, the firm’s total assets were $691.1 billion and ­stockholders’ equity was $22.5 billion. The leverage ratio was an aggressive 30.7. Leverage Ratio =

668.6 691.1 = 30.7 or = 29.7 22.5 22.5

The total liabilities were $668.6 billion Debt per dollar of equity =

668.6 = 29.7 22.5

This is a large amount of debt. Lehman Brothers removed $50 billion of debt (a repro transaction) to window dress its end-of-year financial measures. The above measures of debt usage understate the firm’s use of debt leverage. In the year 2007, Lehman made $4.2 billion of net income. This was a record earning year for the firm. The 2007 closing stock price was $62.63. The high for the year was $67.73; the low was $51.59. The Lehman 2007 annual report is 128 pages long, with some words but mostly a large amount of relevant financial data. Risk management is covered in 6 pages ( pp. 64 – 69). “While risk cannot be completely eliminated, we have designed our internal control environment to put appropriate risk mitigants in place” ( p. 64). I started my financial review of Lehman in order to find the stupid ­mistakes they made. From reading their annual report, the only possible faulty financial decision I could identify was that the firm used more than $30 of debt for each dollar of equity; nothing else reported mattered. When

84

Beating the Bear

the value of some percentage of assets (subprime mortgages) went down, the firm, with the amount of leverage it used, could not pay its debts. On November 30, 2007, Lehman had $5.3 billion of securities ( p. 95) in its asset portfolio that were called “U.S. residential subprime mortgages.” On the same date, the firm owned $313.1 billion of financial instruments, including $89.1 billion of mortgage-backed securities. The total assets were $691.1 billion. Thus reported subprime mortgages were only 0.77  percent of assets. An investor reading the annual report would not have been warned of the risky nature of the assets. Looking at the Lehman 2007 annual report more carefully than if I were making a real investment decision, I would buy the stock. With a P/ E of 8.6 and earnings growing rapidly, it looks like a reasonable conservative common stock investment. The only concern is the amount of debt; but if the assets are reasonably conservative and if I respect management, I can live with the amount of debt (yes, that is a mistake). Maybe if I spent a month studying Lehman’s 2007 annual report I would find a second smoking gun, but I think not. The important lesson here is that a prosperous, widely respected firm can be worth $62.63 per share and then, eight months later, the stock can be close to worthless. Only diversification can save an investor from an investment disaster. Careful financial analysis does not achieve safety. A rule preventing more than $10 of debt for $1 of equity would have improved the likelihood of Lehman surviving, but such a rule did not and does not exist. Lehman Brothers filed for Chapter 11 bankruptcy protection on September 18, 2008. On September 20, 2008, Barclay’s Bank acquired the core business of Lehman. The bankruptcy of Lehman Brothers (over $600 billion in assets) was the largest bankruptcy filing in the history of the United States. The Dow Jones index closed down over 500 points on the day of the bankruptcy. This was the largest drop in points in a single day since September 11, 2001. The logic of the government allowing Lehman to become bankrupt will be debated for many years. This author does not understand the $122.8 billion bailout of AIG by the government while it refused to offer Lehman a lifeline. McDonald and Robinson tell the tale of Lehman’s collapse in more detail.5 General Electric (2006–2009) In 2006, GE earned $19.3 billion (income from continuing operations), in 2007 it earned $22.5 billion, and in 2008 it earned $18.1 billion. In 2007,

The Great Crash of 2008

85

the high stock price for the year was $42.15 per share; in 2008, it was $38.52. In December 2008, the stock price was $16.20. In March 2009, GE stock fell to levels below $7. The 2008 earnings per share was $1.78. Why did its stock price fall? Why was its price–earnings ratio only 3.9? On GE’s consolidated balance sheet were $798 billion of assets financed by $105 billion of common stock equity. There was $684 billion in liabilities. With this amount of debt, there did not have to be a large percentage of bad assets to put a large dent in the firm’s stock equity. The stock market anticipated a significant loss (in March 2009 not yet recognized) in GE’s assets. GE capital earned nearly $9 billion in 2008 (p. 5 of GE’s 2008 annual report). Mr. Immelt stated (p. 6) that “we are repositioning our financial services business to operate as a more focused and smaller finance segment.” The rest of Immelt’s statement regarding GE capital glows about its achievements for the year, with no hint of why a repositioning would be desirable. By not revealing the problems with its loans, Immelt raises concern among investors that there is bad news hidden in the good news. In February 2009, GE reduced its quarterly dividend from $0.31 per share to $0.10 per share. Citigroup 2006–2009 In the year 2006, Citigroup earned $21.54 billion for its stockholders. The return on its stockholders’ equity was 18.8 percent. In 2007, Citigroup earned a net income of $3.62 billion — a 2.9 percent return on equity. In 2008, it had an operating loss of $27.7 billion. On December 31, 2008, it had total assets of $1,938.5 billion. Unfortunately, the stock market could not trust the accounting measurements leading to $1,938.5 billion of assets. If there was a 10 percent overstatement (or that degree of optimism), it could wipe out the $141.6 billion of stockholders’ equity. The ratio of common stockholders’ equity to ­assets on December 31, 2008, was 3.66 percent. In 2008, Citigroup was very heavily leveraged. In 2007, Citigroup’s high stock price for the year was $55.25; the low was $29.29, In 2008, the high was $29.69 and the low was $3.77. Shortly thereafter, the New York stock price in 2009 would drop below $1. Accompanying the bank’s financial disaster, Citigroup and other banks in a comparable situation stopped lending money. The U.S. credit market was frozen. The recession had started. What caused Citi’s financial difficulties? We start with subprime mortgages and related financial securities. Wall Street repackaged mortgages

86

Beating the Bear

and banks bought them. The credit rating agencies were generous in their ratings and the banks rarely sought out the basic documents backing up the mortgages to check the conclusions of the rating agencies. Some banks sought to reduce risk by engaging in credit default swaps. But they frequently did not check to make sure that the counterparty, who had promised to pay if the assets were not good, was able to pay. AIG was too frequently the counterparty promising to pay if the bonds held as assets did not pay, but AIG did not back up this payment promise with a sufficient amount of real assets. AIG was willing to collect the swap payments in good years but was not able to pay if there were defaults and AIG, by contract, had to pay. Citigroup had too many risky assets financed by too much debt. To ­reduce the risk, it engaged in credit default swaps but failed to make sure the counterparties would be able to pay if there were a large number of debt defaults. When house prices stopped increasing and owners stopped paying on their mortgages, Citi was left with bad paper and a large amount of debt. Citi’s risk management was a victim of a strategy of maximizing expected profits without adequate consideration of what would happen if many mortgages were not paid. The Citi stockholders paid dearly for these bad management (financial) decisions. Since this was typical of too many financial institutions, the world economy also was severely harmed as credit for business activity dis­ appeared. In the summer of 2009, it was generally believed that Citigroup still had loans on its books that were overstated in value by over $60 billion. Of course, an improving economy could result in that reduction in value being mitigated, but we shall have to wait and see. Merrill Lynch In January 2008, Merrill reported $9.83 billion in losses (including a $16.7 billion write-down of subprime mortgages). Next there was a $1.97 billion loss for the first quarter of 2008. On September 14, 2008, Bank of America announced that it had bought Merrill for $50 billion ($29 per share). This was a 70.1 percent premium over the September 12 closing price. It is alleged that the Bank of America was forced to acquire Merrill at the above terms by the federal government. Bank of America’s acquisition of Merrill was complicated by the payment of $3.6 billion of bonuses to Merrill’s management at the same

The Great Crash of 2008

87

time as Merrill was receiving $9.945 billion of federal bailout money and ­reporting billions of dollars in investment losses. Why did the U.S. Treasury (under Henry M. Paulson Jr.) become ­involved with the sale of Merrill to Bank of America? In Paulson’s words (New York Times, July 17, 2009): “What the taxpayer got was an averted calamity.” American International Group AIG was founded in 1919 and went public in 1969. AIG did business worldwide and was the largest underwriter of commercial and industrial insurance in the United States. AIG also sold auto insurance. It had over $860 billion of assets in 2007. One business of AIG was insuring investors against financial diffi­ culties with their investments. When the financial panic hit, AIG suffered large losses. The Federal Reserve Bank, in September 2008, created an $85 billion credit facility in exchange for stock warrants for 79.9 percent of AIG’s stock equity. The government eventually ­increased the credit available to AIG to $122.8 billion; then it increased the amount further to $182.5 billion. There were immediate problems with the magnitudes of managerial bonuses and frivolous fringe benefits for AIG exe­ cutives. This was the largest government bailout of a private company in U.S. history. (The Fannie Mae and Freddie Mac bailouts were larger, but they had government links.) During the final three months of 2008, AIG lost $61.7 billion. Debt and Risk There is much about decision making under uncertainty that we do not know. But what we do know is very useful. Consider a type of security that has a risk which can be measured by its variance (Var X). The variance of the return on its stock equity is then 1/V2 Var X, where V is the stock equity with zero debt. We may not know the value of Var X, but that does not affect the ­conclusions to follow. Now substitute B of debt for B of stock. The new risk measure is now 2  1  Var X where V–B is the reduced amount of stock, with B of debt  V − B  Var X   replacing B of stock. To clarify the above relationships, assume that Var X = 100 and V = 10 (the firm is financed with all stock).

Beating the Bear

88

Risk = Var (r) =

1 102

(100) = 1 .

With zero debt, the risk measure is 1. Now assume that the firm used $9 of debt and $1 of stock equity. We now have for risk: 

1



2

Risk = Var (r) =   Var X = 100  10 − 9  With $9 of debt, there is 100 times more risk than with zero debt. The $1 risk measure with all stock may not be correct, but the risk measure with $9 of debt is 100 times larger. Finally, consider an example more consistent with the financing of banks and investment banks in 2008. The ratio of debt to stock is 30 to 1. Thus S = $0.32258 and B = $9.6774 2

1   Var X = (3.10)2 Var X   0.32258 

Risk = Var(r) = 

= 9.61(100) = 961. The firm’s risk was 1 with zero debt. With $30 of debt for each $1 of equity, the risk is 961 times as large as with zero debt. One can argue that we do not know that the risk is one with zero debt. But one cannot argue that the risk is 961 times as large when the capital structure is $30 of debt for each dollar of equity. If the firm’s assets are somewhat risky, using a little debt in the capital structure is acceptable. If the firm’s assets are very risky (e.g., subprime mortgages), then using $30 of debt for each dollar of equity is equivalent to committing financial suicide. Note that we can define reasonably accurately the increase in the amount of risk caused by the substitution of debt for equity. However, we cannot define the optimal amount of debt. Assume that debt costs 0.08 and that risky investments earn an expected return of 0.10. Using debt to finance the risky investments will add to the expected return. There is no model that gives an exact answer to how much debt should be used. There is no financial barrier to the investors using too much debt except for lenders refusing to supply the debt. If the money can be borrowed, there are likely to be economic pressures on the investors to borrow the funds.

The Great Crash of 2008

89

Long-Term Capital Management (1998): The Canary in the Mine In September 1998, Wall Street became aware that Long-Term ­Capital Management (LTCM) was in severe financial difficulties. To avoid worldwide financial and economic disaster, the Federal Reserve organized a ­rescue effort. LTCM was a hedge fund. The first hedge fund appeared in 1949 and the term “hedge fund” first appeared in a Fortune magazine article in 1966. The first hedge fund actually hedged the assets it purchased with other assets and liabilities. By 1998, there were over 3,000 hedge funds with ­approximately $1 trillion in total assets ($300 billion in equity capital). For comparison, commercial banks had over $4 trillion and mutual funds $5 trillion of assets. LTCM was founded in 1994. It engaged in various trading strategies (long and short) involving: 1.  Government bonds Mortgage-backed securities Emerging market and country bonds Equity securities 2.  Futures and forwards Interest rates Equity index 3.  Derivatives (interest rate and equity) Swaps Call options Put options 4.  Foreign exchange rates

Despite the fact that the details of its operations and financial strategies were secret, the fund was able to raise $5 billion of equity capital and $120 billion of debt, thanks to the reputations of its major participants including: John Meriwether (ex-trader employed by Salomon) Robert Merton (a Nobel Prize winner and teacher at Harvard Business School [HBS]) Myron Scholes (a Nobel Prize winner, a teacher at Stanford and one of the two Black–Scholes authors) David Mullins (a teacher at HBS and former vice chairman of the Federal Reserve Board)

At the end of August 1988, LTCM had $125 billion in assets. With $4.8 billion of equity, this is a debt-to-equity ratio of 25 to 1. In addition,

90

Beating the Bear

there were swap contracts of $750 billion and other derivatives of over $400 billion, adding additional implied leverage. In many of the markets in which it traded, LTCM’s portfolio was a multiple of its closest ­competitor in that market. By August, LTCM’s capital base was below $2.3 billion and LTCM needed an infusion of capital. On September 22, Warren Buffett, ­Goldman Sachs, and AIG, Inc., offered to supply $4 billion of new capital. LTCM’s partners would own 5 percent of the equity. Meriwether would be terminated. Meriwether refused the offer. On September 23, the Federal Reserve Bank of New York organized a 14-member creditor consortium to inject $3.625 billion in exchange for 90 percent of the equity (average investment about $250 million apiece). Prior to 1998, the management fee of LTCM was 0.02 of the fund’s assets. In addition, the principals received 0.250 of the firm’s profits. In 1998, when the problems hit, the fee was reduced to 0.01 and the split of the profits was reduced to 0.125. The Returns LTCM earned the following returns on the equity capital: 1995: 1996: 1997: 1998:

0.428 0.408 0.171 ?

From 1995 to 1998, an investment of $1 billion grew to $2.354 billion: SE = 1 (1.428)(1.408)(1.171) = $2.354 billion

In 1998, the value of the equity investment fell to close to zero (with a bailout). Sample transactions of LTCM were: 1.  Buy high yield debt; sell U.S. Treasuries. Expect spreads to narrow (high-yield debt’s rate to decrease and ­Treasury yields to increase). This is a “convergence trade.” In 1998, yields just increased and Treasury yields decreased. “Flight to quality.” 2.  Swaps. Pay dollar LIBOR Receive Russian rubles and fixed interest rate. There was a flight to quality. 3.  Buy high-yielding newly issued Treasuries (“on-the-run”) Sell lower-yielding seasoned Treasuries (“off-the-run”) Small margins but can win.

The Great Crash of 2008

91

4.  Speculate in emerging market securities (fell in August). 5.  Mergers and Acquisitions risk arbitrage (unraveled mergers created losses).

The major losses suffered by LTCM in 1998 were: Swaps Equity volatility: Emerging markets: Bond trades: Equity:

$1.6 billion $1.3 billion $430 million $471 million $489 million

Fortunately, Roger Lowenstein has written a classic book on the demise of LTCM, so the details are readily available.6 Unfortunately, the implications of the dead canary were not adequately noted by the financial community. The bailout by the Fed possibly helped avoid a financial calamity in 1998, but it sent an incorrect signal to the ­market that the Fed would be able to correct mistakes made by the ­financial market participants. But the two major failures to learn from the death of the canary were the issue of the degree of regulation of hedge funds and banks and, most importantly, the question of whether the amount of debt leverage used by financial institutions should be regulated. Should the amount of leverage be a function of the amount of the riskiness of the assets owned by the firm? The obvious answer to this last question is yes. The Role of the Fed in 2008 When Bear Stearns collapsed in March 2008, the Fed and the U.S. Treasury stepped in to direct the rescue by Chase. The Fed’s activist story is told well by David Wessel. Wessel, in “In Fed We Trust,”7 shows how hostility to federal government oversight of financial institutions during the years of Alan ­Greenspan (from 1987 to 2006, he headed the Federal Reserve) led to excesses that, in turn, led to the need for Ben Bernanke taking unprecedented actions as head of the Federal Reserve. These actions by ­Bernanke included the sale of Bear Stearns to Chase, the bailout of AIG, and the unfortunate lack of action that resulted in the Lehman Brothers bankruptcy. Since Greenspan was not in charge when the 2008 collapse occurred, there are limits to the amount of blame that can be heaped on his shoulders.

92

Beating the Bear

In September 2008, neither the Fed nor the Treasury acted to save ­ ehman Brothers. Barclay’s Bank acquired the core business of Lehman L after the bankruptcy. The FDIC Bank Debt Guarantee After November 2008, the Federal Deposit Insurance Corporation ( FDIC) guaranteed the payment of new debt issued by financial firms. This program continued past the summer of 2009. The program included (among other banks) Citigroup, Wells Fargo, Morgan Stanley, J. P. ­Morgan Chase, Goldman Sachs, Bank of America, American Express, and ­General Electric (GE Capital). The program was scheduled to end in October 2009. Assume that the program saves a bank 600 basis points or 0.06 on its borrowings. On $1 billion of new debt, the program saves the bank $60 million per year. Instead of a bank having to earn in excess of 0.09 (the cost of debt without the FDIC guarantee), the bank has to earn only more than 0.03 with the guarantee program. Obviously, the program stimulated bank lending. It is not difficult to understand the complaints by the federal government when an employee of a bank benefiting from the program is paid a very large salary or bonus. The Primary Lesson for Investors The prime lesson to be taken from both the 1929 and the 2008 crashes is that it is not possible to predict when the stock market has reached its peak and is about to decline. Equally important, even if we successfully called the time to sell (if the decline were about to start), it is just as difficult to determine when it is time to buy. After suffering almost four years of stock price declines and with the world in a severe depression, 1932–1933 was the time to buy stock. How do I know this? From the historical stock ­market price statistics. In 1932, I certainly would not have known that it was the time to buy. In like manner, in March 2009, I knew that the market had fallen 50 percent in less than 12 months. It was not obvious in March 2009 that one should buy stocks. In fact, in the fall of 2008, when the stock of Citigroup reached $20 per share, it was obviously a time to buy stock of Citigroup. But then Citigroup stock went to $10. If it was a good buy at $20, it was a great buy at $10. But then the stock price went to $1 per share. Was it time to buy? Next the price went below $1 per share and Citi’s horrible ­operating results were reported.

The Great Crash of 2008

93

Instead of the Citigroup stock, the same game can be played with the stock of GE, Bank of America, and many other stocks. The problem is that we can read and analyze the published financial statements, but at any ­moment in time there is a great deal of financial information not yet published that helps determine stock values. To what conclusions does this all lead? Since we cannot forecast when a stock portfolio will lose 50 percent of its value, we have to act as if the portfolio will lose 50 percent of its value. Diversification into other assets than stock is one necessity. There will be long periods of time when 100 percent investment in stocks will be better than any mix of stocks and other assets. But this is the exact time when diversification into other asset classes is most desirable. Second, when stocks have the most miserable performance record is the time when you should consider buying stocks. The Flight to Safety: 2009 Early in 2009, investors reacted to the devastating investing experience of the last half of 2008 and the first quarter of 2009. They bought U.S. Treasury bonds, driving the yield on short-term Treasuries down close to zero. The Investment Performance The 2008 annual report of the College Retirement Equities Fund (CREF) included the 10-year results of its four different stock portfolios (stock, global equities, growth, and equity index). Over the 10-year period ending December 31, 2008, the best-performing portfolio earned – 0.73 percent (stock) and the worst earned – 4.94 (growth). During this 10-year period, an investor did not want to be invested in U.S. stocks. As of December 31, 2008, what did you want your investment ­portfolio to be? When I started teaching at the University of Chicago, one had to choose the percentage of investment funds that went to CREF (stock) and the percentage that went to TIAA (more or less fixed income and real ­estate). The correct decision based on the investment history of 1955 to 2005 was 100 percent in CREF. For a person starting a career in 2009, what do we recommend? Although this question is difficult to answer, let us consider a different question. Assume the owner of a retirement account has computed that the amount necessary for a successful retirement would be $2 million and there is currently $3 million in the stock account. Since only $2 million is needed, the primary investment objective has been met and the $2 million

94

Beating the Bear

invested in stocks could be transferred to portfolios of other assets whose returns are relatively independent of stock market returns. So, while it is difficult to be sure of recommendations at all times, our knowledge of stock market crashes (1929 and 2008) leads to a strategy of avoiding large losses when large gains are not necessary to achieve the investor’s objectives. Paul Krugman8 (The New York Times columnist and Nobel Prize ­winner), in a book review of Justin Fox’s9 The Myth of the Rational Market, states “Wall Street bought the ideas of the efficient market theorists, in many cases literally. . . .” The bankers who dictated that their firms buy subprime mortgages with $30 of debt for each dollar of equity did not need the “efficient market” hypothesis to execute their deals. The calculations of expected return and the bonus arrangement were all that was necessary. Early Warning Ignored McDonald and Robinson5 accuse Lehman’s chairman and chief ­executive of ignoring advice from other Lehman executives that would have led Lehman to avoid the worst consequences of the fall 2008 panic. The purchases of high-risk securities and overpriced real estate financed by more and more debt was a sure recipe for financial disaster. In September 2008, it happened. Conclusions I have studied the two largest stock crashes of the last 100 years. ­Unfortunately I could not have predicted either one. However, by judicial financial planning, I avoided the most severe consequences of the 2008 crash. Being human, I allowed myself the luxury of assuming that stocks were oversold in October – November 2008. I continued to buy in December 2008 to February 2009, but then, remembering Irving Fisher’s 1929 – 1930 experience (he lost his entire wealth), I stopped buying, ­rejoiced in my tax losses, and wrote a book. A knowledge of the 1929 – 1932 crash saved me a lot of money in 2009.

Chapter 8

STOPPING THE SPECULATORS: MARGIN BUYING, POOLS, TRUSTS, SHORT SELLING, AND THE 1929 CRASH

„It is a terrible thing,‰ says Snowden, British Chancellor of the Exchequer, addressing British workingmen in defense of the Bank of EnglandÊs 61Î2 percent discount rate, „that an orgy of speculation on the other side of the Atlantic should disturb our internal economy.‰ And thus brokersÊ loans become sinister in the conversations of English pubs. Wall Street is the center of interest of the whole world. ·The Magazine of Wall Street, October 19, 1929 In 1929, one could run out of fingers and toes counting the references to speculators and the effects of speculation on the stock market. A popular expression was „the orgy of speculation,‰ first offered by Philip Snowden on a visit to New York. In 2008, before and after the great crash of 2008, one could count the references to speculation in the stock market on one hand and have fingers left over. Bond and mortgage investors bought high-risk securities, but investors in stocks were not knowingly speculating when they bought Fannie Mae, Freddie Mac, Citigroup, Bear Stearns, Lehman Brothers, Wachovia, and GE. Most of these stocks were considered blue chips. With hindsight, we know investors were about to lose over 90 percent of the value invested in these stocks.

96

BEATING THE BEAR

Why the difference between 1929 and 2008? We can assume the speculators of 1929 had children and grandchildren with inherited personality faults. Where were they in 2008? My conclusion is that there were as many (or as few) speculators in 2008 as in 1929. The press, the president, and the Federal Reserve Board chose in 1929 to focus on the speculators without effectively defining the term. Basic human nature does not change in a 90-year period. There was no a speculative orgy in 1929 or in 2009. Stock prices can go down by 50 to 80 percent without the prices initially being unreasonably high. Margin buying during the 1920s was not controlled by the government. It was controlled by brokers interested in their own financial well-being. Prior to October 1929, the average margin requirement was 50 percent of the stock price. On selected stocks, it was as high as 75 percent. When the crash came, no major brokerage firm was bankrupted because the brokers managed their finances in a conservative manner. The fact that stock prices continued downward did result in three major brokerage firms going bankrupt in the first nine months of 1930. At the end of October, margins were lowered to 25 percent. The level of the margin requirements at the beginning of October compared with the end of October implies that the broker community either thought some stock prices were too high on October 1 or too low on October 31. In 1929, New York Stock Exchange (NYSE) member firms had 560,000 margin accounts out of 1,549,000 customers. Broker loans increased from $6,735 million to $8,549 million from January to September 1929. With a 50 percent margin, the $1,814 million increase in broker loans would support $3,628 million of stock investment. The market value of all stock securities (common and preferred stock) listed on the NYSE was $89.7 billion on September 1, 1929 (Stock Exchange Practices, 1934, p. 7). With a value of $67.5 billion in January, the market increased by approximately $22.2 billion during that eight-month period. Obviously, margin buying was not the only factor causing the upswing. Using WigmoreÊs (1985, p. 641) $82.1 billion estimate of value of all common stock on the NYSE as of September 1, 1929, and the brokersÊ loans of $8.5 billion on October 1, 1929, the ratio of loans to market value is 10.4 percent. This ratio could be reduced by the fact that the broker loans would also be used to finance preferred stock, bonds, and stocks listed on other exchanges. It is interesting that the amount of margin buying and the level of the loans to brokers were major concerns to the financial community in 1929, and in 2008–2009 these factors received little or no attention in the financial press. Could they have been important in 1929 but not in subsequent years?

STOPPING THE SPECULATORS

97

Margin buying in 1929 was a likely factor in causing stock prices to go up by increasing demand, but there is no reason to conclude that margin buying triggered the October crash. Once the selling rush began, the calling of margin loans probably exacerbated the price declines. The buying of stock on margin was one more layer of leverage in a market that was already, in several segments, excessively leveraged. Wigmore (1985) gives excellent statistics concerning the dividend yield and call loan costs ( p. 572 and pp. 626–27). Given the low stock yields (3 percent) and the high costs of the loans to finance the stocks (5 to 14.4 percent), the investor buying on margin needed the expectation of stock price increases. This fact made the investors who bought on margin sensitive to any large selling activity and the possibility of stock prices not going up. MARGIN BUYING The Senate Committee on Banking and Currency defined the margin transaction as follows: „Margin purchasing is speculation in securities with borrowed money.‰1 Note the choice of the word „speculation‰ rather than „investing.‰ Although margins required to buy common stock could be as low as 10 percent in 1929, brokers generally required a minimum margin of 25 percent of market value and liquid collateral for the remainder. Thus, if a stock costing $100 was purchased, the investor would pay in $25 cash and the broker would keep the stock as collateral. If the stock price went to $90, the broker would likely ask for an additional $10 cash. If the cash was not forthcoming, the stock might be sold before the price of $75 was reached. The broker would normally obtain a call loan from a bank, and during 1929 the loans from corporations and other brokers increased dramatically. Because of the stock collateral, the broker was not concerned with the creditworthiness of the investor–borrower. Compulsive gamblers found margin buying to be a reasonable substitute for the race track. The value of all securities traded on the NYSE was approximately $60.5 billion on January 1, 1925. On July 1, 1929, the value was estimated to be $124 billion.2 Broker loans as reported by the NYSE were about $3.5 billion in 1925 and $8.5 billion at the end of September 1929.3 The increase of broker loans was only from 5.8 percent of market value in 1925 to 6.9 percent in 1929. There were no legislated margin requirements prior to 1934 (the Federal ReserveÊs margin authority is derived from the Securities Exchange Act of 1934). The NYSE had unwritten margin requirements that ranged from

98

BEATING THE BEAR

10 percent of higher-priced stocks to 25 percent for lower-priced stocks, but most brokers required margins of 50 percent or more. The head of the NYSE indicated that in the first six months of 1929, the margin in customer accounts with brokers averaged 40 percent of the market value of long stocks.4 The following extract from January 25, 1930, issue of The Magazine of Wall Street ( p. 531) gives insights relative to the requirements of margin buying during the period 1929–1930: Brokers Generally Required 1. A minimum margin of 25% of market value 2. Liquid, easily handled and stable collateral 3. Additions to cash, or collateral, to conform with such price changes as may occur in securities held 4. Immediate revisions in marginal accounts, as and when required, upon reasonable notice

Margin requirements vary with market conditions, and the individual must be prepared and willing to adapt to changes deemed necessary. If speculators fueled the $63.5 billion increase in security value from 1925 to 1929 with a 10 percent margin, there would have been 0.10(63.5) = $6.35 billion of additional call loans. The actual reported increase was approximately $5 billion. Although the margin debt is very important to any explanation of the crash, it should be recognized that the boom was not fueled solely by borrowed funds. Broker loans were a small percentage of total investment and even a small percentage of the value increase. A second factor at work is that early in February 1929 the Federal Reserve announced its concern about the amount of speculation (see chapter 4, Appendix 1). It urged (with threats) banks to reduce speculative loans and proceeded to tighten credit, with a resulting increase in interest rates. The call interest rate reached 20 percent in May 1929 and 15 percent during the summer of 1929. Public utility common stock dividend yields were only 3 percent.5 The August 1929 issue of The Federal Reserve Bulletin highlighted the dramatic increase in total broker loans from 1926 to 1929. The total broker loans increased from 3 billion in 1926 to 6 billion by the middle of 1929. The explanations in the bulletin emphasize the FedÊs excessive concern for the participation of domestic banks in the financing of speculation: „As is brought out by the chart, loans to brokers were at a high point in the latter part of July, and the recent increase has been for the most part in loans by domestic banks.‰

STOPPING THE SPECULATORS

99

This is a strange statement, given the fact that domestic banks had not increased their loans to brokers; but there was an increase in the „accounts of others.‰ The desire for the Fed to curb domestic bank loans to speculators had become extraordinary. The increase of the loans of others is extremely significant. When the crash came, broker loans contracted sharply. From September 25 to the end of December, broker loans decreased from $6.8 billion to $3.3 billion.6 National City Bank reported in one week (October 23 – 30) that broker loans dropped from $6.6 to $5.538 billion. Once the break in prices occurred, the New York City banks increased the loans for their own account as loans of the out-of-town banks and the accounts of others shrank. New York City member banks from October 23 to October 30 increased broker loans from $1.08 billion to $2.07 billion. At the same time, the out-of-town accounts and accounts of others decreased by over $2 billion.7 Prior to October 24, the Federal Reserve Board had effectively prevented New York City banks from increasing their broker loans. This forced the interest rate on broker loans up to as high as 20 percent. Given the fact that broker loans were a very safe investment, offering an extremely high return, the rest of the country (and world) supplied the fuel for the stock price increases in the first nine months of 1929. But in October 1929, the market was being sustained by high-cost money and the gap between the stock dividend yields and the carrying cost of the stock was between 1200 and 1700 basis points (assuming 3 percent dividend yields and costs of borrowing between 15 and 20 percent). In addition, the funds being supplied were very unstable, ready to leave New York at the first hint of risk. From January 1928 to October 16, 1929, New York bank loans to brokers and dealers decreased from $1.5 to $1.1 billion. The loans of outof-town banks increased from $1.4 to $1.8 billion. But the loans of others increased more dramatically, from $0.9 to $3.4 billion.8 New York banks did not expand their loans to brokers from 1928 to 1929 for their own accounts, but total loans had expanded. Broker loans during 1928–1929 were financed not by banks but rather by individuals and industrial corporations, domestic and foreign nonbank lenders. They were attracted by the high interest rates, and it was forecasted that they would withdraw their funds with any significant drop in interest rates or drop in stock prices. They did withdraw their funds in late October 1929, reducing total broker loans via New York City banks by more than 20 percent in the last week of October. The financial institutions were amazingly resilient to the October crash. As reported by First National City Bank of New York: „one of the marked differences between this one, the greatest of market disasters on record,

100

BEATING THE BEAR

and all the others is that there has been no failure of a brokerage house on the big exchange and only two small failures on all of the New York exchanges.‰9 INVESTMENT TRUSTS By 1929, investment trusts were very popular with investors. These trusts were the 1929 version of closed-end mutual funds. In recent years, seasoned closed-end mutual funds sell at a discount to their fundamental value. The fundamental value is the sum of the market values of the fundÊs components (securities in the portfolio). In 1929, the investment trusts sold at a premium. Malkiel concludes ( p. 51) that this „provides clinching evidence of wide-scale stock-market irrationality during the 1920s.‰ However, Malkiel also notes ( p. 442), „As of the mid-1990Ês, Berkshire Hathaway shares were selling at a hefty premium over the value of assets it owned.‰ Warren Buffet is the guiding force behind Berkshire HathawayÊs great success as an investor. If we were to conclude that rational investors would currently pay a premium for Warren BuffetÊs expertise, then we should reject a conclusion that the 1929 market was proven to be irrational. Hedge funds in 2008 – 2009 were another example where investors paid a multiple of book value in order to buy rare expertise. We have current evidence that rational investors will pay a premium for what they consider to be superior money management skills. A total of $1 billion of investment trusts were sold in the first eight months of 1929, compared of $400 million in the entire year of 1928. The Economist reported that this was important (October 12, 1929, p. 665): „Much of the recent increase is to be accounted for by the extraordinary burst of investment trust financing.‰ In September alone, $643 million was invested in investment trusts (Financial Times, October 21, p. 3). While the two sets of numbers (from the Economist and the Financial Times) are not exactly comparable, both sets of numbers indicate that investment trusts had become very popular with investors by October 1929. Wigmore ( p. 4) shows the ratios of market price to book value for five investment trusts in 1929 (see Table 8.1). These ratios appear to be high. But remember that book values were historic cost measures and not the market value of the trustÊs assets; thus Table 8.1 is meaningless. We do not know if these investment trusts were overvalued in 1929, since we do not know their net asset values. We do know that they dropped by over 30 percent in price from their highs in the crash. But the underlying stock prices also dropped by this magnitude.

STOPPING THE SPECULATORS

101

Table 8.1 The Stock Market Price to Book Value Market Price Divided by Book Value Goldman Sachs Trading

2.95

Lehman Corp.

1.49

Tri-Continental Corp.

3.56

United Corp.

2.05

United Founder

2.45

The common stock of trusts that had used debt or preferred stock leverage were particularly vulnerable to the stock price declines. For example, the Goldman Sachs Trading Corporation was highly leveraged with preferred stock, and the value of its common stock fell from its high of $104 a share in 1929 to $1.75 in 1933. Many of the trusts were leveraged, but the leverage of choice was not debt but rather preferred stock. In concept, investment trusts were a sensible investment alternative. They offered expert management and diversification. Unfortunately, in 1929 a diversification of stocks was not going to be a big help given the universal price decline. Irving Fisher, on September 6, 1929, was quoted in the New York Herald Tribune as stating: „The present high levels of stock prices and corresponding low levels of dividend returns are due largely to two factors. One, the anticipation of large dividend returns in the immediate future; and two, reduction of risk to investors largely brought about through investment diversification made possible for the investor by investment trusts.‰ The ideal information to establish whether market prices are excessively high compared with intrinsic values is to have both the prices and values at the same moment in time. For the normal financial security, this is impossible, since the intrinsic values are not objectively well defined. There are two exceptions. DeLong and Schleifer (1991) followed one path, very cleverly choosing to study closed-end mutual funds. Some of these funds are traded on the stock market, and the market values of the securities in the fundÊs portfolio provide a very reasonable estimate of the intrinsic value. DeLong and Schleifer state ( p. 675): „We use the difference between prices and net asset values of closed-end mutual funds at the end of the 1920s to estimate the degree to which the stock market was overvalued on the eve of the 1929 crash. We conclude that the stocks making up the S&P composite were priced at least 30 percent above fundamentals in late summer, 1929.‰

102

BEATING THE BEAR

Unfortunately (p. 682), „portfolios were rarely published and net asset values rarely calculated.‰ It was only after the crash that investment trusts started to reveal routinely their net asset value. In the third quarter of 1929 (p. 682), „Three types of event seemed to trigger a closed-end fundÊs publication of its portfolio.‰ They were (1) listing on the NYSE (most of the trusts were not listed); (2) start-up of a new closed-end fund (this stock price reflects marketing pressure); and (3) shares selling at a discount from net asset value (in September 1929 most trusts were not selling at a discount; the inclusion of any that were introduces a bias). After 1929, some trusts revealed 1929 net asset values. Thus DeLong and Schleifer lacked the amount and quality of information that would have allowed definite conclusions backed by hard evidence. In fact, if investors also lacked the information regarding the portfolio composition, we would have to place investment trusts in a unique investment category where investment decisions were made without useful audited financial statements. If investors in the third quarter of 1929 did not know the current net asset value of investment trusts, this fact is significant. A factor that would make generalizations from newly issued closedend investment trusts difficult is that the funds were aggressively sold. There was frequently an organization fee of $X per share and an ongoing management fee (based on size and /or profits). In addition, the organizers received options to buy at net asset value. These were impressive incentives to form funds and sell the shares. They were also incentives to have successful funds. Given the conventional perspective in 1929 that financial experts could manage money better than the person not plugged into the street, it is not surprising that some investors were willing to pay for expertise and to buy shares in investment trusts. Thus a premium for investment trusts does not imply the same premium for other stocks. The Wall Street Journal of October 1 ( p. 1) took note of increasing investment trust prices: „The rapid advances in prices of some trust stocks to substantial premiums above liquidation values have injected a new complication into an already involved security market.‰ But the Journal then added that „management is the essence of investment trust valuation.‰ Thus the premiums might be justified if expert investment management was being bought. THE GOLDMAN SACHS TRADING CORPORATION The Goldman Sachs Trading Corporation has received a large amount of attention because of its large losses. In 1929, the stock had a high

STOPPING THE SPECULATORS

103

price of $350, and it fell to a price of $1.75 a share in 1933. In 1933, the corporation was dissolved. It was a major embarrassment to its parent. The execution of the investment strategy turned out to be a disaster, but the underlying incentive plan for Goldman should have been attractive to an investor (New York Times, October 4, 1929, p. 8). The corporation „ receives no compensation until the corporation earns during the year 8% on its capital.‰ Also, Goldman made a $10 million investment, buying 10 percent of the shares at $100 a share (100,000 shares). We do not know if Goldman (the parent) bailed out early. Goldman was to get 0.2 of the income if the income exceeded 0.08 of the book value, but only if the amount earned in a year were in excess of 0.08. Goldman had to undertake investments with a large variance. The large variance investments combined with a large amount of leverage, a falling stock market, and slackening economic activity spelled disaster for the Goldman Sachs Trading Corporation. The October 4, 1929, issue of the Wall Street Journal had an extensive article on Goldman Sachs Trading Corporation. It had been operating for approximately a year and was reasonably profitable (paid a special $2 a share cash dividend). The article described the details of the acquisition by Goldman Sachs Trading Corporation of the more profitable Financial & Industrial Securities Corporation. The acquisition was implemented by the issuance of stock by Goldman Sachs Trading. The transaction was apparently structured to be fair to all parties. Goldman Sachs Trading announced a policy of a 6 percent stock dividend per year. The Wall Street Journal article said, „Payment of dividends in stock is akin to paying dividends in cash and selling new shares to the stockholders.‰ This, of course, is correct. However, it would also have been correct for the Journal to have added, „Payment of dividends in stock is also akin to the corporation retaining the earnings. The stock dividend itself does not affect shareholder wealth.‰ POOLS There were many questionable acts by manipulators of the stock market. One of these was the manner in which investment pools operated. Investment pools were formed by a group of investors to trade actively in a single security. They might include a broker or an investment banking firm. Their stated purpose was to buy and sell stocks, but in actual practice they were frequently vehicles for manipulating the price of stock, sometimes by disseminating misleading (fraudulent) information and by buying and selling the stock to itself (to stimulate interest). Pool operations could conflict with the rules of the NYSE, but some

104

BEATING THE BEAR

pools did not violate the ethical standards of the time or the rules of the NYSE. A pool might buy shares of a firm and then spread stories in the hope that other people would buy the stock, driving up the stock price so that the pool could unload at the higher price. The Senate hearings produced the following exchanges: Mr. Pecora: This is the point I am trying to make. The general purpose of pools is to distribute securities at profit to the members, is that not so? Mr. Whitney: Yes, sir. Mr. Pecora: But it is possible under the operation of the exchange for a group so to operate in the market as to more or less control prices for the time being? Mr. Whitney: If their stock and if their money holds out, yes. Mr. Pecora: And it is that sort of thing which the exchange does not like to have done, is it not? Mr. Whitney: If there are no improper transactions connected with such an operation my answer is that the exchange does not object. The exchange has no objection to a man or a pool bidding 40 for 5,000 shares and offering 5,000 shares at 401Î8. None whatsoever. Mr. Pecora: Is it easily possible for a group operating through the medium of a pool to exercise temporarily, at least, or for the purpose of the operations, a control of the market price? Mr. Whitney: I will answer yes, sir; on the conditions . . . Mr. Pecora: The market price of a given security? Mr. Whitney: As long as the stock and their money holds out, yes.10

During 1929, a total of 107 stock issues listed on the NYSE were subject to one or more pool type of activity.11 SHORT SELLING The „bear crowd‰ was active in 1929, but unfortunately we do not have the information we would like regarding short selling during the first 10 months of 1929. Meeker provides us with some information for 1929, but unfortunately the information available does not cover the September – October 1929 period.12 As of November 12, 1929, there were $57 million of shares short (759,710 shares), and the market value of the companies whose shares were shorted was $19,373 million (234,447,293 shares).13 These totals were for firms in which over $500,000 of short positions had been taken. The short positions in September and October 1929 are not available. Bear raids and short selling were thought to be a very important part

STOPPING THE SPECULATORS

105

of all crashes. Martin Mayer holds that „about 90 percent of the damage done on Wall Street has come from short selling.‰14 How important was short selling in causing the 1929 crash? One exhaustive study of short selling was done by F. R. Macaulay and David Durand for the Twentieth Century Fund.15 But their study is of little help in evaluating the impact of short selling on the 1929 stock market: „From the statistical standpoint, it is unfortunate that the sensational market operations so interestingly described in such books as those of Henry Clews or the biographies of Daniel Drew all occurred in the prestatistical age. Daily prices go far back; but continuous short-selling figures do not. No statistical material presented in this report, except a brief series covering nine market days in November 1929, goes further back than May 1931.‰16 They do conclude this: „From the nonstatistical records of the early days of the New York Stock Exchange, there seems little doubt that short selling often had a temporarily disorganizing effect on the price movements of a particular stock and sometimes on the market as a whole. But there seems little evidence that, even in those days, it was ever a serious factor in determining the larger and longer-term movements of the market in general or even of individual stocks.‰17 Thus we can hypothesize that short selling contributed to the marketÊs unrest in October 1929, but we cannot be sure of the magnitude of its consequences. Statistical evidence is not available for the first eight months of 1929. THE CRASH OF 1929 Once stock prices began to drop, the fall fed on itself as margin accounts were sold out. Fisher describes the October situation as holders not selling but rather being sold out.18 Imagine a situation where an investor owns 100 shares of stock with a current market price of $100 per share. The stock is financed by a 90 percent margin. Therefore the stockholder has a debt of $9,000 in total and $90 per share. Now assume that other investors sell the stock in sufficient numbers to drive the price down to $90 (more about the triggering event later). The new price will only support $81 per share of debt. Therefore, our hypothetical shareholder must come up with $900 to eliminate the debt gap. If the investor cannot raise the money elsewhere some of the stock will be sold (i.e., the investor is sold out). As more and more investors face the debt gap, more stock is sold driving the price of the stock even lower. It can be readily seen that the crash can very well feed on itself. What can trigger the initial sale? In the summer of 1929 the French and English had a disagreement and the French suddenly sold large amounts

106

BEATING THE BEAR

of English securities which they held. The sale created a small panic in London. Also in England it was discovered in September that the respectable Hatry investment firm had forged securities and that it only had £4 million in assets and £20 million in liabilities. The firm failed, and the failure resulted in English investors having to sell U.S. securities. There were also extensive liquidations of holdings on the London Stock Exchange, as well as the Paris and Berlin markets. Was the Hatry affair a match thrown on the floor of a forest which had been dried out by the Federal Reserve tight money policy combined with low margin requirements? On September 21, 1929, The Commercial and Financial Chronicle reported that Roger Babson had again predicted a crash and that „ this predicted Âcrash,Ê if and when it comes, undoubtedly has in it the elements of serious disaster.‰19 On September 28, the Chronicle reported that the Bank of England had raised its discount rate from 5 1Î2 to 6 1Î2 percent (its highest rate in eight years). The bankÊs gold holdings during the week had dropped to £133 million, having lost £40 million in one year. The Chronicle conjectured that „the primary cause is found in the gigantic speculation that has continued so long in the New York stock market.‰20 The increase in discount rates by several central banks tended to reduce the willingness of foreign investors to buy U.S. stocks. The Federal Reserve Board reported in September that the August production in basic industries was higher than in July, but the increase was less than usual. On October 5, 1929, the editor of the Chronicle described the level of broker loans to be „of such appalling magnitude that the commentator is at a loss to find language adequate to describe the same.‰21 As of September 30, borrowings by stock exchange members reached a total of $8.5 billion. In explaining the weakness of the stock market for the week, the October 19 issue of the Chronicle identified the main depressing influences to be the indications of a recession in steel and the Massachusetts Department of Public Utilities not allowing the Edison Electric Illuminating Company of Boston to split its stock. As a result of the decision and explanations offered for the decision, public utility stocks suffered severe declines. Edison lost $100 of value per share. Not only was credit being tightened during the spring and summer of 1929, but $8.1 billion of new domestic corporate securities was issued in the first 10 months of 1929 compared with $4.3 billion in 1928.22 In September alone, $1.0 billion of new securities was issued.23 On Tuesday, October 24, the first major break in stock prices occurred. The Chronicle of October 26 placed a large amount of blame for the stock

STOPPING THE SPECULATORS

107

market boom, and thus the bust, on the easy money policy of the federal reserve system which had begun in 1927. The November 9 issue stated that there was no mob selling, but rather that they were sold out. The First National Bank of New York Newsletter for November 1929 showed that there was essentially no growth in bank loans and investments from 1928 to 1929. On June 30, 1928, there was $22.0 billion of loans and investments of reporting member banks, and on June 30, 1929, there was $22.4 billion. The increase was insignificant. Banks were not feeding money into the economy either for stock market or real investments.24 THE SOROS RECOMMENDATION: 2009 In an editorial contribution (Wall Street Journal, March 24, 2009, p. A17), George Soros argues that the credit default swaps need stricter regulation and „Only those who own the underlying bonds ought to be allowed to buy them.‰ He identifies the importance of short selling in the destruction of financial institutions in 2008: „itÊs clear that AIG, Bear Stearns, Lehman Brothers, and others were destroyed by bear raids in which the shorting of stocks and buying CDs mutually amplified and reinforced each other.‰ SHORT-SELLING 2008–2009 In 2007–2009, short selling of Bear Stearns and Lehman Brothers had a significant impact on the financial health of these firms. These two firms were financing long-lived bonds (mortgages) with short-term liabilities (overnight money and repurchase agreements). The short-selling and resulting fall in stock prices convinced the lenders of the short-term capital that there was more risk than they wanted, and they took their capital elsewhere. News reports indicated that subprime mortgages and related debt held by Bear and Lehman had become more risky than anticipated, which reinforced the reluctance of investors to contribute capital. Bear was purchased by Chase and Lehman went bankrupt. The short sellers won big. The stocks of Citigroup, Bank of America, and General Electric were also hit hard by short selling. But thanks to federal government assistance, all three avoided bankruptcy. On the other hand, their common stocks were battered. CitigroupÊs stock dipped below $1, GEÊs stock went below $7, and Bank of AmericaÊs stock dropped to $3. Of course, even without the short selling, the presence of large amounts of risky debt-type assets, not marked to market, might have scared stock investors sufficiently to cause a drastic fall in stock prices.

108

BEATING THE BEAR

Many of the bad assets were held by off-balance-sheet subsidiaries of banks; but if the parent was responsible for its subÊs debt, the complex financial structure would not save the parent from financial embarrassment. CONCLUSIONS Many of the trusts in 1929 invested in public utility stocks, with their relatively high dividends, thus inflating utility stock prices above their already high values. Also, the trusts added another level of leverage. More leverage was not needed and would turn out to be one of the accelerating factors of the crash. For the level of both margin buying and investment trusts, the most significant factor was that they both added layers of debt leverage. The leverage made the investor in the stock of investment trusts (especially the stock bought on margin) very vulnerable to any change in value of the underlying stock held by the trust.

Chapter 9

THE SENATE HEARINGS OF 1931 CONCERNING 1929

No worse catastrophe has occurred in American financial history, and when the great calamity can be seen in its true perspective it will be recognized as the greatest financial disgrace in American history. ·The Magazine of Wall Street, November 16, 1929 The U.S. Senate Committee on Banking and Currency held hearings in January 1931 regarding the performance of the federal reserve system. The events of 1929 were of major interest to the committee. The first person to offer testimony was George L. Harrison, governor of the Federal Reserve Bank of New York. Senator Peter Norbeck of South Dakota was the chairman of the committee. He wanted to establish the fact that the federal reserve banks financed speculative loans. Harrison responded that the Federal Reserve Bank did not finance speculative loans, but that the borrowing bank did. The Chairman: The Federal Reserve Bank permits the borrowing bank to do it. It is the business of the Federal Reserve Bank to know what the borrowing is doing and for what purpose it is doing it. If that is not the meaning of this act, why should they feel · your board of directors ever feel, in any sense or degree · warranted in admonishing member banks in New York to reduce their loans to brokers? Governor Harrison: Senator, we never did it. The Chairman: You did not? Governor Harrison: No, Sir. We did it . . .

110

BEATING THE BEAR

The Chairman: Did not the Federal Reserve Board do it? Governor Harrison: That is a matter of public record. We never did it in New York . . . The Chairman: Should not you have done it? Governor Harrison: For two reasons: In the first place, the so-called brokersÊ loans of the New York banks were not going up. They were staying stable at the figure at which they rested even before the period of speculation began and, in the second place, our directors felt from the beginning the proper method of breaking such expansion, if it occurred, was through the rate rather than through a particular admonition to particular banks.

Harrison was either forgetful or too modest. On May 13, 1929, Harrison talked with the president of Guaranty Trust Company and the president of the First National Bank and exerted a great deal of pressure on them to restrict their loans. Norbeck then asked some crucial questions: The Chairman: If not to be controlled, if you have no authority to abate or control that sort of thing, why do you do it through the rediscount rate? Why do you apply the rediscount rate to a situation of that sort and penalize the legitimate commerce in order to control something you say you have no right to control? Governor Harrison: I think we have a perfect right to control an expansion of credit, regardless of the cause of it, when credit is expanding as it was in 1928 and 1929 at a great rate all through the country. Because of the demand for money for speculative purposes, we wanted to put up our rediscount rate believing that was a proper means of limiting a too rapid use of the countryÊs assets for speculative or other purposes.

Harrison, as others, was somewhat confused about the „countryÊs assets‰ and rights to those assets called „stocks and bonds.‰ The failure to distinguish real assets from the securitized claims to those assets was devastating to the economy. Harrison, ever the gentleman, said regarding the rediscount rate: „We made mistakes. I do not think we went up fast enough.‰ He never shifted the blame (or credit) to the Federal Reserve Board for not increasing the rediscount rate from February 1929 to August 1929. On the subject of speculation, Harrison made clear that he could not always identify it. The Chairman: Well, the intent of the provision of the law, Governor, was to provide against emergency embarrassment. It was not intended to enable the bank to get loans from federal reserve banks for stock speculative purposes. I wish I could think, as you seem to imply, that there is not any excess in stock speculative activities in New York.

THE SENATE HEARINGS OF 1931 CONCERNING 1929

111

Governor Harrison: Well, I want to complete my statement on that because if I leave the record at this point it will appear that I am disingenuous, which I do not want to be. Of course, there was speculation in New York; there was speculation all over the country and all over the world. It was a matter of the greatest concern, not only to you but to all of us in the federal reserve system. We exercised our imagination and ingenuity, I think, to the limit to do what was proper to control it.

The attention of the Federal Reserve Bank of New York was on controlling speculation that it could not define. Norbeck captured this thought with the following observations: „Well, in a word, it seems to me you belong to the school of thought that insists that the way to minimize speculative activities is to penalize legitimate commerce by raising the rediscount rate?‰ The second witness was J. H. Case, chairman of the board of directors of the Federal Reserve Bank of New York. Case pointed out that the increase in broker loans in 1928/29 was not financed by the banks: „The bull market of 1928/29 was largely financed not by the banks but by corporations, firms, and individuals, in the form of advances classified in the report as Âloans for account of othersʉ These loans by corporations, firms, and individuals not in the banking business, attracted by high rates, rose from $1,500,000 at the beginning of 1928 to something like $5,500,000,000 if the figures from all sources are put together. It was the fact that these funds were not bank funds that made the speculative movement so difficult to control.‰ Adolph Miller also testified. This is an opportunity for us to better understand the boardÊs rejection of the New York bankÊs move to increase the rediscount rate on February 14, 1929. At first Miller does not respond. The Chairman: Then just exactly why, may I ask, did the Federal Reserve Board decline to sanction further advances in the rate at New York? Mr. Miller: The rate was raised by the New York bank to 5 percent on the 13th of July, 1928. It was not until the 14th of February, 1929, or seven months later and one week after the board issued a public statement to the country with respect to credit conditions, in which was emphasized the dangers inherent in the extraordinary growth in the volume of speculative security credit, that the Federal Reserve Bank moved. It was not until after the board issued that statement, that the first proposal to raise the rate to 6 percent was made to the board.

But later Miller makes clear his position relative to a discount rate increase. Mr. Miller: It was my opinion, expressed several times in discussions at federal reserve meetings, in the opening month of the year 1929, that the federal

112

BEATING THE BEAR

reserve system was drifting; that it was in the midst of a perilous situation without a policy. It was also my opinion that the Federal Reserve Board was far more alive and aware of the terrific implications of the situation existing at the opening of the year 1929, than were the banks and that, in default of any program on the part of the federal reserve banks for dealing with the situation, the Federal Reserve Board owed a responsibility to the country and to the future of the federal reserve system, for which it must find a solution. That solution was found in a rejection of discount policy as a suitable expedient in the circumstances, as they had then developed, and the adoption of „direct pressure.‰ If was our belief that an increase to 6 percent in February 1929, would have been nothing but a futile gesture; that it would have been a practical declaration to the speculative markets of the country that the doors of the federal reserve system were open to all comers with paper of the kinds eligible for rediscount provided they paid 6 percent. With call rates mounting to 8, 9, 10, 15 and 20 percent, a 6 percent discount rate would have been an admission of defeat and given great relief to the speculating public.

Charles Hamlin also revealed his thinking in rejecting the move by the New York bank to increase the rediscount rate in February 1929: „To make a long matter short, personally, I believe that at that moment, January 1, 1929, the discount rate had ceased to be an effective instrument for curbing speculation which had developed into a perfect mania. While I would have been willing, looking back, to have voted for a 6 percent rate in the middle of 1928, thinking that then it might have proved a curb, I felt that in January, 1929, it had absolutely gone by the board, and the discount rate would have been of no help to us whatsoever.‰ Later in his testimony, Hamlin added to his explanation: When a speculative mania is once under way you cannot do anything with it by the use of higher discount rates; when speculation was beginning, higher rates might have been effective. But when you came to 1929, the period we were considering, it would have no effect whatsoever. The speculators, I believe, wanted us to approve the 6 percent rate. Six percent meant to those men easy money, because it meant, as they hoped, a discontinuance of direct pressure and permission to borrow all the money they wanted if they would merely put up good collateral and pay the increased discount rate. A 6 percent rate would have been to the speculator a relief.

Hamlin forgot his recording of MillerÊs desire for a „sudden liquidation and crash‰ (Hamlin, February 5, 1929). In June 1929, the board suspended its program of direct action. Mr. Hamlin: Another interesting fact is that, although the direct pressure was suspended in June, and a change was made in the discount rate, which I will explain in a minute, on August 9, yet even after that, right up to the time of the stock crash the federal reserve credit outstanding increased for the system as a

THE SENATE HEARINGS OF 1931 CONCERNING 1929

113

whole, comparatively little. It increased simply by the amount of the increased demand for currency in circulation.

HarrisonÊs comments regarding the causes of the October stock market price decrease are of interest: The Chairman: Do you think that is why the turn came? Governor Harrison: I think it came from a variety of reasons. First, when business started to decline in July 1929, it later began to have its effect on speculation; second, very definite nervousness was contributed to the Hatry failure in England, the ramifications of which were great; third, restraint was contributed to by the increase in our rediscount rate in August; fourth, even though we cannot estimate its effect, the increase of the Bank of England rediscount rate was a factor; and then, fifth, and perhaps the most important, things had gotten so top-heavy that they could not go on any further.

It is interesting that Harrison acknowledges that the August increase in the rediscount rate might have caused the market turn. After all, that was the objective of the increase, and the objective of the actions in 1929 of both the Federal Reserve Board and the Federal Reserve Bank of New York.

Chapter 10

DISPELLING THE MYTHS OF 1929

Senator Fletcher: „Did you do anything to check this wild speculation up to October of 1929 that occurred on the stock exchange?‰ ·Stock exchange practices hearing, 1933 In this chapter, an attempt is made to dispel three myths: „stocks were obviously overpriced,‰ „the Great Crash occurred in October 1929,‰ and „the crash was inevitable.‰ Was the stock market, driven by immoral and unthinking speculation, unreasonably high in 1929? We need to review economic fundamentals and stock market prices in September and October 1929. The stock market crash is conventionally said to have occurred on Thursday October 24 and Tuesday October 29, 1929. These two dates have been dubbed Black Thursday and Black Tuesday, respectively. On September 3, 1929, the Dow Jones Industrial Average reached an all-time high of 381.2. At the end of the market day on Thursday, October 24, the market was at 299.5·a 21 percent decline from the market high. On the single day of October 24 the market fell 33 points (using the low value for the day)·a drop of 9 percent for the day. By November 13, the market had fallen to 230·a drop of 40 percent from the marketÊs high. THE STOCK MARKET·1929 The so-called great crash of 1929 was a very modest decrease in stock prices compared with 2008. The value loss for the year 1929 was only about 11.4 percent (Table 10.1).

116

BEATING THE BEAR

Table 10.1 Index of Stock Market Value Year

Index of Value

Change in Index

Percentage Change

1925

1.000

1926

1.057

0.057

1927

1.384

0.327

+30.9

1928

1.908

0.524

+37.9

1929

1.681

0.227

11.9

1930

1.202

0.479

28.5

1931

0.636

0.566

47.1

1932

0.540

0.096

15.1

1933

0.792

+0.252

+46.7

+5.7%

Source: Adapted from R. G. Ibbotson and R. A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past and the Future (Charlottesville, VA: Financial Analysts Research Foundation, 1982), pp. 17 19.

Table 10.1 shows an index computed by R. G. Ibbotson and R. A. Sinquefield for the years 1925 1933.1 The table shows the crash actually persisted for four years, during which time the stock market lost approximately 72 percent of its total value.2 The largest losses occurred in 1930 and 1931. It is a myth that the market „crashed‰ in 1929. The crash only began in 1929. The fact that the stock market lost over 70 percent of its value from 1929 to 1932 indicates that the market, at least using this one criterion (actual performance of the market), was overvalued in 1929. John Kenneth Galbraith implies that there was a speculative orgy and that the crash was predictable: „Early in 1928, the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.‰ Galbraith has no difficulty identifying the end of the real economic boom: „On the first of January of 1929, as a matter of probability, it was most likely that the boom would end before the year was out.‰3 Compare this position with the fact that Irving Fisher, one of the leading economists in the United States at the time, was heavily invested in stocks and was bullish before and after the October selloffs; he lost his entire wealth (including his house) before stocks started to recover. In England, John Maynard Keynes, possibly the worldÊs leading economist during the first half of the twentieth century, and an acknowledged master of practical finance, also lost heavily. Paul Samuelson quotes P. Sergeant Florence (another leading economist): „Keynes may have made his own fortune and that of KingÊs College, but the investment trust of Keynes and Dennis Robertson managed to lose me my fortune in 1929.‰4

DISPELLING THE MYTHS OF 1929

117

GalbraithÊs ability to „forecast‰ the market turn is not shared by all. Samuelson admits that „playing as I often do the experiment of studying price profiles with their dates concealed, I discovered that I would have been caught by the 1929 debacle.‰5 For many, „the collapse from 1929 to 1933 was neither foreseeable nor inevitable.‰6 The stock price increases leading to October 1929, then, were not driven solely by fools or speculators. There were also intelligent, knowledgeable investors who were buying or holding stocks in September and October 1929. Also, leading economists, both then and now, could neither anticipate nor explain the decline of the market in the fall of 1929. The remainder of this chapter will show that it is a myth that the stocks were obviously overpriced and that speculation determined stock prices. THE ECONOMIC FUNDAMENTALS The total real income from 1921 to 1923 rose to 10.5 percent per year, and from 1923 to 1929 it rose 3.4 percent per year. The 1920s were, in fact, a period of real growth and prosperity. For the period of 1923 1929 wholesale prices went down 0.9 percent per year, reflecting moderate, stable growth in the money supply during a period of healthy real growth. In 1929 the stock of money declined very slightly „as a result of the restrictive monetary measures arising out of the Federal Reserve SystemÊs concern with the contemporaneous stock market boom.‰7 Examining the manufacturing situation in the United States prior to the crash is also informative. Irving FisherÊs Stock Market Crash and After, written in the fall of 1929, offers much data indicating that there was real growth in the manufacturing sector. The evidence presented goes a long way to explain FisherÊs optimism regarding the level of stock prices. What Fisher saw was manufacturing efficiency rapidly increasing (output per worker). as was manufacturing output and the use of electricity. The financial fundamentals of the markets were also strong. During 1928, the price earnings (P/ E) ratio for 45 industrial stocks increased from approximately 12 to approximately 14. It was over 15 in 1929 for industrials and then decreased to approximately 10 by the end of 1929.8 although not low, these P/ E ratios are by no means out of line historically. Values in this range would be considered reasonable by most market analysts. The rise in stock prices was not uniform across all industries. The stocks that went up the most were in industries where the economic fundamentals indicated there was cause for large amounts of optimism. They included airplanes, agricultural implements, chemicals, department stores, steel, utilities, telephone and telegraph, electrical

118

BEATING THE BEAR

equipment, oil, paper, and radio. These were reasonable choices for expectations of growth. To put the P/E ratios of 10 to 15 in perspective, remember that government bonds in 1929 yielded 3.4 percent.9 Industrial bonds were yielding 5.1 percent. Joseph Stagg Lawrence of Princeton University thought the stock market was not overpriced and that broker loans were not excessive. He took the $70 billion of stock value (as of April 1, 1929), added $47 billion of bonds, and divided that into the $6.8 billion of broker loans. The $5.81 of debt per $100 of securities was much less than $9.10 of debt per $100 of farm property.10 PRODUCTION AND PRODUCTIVITY, 1920 1929 To understand the stock market in 1929, we should attempt to understand the real economy for the period 1920 1929. The Federal Reserve Bulletin reported production in 1920 at an index of 87.11 The index went down to 67 in 1921, then climbed steadily (except for 1924) until it reached 118 in 1929. This is an annual growth rate in production of 3.1 percent. During the period commodity prices actually decreased; thus the production record for the 10-year period was exceptionally good. During 1929, each of the first six months showed production increases. In June the index was 125; in July it went down to 119; in August it was back up to 121; and in September it increased to 123. Even in October the production index was 120. Looking at this widely publicized measure of industrial production, the stock market had little cause for fear. Factory payrolls in September were at an index of 111 (an all-time high). In October the index dropped to 110, which beat all previous months and years except for September 1929. The factory employment measures were consistent with the payroll index. In September unadjusted measure of freight car loadings was at 121 · also an all-time record. In October the loadings dropped to 118, which was a performance second only to SeptemberÊs record measure. Farm product prices throughout the year were equal to or higher than 101; for the year this figure was at 105. (In 1928, it had been 106, but only 99 in 1927 and 100 in 1926.) In addition, the prices of nonfarm products had gone down in 1929 compared with 1928. Building contracts awarded in August and September were down from a very good July; this undoubtedly was disappointing to a market needing growth in order to survive. J. W. Kendrick offers us estimates of productivity increases during various time periods.12 We define productivity as output per unit of

DISPELLING THE MYTHS OF 1929

119

input. With changing products and changing mixes of different factors of production, it is difficult to measure exact changes in productivity, but reasonable measures have been obtained by Kendrick. The period 1919 1929 had the largest average annual rate of change in total factor productivity. The annual rate of 5.3 for 1919 1929 for the manufacturing sector was more than twice the 2.5 rate of the second best period (1948 1953).13 Farming productivity change for 1919 1929 was second to that for the period 1948 1953, while mining productivity was second to that for the period 1929 1937. Transportation was beaten by two time periods but was competitive with four other time periods. Communications and public utilities did not do as well during the other time periods. Overall, the period 1919 1929 easily took first place for productivity increases, handily beating the six other time periods studied by Kendrick with an annual productivity change measure of 3.7 percent. This was outstanding economic performance · performance that justified stock market optimism. Lawrence also thought that the high level of stock prices merely reflected the high level of business profitability and growth, and that the federal government should not make judgments (and take actions) regarding the level of the stock market: 1929 Stock Values Justified With marked progress in individual industries, in an era of radical improvements in our economic life comparable to the Industrial Revolution, attended by singular good fortune in the expansion of foreign trade and achieving a dominant place in the firmament of international commerce and finance, with peace at home and abroad and with an administration in which the country has the greatest confidence, it is little wonder that those who buy stocks, who, in terms of the economist, are paying a present sum for an infinite series of future incomes, should be inclined to pay a rather high price. These people are placing a high value upon future increments of income and subjecting them to a low discount. They may be in error. It is for them to judge and most emphatically not for a body in Washington.

Lawrence concluded that the record for the first quarter of 1929 (the time of his manuscript submission) revealed „a prosperous state of business, one of the most brilliant in fact of recent years.‰14 For the first nine months of 1928, cash dividends were $2.4 billion. Dividends increased to $3.1 billion for the first nine months of 1929 · an increase of about 30 percent.15 In September 1929, dividends were $399 million, compared with $278 million in September 1928

120

BEATING THE BEAR

(an increase of 44%). These are dramatic numbers and a reasonable basis for optimism. In the first nine months of 1929, 1,436 firms announced increased dividends. In 1928, the number was only 955, and in 1927 it was 755.16 In September 1929, dividend increases were announced by 193 firms, compared with 135 the year before. The financial news from the corporations was very positive in September and October 1929. But if the above numbers for dividends merely reflected the distribution of a larger percentage of earnings, there would be cause for concern. For September 1927 the dividend payout rate was 71 percent. For September 1928 this rate increased to 75 percent, for September 1929 it decreased to 64 percent. Not only dividends but also corporate earnings were increasing significantly in 1929. The May 4, 1929, issue of The Magazine of Wall Street had an article entitled „Yields below Carrying Charges.‰ The concern was the low dividend yield compared with the rate at which funds were being borrowed. A second article dealt with the effect the tax on capital gains had on stock prices. The theory offered was that the tax discouraged the sale of stock, encouraging stock price increases. The June 1 issue also worried about the relationship of prices and earnings: „The accepted rule of thumb measure which placed the fair market value of a stock at from ten to fifteen times the earning power per share, depending on the character of the enterprise, has from force of circumstances passed into the limbo of comparative uselessness. Today market appraisal, to judge from present ratios, is far less circumscribed.‰17 The October 19, 1929 issue of The Magazine of Wall Street offered several interesting investment recommendations backed with persuasive stories. One article entitled „Opportune Time of Investment in Retail Store Stocks,‰ recommended stocks of five different retail firms. A second article cited the expansion in the use of tin cans and recommended for consideration the American Can Company and the Continental Can Company. A third article described how machinery transformed business practice. The article included a picture of business equipment and a table (Table 10.2; Table 10.3 shows the P/ E ratios for the five firms) showing the records of five „business appliance‰ companies. All the P/ Es are on the high side; but except for Burroughs and Remington-Rand, they are not shockingly high for companies expected to exhibit high growth rates. Also, P/ Es are frequently computed using projected incomes rather than the earnings of the most recent year. IBM had a 10 percent growth in earnings in 1927 1928 and a 20 percent projected growth in 1928 1929. With these growth rates, it is not difficult to justify a P/ E of 27.2. In 1927, IBM sold for a low of 53; even

7.67

4.70

1.17

5.38

International Business Machine Corp.

National Cash Register Company

Remington-Rand, Inc.

Underwood-Elliot-Fisher Company

6.16

1.13

5.21

8.83

$8.23

Source: Adapted from The Magazine of Wall Street, October 19, 1929.

$9.00

Burroughs Adding Machine Company

4.57

0.80

3.70

5.29

$1.05

4.00

·

4.00

5.00

$0.80

170

53

125

240

94

24

·

32

21

08

Steadily increasing earning power. Good long term investment rating.

Company now making fine progress. after merger troubles. One of the most attractive issues in the group.

Present price rise reflects good long-term outlook and strong position.

Excellent for investment purposes. Sales setting new records.

Priced high on current (1929) earnings but sound for longterm holding.

Earned per Earned per Share Common Share Common EPS 1929 Dividend Recent Dividend Stock 1927 Stock 1928 (6 months) Rate Price Yield % Comment

Table 10.2 Records of Leading Business Appliance Companies

122

BEATING THE BEAR

Table 10.3 Price Earnings Ratios 1928 Earnings

P/E Ratios Using 1928 Earnings

Recent Price

8.28

470

Burroughs

56.8

8.83

240

IBM

27.2

5.21

125

National Cash

24.0

1.13

53

Remington-Rand, Inc.

46.9

6.15

170

Underwood-Elliot-Fisher

27.6

Note: We are assuming the $94 recent price for Burroughs is after the stock split; without the split the price would be $470.

in the first nine months of 1929, it could have been bought at 150 (a P/ E of 14.2). The dividend yields of Table 10.2 are low compared with the call loan costs of 6 to 10 percent. But on the same date, industrial bonds had yields to maturity ranging from 5 to 7 percent (there were „junk‰ bonds in 1929, but they went by a different name: „speculative‰). If one wanted equity dividend yields that were higher than those of the common stock, one could buy industrial preferred stock yielding between 5.6 and 8 percent. International PaperÊs preferred stock yielded a high 8 percent because its earning coverage was relatively low. Some investors were looking at fundamentals. But the preferred yields were lower than the cost of call loans and thus could not be profitably financed with debt. The May issue of The National City Bank of New York Newsletter indicated the earnings statements for the first quarter of surveyed firms showed a 31 percent increase compared with the first quarter of 1928. The August issue showed that for 650 firms, the increase for the first six months of 1929 compared with 1928 was 24.4 percent. In September the results were expanded to 916 firms with a 27.4 percent increase. But even National City Bank thought speculation was excessive and „a temporary slackening of the business pace, which would have as its effect a sobering influence on speculative sentiment, should be the very thing needed to keep business on a sound and enduring basis.‰18 The November issue labeled the October decrease in stock prices as „the collapse of stock speculation.‰ The earnings for the third quarter for 638 firms were calculated to be 14.1 percent larger than for 1928. The March 1930 issue showed that for 1,509 firms the annual earnings had increased by 13.5 percent for 1929 compared to 1928. There is conclusive evidence that the general level of business activity and reported profits were excellent at the end of

DISPELLING THE MYTHS OF 1929

123

September 1929 and the middle of October 1929. (Appendix 1 shows the details of two National City Bank earnings surveys.) Barrie Wigmore researched the financial data for 135 firms.19 For 1929, he found a P/ E ratio of 29.8 using the high stock prices for the year and 12.4 using the low prices. The market price as a percentage of year-end book value was 420 percent using the high prices and 181 percent using the low prices. However, the return on equity for the firms (using the yearend book value) was a high 0.165. The dividend yield was 2.96 percent using the high prices and 5.90 percent using the low prices. The dividend payout rate was 66 percent. For WigmoreÊs sample, the closing price of 1929 as a percentage of the high prices of 1929 was 59 percent. Wigmore computed the value of all stocks on the NYSE as of September 1, 1929, to be $82.1 billion.20 If preferred stock is included, the value is $89.7 billion. Although member firm borrowings increased from $3.3 billion on January 1, 1927, to $8.5 billion on October 1, 1929, the ratios of borrowing to market value of all listed stocks increased only from 8.6 percent to 9.8 percent. This was the highest percentage for the three-year period ending December 31, 1929.21 The May 24, 1929, issue of The Magazine of Wall Street carried an article entitled „Untapped Reservoir of Future Expansion in Rural Electrification.‰ The article estimated that an $8 billion capital outlay was needed to electrify 6.3 million farms. The farmers would have a $12 billion equipment cost. The potential was vast. Other articles in the same issue described growth opportunities in the South and far West, and one reported „Stocks in Favorable Earning Position.‰ The October 1 issue of Forbes carried an article with the following headline: Rail Earnings Break Records Improvements, Operating Efficiency Responsible for Best Returns In Railroad History

The first paragraph read as follows: „It seems certain now that in the entire year 1929 the railways as a whole will earn the largest percentage of return on their property investment that they have earned since 1916, and a larger average net income per share of stock than they ever have earned.‰22 Article after article from January to October in business magazines carried news of outstanding economic performance. E. K. Burger and A. M. Leinbach, two staff writers of The Magazine of Wall Street, wrote in June 1929, „Business so far this year has astonished even the perennial optimists.‰23

124

BEATING THE BEAR

The economyÊs healthy state is illustrated by the following Gross National Product (GNP) measures. Although all GNP measures are estimates based on assumptions and incomplete information, Table 10.4 is an attempt to provide information regarding the health of the U.S. economy. Real GNP was growing in a healthy fashion in 1929. In the third quarter of 1929, real GNP was being generated at a 323.69 rate. Only residential and nonresidential structures showed a sign of weakness in the third quarter of 1929 ( Table 10.5). All other productivity measures were strong. In fact, the total production numbers (Table 10.6) were strong all the way through 1929. There was little hint of a severe weakness in the real economy in the months prior to October 1929. Table 10.4 Gross National Product: 1925 1929 Year

Nominal GNP

Real GNP (1972 Dollars)

1925

93.30

276.03

1926

97.17

291.81

1927

95.01

293.27

1928

97.17

296.22

1929

103.42

315.69

Source: N. S. Balke and R. J. Gordon, „Historical Data,‰ in The American Business Cycle (Chicago: University of Chicago Press, 1986), p. 782.

Table 10.5 Expenditures ProducersÊ Durable Equipment (1972 dollars)

Nonresidential Structures

Residential Structures

Durable Goods

Nondurables

1

14.06

19.06

16.66

19.14

189.52

2

14.55

20.11

16.91

19.29

187.62

3

15.24

19.51

15.55

20.05

192.72

4

16.31

20.27

14.79

21.19

195.45

1

16.47

23.04

15.04

21.58

194.56

2

16.79

23.08

14.73

21.16

193.40

3

17.40

20.87

12.82

21.35

196.20

4

15.52

19.71

9.50

19.56

192.23

Quarter 1928

1929

Source: N. S. Balke and R. J. Gordon, „Historical Data,‰ in The American Business Cycle (Chicago: University of Chicago Press, 1986), pp. 810 23.

DISPELLING THE MYTHS OF 1929

125

Table 10.6 Total Manufacturing in 2009 January

13.526

June

14.097

July

14.187

August

14.048

September

13.827

October

13.812

November

13.219

December

13.585

Source: N. S. Balke and R. J. Gordon, „Historical Data,‰ in The American Business Cycle (Chicago: University of Chicago Press, 1986), pp. 842 43.

In conclusion, there is a great deal of evidence that in 1929 stock prices were not out of line with the real economics of the firms that had issued the stock. Leading economists were betting that common stock in the fall of 1929 was a good buy. Conventional financial reports of corporations gave cause for optimism relative to the current earnings of corporations. P/ E ratios, dividend amounts, and changes in dividends and earnings all gave cause for stock price optimism. A NUMERICAL JUSTIFICATION OF THE MARKET LEVEL The October 19 issue of The Magazine of Wall Street reported that the average public utility bonds yielded between 5 and 6 percent, and average public utility preferred stock yielded between 6 and 7 percent. U.S. Treasury bonds as of the end of September 1929 yielded 3.7 percent.24 It would not be unreasonable to estimate the cost of equity capital to be 8 percent. The dividend payment rate in 1929 was approximately 0.7. Using the basic dividend discounted cash flow model and assuming constant dividend growth for perpetuity, we have: P=

(1 − b ) E D = k −g k −g

or P /E =

(1 − b ) k −g

126

BEATING THE BEAR

where P = the expected price per share based on the values of b, k, and g E = the earnings per share P/ E = the expected P/ E ratio D = the dividends per share K = the discount rate (required return) used by the market for common stock G = the expected growth rate B = the retention rate (1 b) = the dividend payout rate

If (1 b) = 0.7, k = 0.08, and P/ E = 16, then, solving for the implied growth rate in dividends, we obtain: P/E =

(1 − b ) k −g

and 16 =

0.7 and g = 0.03625 0.08 − g

The P/ E multiplier of 16 implies that the market expects a growth rate of only 3.6 percent. National Bank reported a growth rate in earnings for 1927 1928 of 14.8 percent and a growth rate for the first nine months of 1929 to be 20.3 percent. With these assumptions, the P/ E of 16 is easily justified. Although the assumption of any growth rate for perpetuity is extreme, the calculations illustrate the fact that an assumption of a large growth rate can lead to the justification of a large P/ E multiplier. If we assume that the market requires a 0.10 return on equity capital, the necessary growth rate becomes: 16 =

0.7 0.10 − g

g = 0.05625

This again is well within the range of reasonable assumptions, given the performance of U.S. industry in the period 1926 1929. The fact is that there were ample reasons to expect respectable growth in earnings and dividends and in stock values in the fall of 1929. More complex models (such as two-stage growth or a different growth rate for each year) lead to the same magnitudes of P/ E multipliers. For example, if we assume a 15 percent growth rate for five years and then a 3 percent growth for perpetuity, Appendix 3 shows that with a discount rate of 0.08, a P/ E multiplier of 23.98 can be justified. The multiplier is very sensitive to discount and growth rate assumptions.

DISPELLING THE MYTHS OF 1929

127

The conclusion that the market was overvalued was primarily based on the fact that stock prices had gone up dramatically; it ignored the fact that real measures of value (earnings and dividends) had also gone up dramatically. The desire to end the „speculation‰ and to „get the New York speculators‰ had blinded many observers to the fact that the stock values in 1929 could be justified by reasonable economic analysis, given the high growth rates in earnings and dividends that could be reasonably expected. The tendency to focus on speculation for 1929 continues to the present. Thus Kaufman (2009, p. 19) states, without justification or explanation: „Then came unprecedented speculation in the 1920s. . . .‰ No one has proven that there was dramatic excess speculation in the 1920s.25 ANALYSIS OF STOCK PRICES AND VALUE Starting with a total return index of 1.000 on January 1926, at the end of August 1929 the index reached 2.485.26 Thus from 1925 to 1929 the funds invested in stocks more than doubled in value over the four-year period (the peak was reached on September 3, 1929). Growth in the index from 1.000 to 2.485 in a four-year period is a 0.256 annual growth rate. The annual return rate from the index measure of 1.908 of 1928 to 2.485 one year later is 0.302. Although large, it does not compare to the numbers shown in Table 10.7. Table 10.7 reveals a large stock price increase, but the average measures show that the prices are not typical for the time period but rather involved relatively unusual stocks that increased in value more than the market increased. Burton G. Malkiel clearly accepts the assumption that the market was running wild: „Conditions could not have been more favorable for a speculative craze . . . Beginning in 1928, however, speculation accelerated to boost prices well beyond supportable levels.‰ Although history has proven these statements to be correct, it is very difficult to cite evidence, other than the stock prices themselves, to prove the market was too high. Thus, to justify his position, Malkiel states that „from early March 1928 through early September 1929 the marketÊs percentage increase equaled that of the entire period from 1923 through early 1928. The price rises for the major industrial corporations sometimes reached 10 or 15 points per day.‰27 Let us consider one company cited by Malkiel, American Telephone & Telegraph, in more detail. In 1929, the company had earnings of $13.96 and was therefore selling at 335.625 ÷ 13.96 = 24 times earnings, using the high price for 1929. The company had 469,801 stockholders. The

128

BEATING THE BEAR

Table 10.7 Stock Price Increases Security American Telephone & Telegraph

Opening Price March 3, 1928

High Price September 3, 1929

Percentage Gain in 18 Months

1791Î2

3355Î8

87.0

7

3

Bethlehem Steel

56 Î8

140 Î8

146.8

General Electric

1283Î4

3961Î4

207.8

Montgomery Ward National Cash Register Radio Corporation of America

3

1

132 Î4

466 Î2

251.4

503Î4

1271Î2

151.2

505

434.5

1

94 Î2

Note: High price is adjusted for stock splits and the value of rights received subsequent to March 31, 1928.

assets and earnings had been growing at 9.9 percent per annum for the previous five years.28 The stock paid a $9 dividend for a yield (using the high price) of 9 ÷ 335.625 = 0.027. The dividend payout was 0.64 of earnings. The $13.96 of earnings excluded $0.25 per share of Western ElectricÊs earnings that were not consolidated, so a reasonable analyst could correctly conclude that the 1929 earnings were $14.21. The company was forecasting a 40 percent increase in plant construction over the next four years. J. B. Williams states that „speculators in the 1929 boom had become excited about the inventions of the Western Electric Company, the wholly-owned subsidiary which manufactured most of the equipment used by the company, because in connection with its scientific researchers on sound this subsidiary had perfected an apparatus for making sound motion pictures.‰ Note the use of the pejorative word „speculators.‰ Williams then states that „sober investors‰ would realize the minor importance of the invention compared to American TelephoneÊs regular businesses. Williams correctly observes that „starting from the same data, different investment analysts reached different appraisals of the stock.‰ He then makes the following assumptions and concludes the stock was overpriced:29 1. 2. 3. 4.

The return on invested assets will remain as at present. The ratio of stocks to bonds will remain as at present. The rate of growth will continue as at present. At the end of 10 years, growth will end.

DISPELLING THE MYTHS OF 1929

129

5. At that time, 10 years hence, the stock will sell at book value. 6. During the 10-year period, the investor shall receive 6 percent on purchase price, as either dividends or appreciation.

Since the company was earning 9.04 percent on net assets and 10.61 percent on book stock equity, the 6 percent estimate of return on investment was conservative, as was the assumption that after 10 years growth would end and the stock would then sell at book value. It is not that WilliamsÊs assumptions are faulty but rather that other assumptions are equally valid and would lead to different valuations. For example, if we assume that the firm could earn 0.1061 on new equity capital, will retain 0.36 of earnings, and have a growth rate of 0.038 (equal to 0.36 × 0.1061), then, with the 6 percent discount rate specified by Williams, using a conventional dividend valuation model, we obtain: P=

dividend 9 = = $409 discount rate − growth rate 0.06 − 0.038

It is not that this calculation is better than that of Williams; it merely illustrates the fact that the $335 market price for American Telephone can be justified if the above discount and growth rate assumptions are made. In 1929 there were 19 million telephones in use in the United States. Most central stations still used manual rather than machine switching. Growth was still feasible. It is extremely difficult to cite objective evidence proving that the stock market prices in September and October 1929 were not justified by real economic performance. In 1934, B. Graham and D. L. Dodd also maintained that the 1927 1933 period should be regarded „more as an economic phenomenon akin to the South Sea Bubble and other isolated instances of abnormal gambling frenzy than as an indication of what the typical speculative cycle of the future will be.‰30 They also did not offer proof of overvaluation. Let us consider the case of United States Steel common stock. According to Table 10.8, the stock price more than doubled from 1925 to 1929. But earnings per share went from $9.20 to $21.20. The P/ E ratio went from 9.8 in 1925 to 9.7 in 1929, a marginal decrease despite the excellent stock price growth record. Williams shows that in 1929 unfilled orders for steel compared favorably with those of 1928, 1927, and 1926.31 New bookings of orders were also strong. In 1929 the rate of operations was 86.3 percent of capacity compared with 81.5 percent in 1928 and 77.4 percent in 1927. The industry as a whole operated at 87.0 percent of capacity in 1929. The year 1929 was a good year for steel.

130

BEATING THE BEAR

In the case of Pennsylvania Railroad (Table 10.9), we find the stock price going up. To a large extent, however, the increase reflects an increase in earnings. The P/ E ratio increased only from 7.9 to 10.4, but in 1929 the growth rate in earnings per share was 20 percent compared with 7.5 percent for 1928. Obviously, one can find illustrations where stock price increases were not matched by earnings increases, but the fact is that the total corporate earnings did increase from 1925 to 1929 and that generally the stock price increases during that period were justified by equivalent earnings increases. Could the economy sustain the profit and dividend increases in the future that took place in the past? Historically, we know that the increases did not take place. But in the fall of 1929 there were good reasons for thinking that the economy would continue to be strong and that corporate profits would continue to increase. Even among professional economists, there were few who understood the forces then at work to deflate the general price level and produce one of the worst depressions in history.32 Table 10.8 United States Steel Company Year

Average Stock Price

Earnings per Share

Price Earnings Ratio

1925

90*

9.2*

9.8

1926

99*

12.9*

7.7

1927

144*

8.8*

16.4

1928

153

12.5

12.2

1929

206

21.2

9.7

Source: B. Graham and D. L. Dodd, Security Analysis ( New York: McGraw-Hill, 1934), p. 615.

*Adjusted for 40 percent stock dividend.

Table 10.9 Pennsylvania Railroad Company Year

Average Stock Price

Earnings per Share

Price Earnings Ratio

1925

49

6.23

7.9

1926

53

6.77

7.8

1927

63

6.83

9.2

1928

69

7.34

9.4

1929

92

8.82

10.4

Source: B. Graham and D. L. Dodd, Security Analysis ( New York: McGraw-Hill, 1934), p. 310.

DISPELLING THE MYTHS OF 1929

131

THE SIRKIN STUDY Gerald Sirkin uses a two-stage growth model where firms grow at a high rate for a finite time period and then grow at a normal rate for perpetuity.33 He takes as his sample the firms in the Dow Jones Industrial Index in 1929. The P/ E ratios for 1929 for his sample range from 11.3 (for American Sugar) to 65.2 (for North American Corporation), with a mean of 24.3 and a median of 20.4.34 Sirkin uses each firmÊs highest price and 1929 earnings per share. He then takes the five-year growth in earnings for the group as a whole to compare the actual growth in earnings with the earnings necessary to support the mean P/ E ratio of 24.3. He then concludes: „If the calculated distributions are roughly realistic, they suggest that conspicuously unsound speculation was not general, but was concentrated in a small proportion of stock.‰35 Sirkin does not claim to be able to justify all the high prices of 1929 with the dividend growth model. He does state that „the distribution of the peak price-earnings ratios, when compared to distributions calculated on the assumption of a short rapid-growth phase, suggest that the marked overvaluation of stocks was not general, but was concentrated in a fraction · in the neighborhood of one-fifth · of the stocks in the sample.‰36 Also, he recognizes that an increase in the expected period of high growth would enable him to justify even more of the high prices of 1929 (Table 10.10).

Table 10.10 Production Industrial Production Total Year and Month

Unadjusted

1919

83

1920

87

1921

67

1922

85

1923

101

1924

95

1925

104

1926

108

1927

106 (Continued)

Table 10.10 Production (Continued) Industrial Production Total Year and Month

Unadjusted

1928

111

1929 January

116

February

120

March

121

April

124

May

125

June

125

July

119

August

121

September

123

October

120

Source: Adapted from The Federal Reserve Bulletin, August 1930, p. 494. Note: Index numbers: 1923 1925 average · 100. The term „unadjusted‰ refers to adjustment for seasonal variations.

Table 10.11 Economic Growth, 1921 1929 Year

Industrial Production

Wholesale Prices

National Income (billions)

Income per Capita (1929 prices)

97.6

$59.4

$522

1921

58

1922

73

96.7

60.7

553

1923

88

100.6

71.6

634

1924

82

98.1

72.1

633

1925

90

103.5

76.0

644

1926

96

100.0

81.6

678

1927

95

95.4

80.1

674

1928

99

96.7

81.7

676

1929

110

95.3

87.2

716

Sources: For industrial production and wholesale prices, The Federal Reserve Bulletin, October 1945, p. 1049. For national income and real income per capita, Simon Kuznets, National Income and Its Composition, 1919 1938 (New York: National Bureau of Economic Research, 1941), pp. 137, 153. This table was adapted from Soule, Prosperity Decade, p. 108. Soule cities the above sources.

DISPELLING THE MYTHS OF 1929

133

PRODUCTION AND EMPLOYMENT Table 10.10 shows that the factory production numbers up until October 1929 were very good. Clear downturns were apparent after October. Commodity prices held constant from 1922 while farm prices were up (but down from 1920). Up until October 1929, factory employment and payrolls were healthy. It is difficult to inspect Table 10.10 without concluding that investors in September and October 1929 were being given optimistic numbers concerning the economy. Table 10.11 shows the real prosperity of in the United States from 1921 to 1929. CONCLUSIONS The extraordinary rise in stock prices from 1925 to 1929 can be justified by the extraordinary performance of the economy and of the companies whose stocks had risen. A reasonably well-informed, conservative investor could find good reasons for buying common stock in September 1929. Sobel states „There were few bears on Wall Street and fewer still on university campuses throughout the nation.‰37 It was only after the crash that academics became proficient at forecasting its inevitability. The crash was not inevitable. The best-informed observers thought that the economic prosperity would lead to even higher stock prices.

Appendix 1

Tables 10.12 and 10.13 show earnings of U.S. corporations for 1926 1929. Table 10.12 shows the data available to analysts in March 1929. Note the large increase for 1927 1928. Table 10.13 shows the data available to analysts in the fall of 1929. Although 1928 was a high basis of comparison, 1929 was even higher. There was cause for optimism.

Table 10.12 American Corporation Earnings (Net Profits) Percent Change No.

Industry

1927

1928

1927 8

7 8 23 12 24

Agricultural implements Amusements Apparel, etc. Automobiles Auto accessories

$17,662 27,296 18,499 294,377 22,689

$22,063 36,209 18,595 348,612 41,800

+24.9 +32.7 +0.5 +18.4 +84.2

3 25 36 11 7

Aviation Building materials Chemicals Coal mining Copper mining

1,218 39,636 104,639 7,678 22,853

2,161 37,347 141,414 7,773 51,325

+77.5 5.8 +35.1 +1.2 +125

19 9 13 24 9

Cotton mills Electrical equipment Bakery and flour Food products, misc Heating and plumbing

9,076 10,759 68,187 67,178 11,091

2,003 27,096 73,024 80,225 13,357

78.1 +152 +7.1 +19.4 +20.4

8 29 9 6 27

Household equipment Iron and steel Leather and shoes Lumber and furniture Machinery

22,648 157,530 30,528 4,225 26,310

24,036 210,403 26,162 4,531 29,648

+6.1 +33.5 14.3 +7.2 +12.7

7 33 14 6 7

Meat packers Merchandising Metals, nonferrous (exc. copper) Office equipment Paper products

16,194 135,798 25,894 7,345 6,975

32,282 150,583 28,015 8,032 7,792

+99.2 +10.0 +8.2 +9.4 +11.7

DISPELLING THE MYTHS OF 1929

135

Table 10.12 American Corporation Earnings (Net Profits) (Continued ) Percent Change No.

Industry

1927

1928

1927 8

32 10 10 14 9

Petroleum Printing and publishing Railway equipment Rubber Shipping, etc.

63,192 5,729 16,823 49,145 8,970

123,988 7,324 13,080 27,189 7,748

+96.2 +27.9 22.2 44.7 13.1

8 13 12 16 2 20

Silk Sugar Textile products, misc Tobacco Wool Miscellaneous

6,288 10,901 13,806 77,957 *43 36,649

4,713 5,488 15,835 80,301 238 47,848

25.2 49.8 +14.7 +3.0 +· +30.5

527 135 63 95

Manufacturing and trading Railroads Telephone and telegraph Other public utilities

1,445,702 1,085,917 233,435 775,177

1,758,250 1,193,134 255,265 857,400

+21.6 +9.9 +9.4 +10.6

820

Grand total

3,540,231

4,064,040

+14.8

Source: Adapted from The National City Bank of New York Newsletter, March 1929, p. 35. *Deficit.

136

Industry

Amusement Apparel Automobile Auto accessory Building material

Business equipment Chemical and drug Coal and coke Electrical Flour and baking

Food products Household goods Iron and steel Leather Machinery

Merchandising Metal mining Paper products Petroleum Printing and publishing

No.

5 2 16 20 10

11 17 6 12 6

17 16 23 2 12

8 14 5 19 5

Table 10.13 American Corporation Earnings

4,656 6,904 1,237 39,101 6,464

24,971 10,444 54,726 618 5,554

4,081 38,578 1,293 23,142 6,033

$4,347 184 111,127 12,332 9,279

1928

4,999 9,125 1,787 46,772 7,060

30,812 11,216 93,204 245 6,775

4,890 43,137 1,761 31,267 8,223

$8,715 124 90,853 11,019 8,928

1929

Third Quarter

+7.3 +32.2 +44.4 +19.6 +9.2

+23.4 +7.4 +70.3 60.6 +21.9

+19.9 +11.8 +36.2 +25.1 +36.3

+100.2 32.6 18.2 6.5 3.8

Percent Change

13,605 21,400 3,802 79,963 20,873

68,990 26,505 138,983 3,727 14,797

10,150 101,399 3,481 58,428 21,382

$12,399 533 327,484 33,721 21,803

1928

Nine Months

15,466 30,476 4,139 117,068 23,543

77,136 30,265 265,394 D-1,821 20,096

13,554 120,980 4,666 78,221 28,055

$20,516 732 318,981 49,070 25,503

1929

+13.7 +42.4 +8.3 +46.4 +12.7

+11.8 +14.1 +91.0 · +35.8

+33.5 +19.3 +34.0 +33.9 +31.2

+65.5 +37.3 2.6 +45.5 +16.9

Percent Change

137

Grand total

638

$1,001,244

$389,398 357,830 63,258 100,758

2,933 7,826

8,489 803 180 976 3,120

$1,142,302

$450,645 398,901 69,516 223,240

3,186 9,851

9,491 1,109 1,061 1,928 3,107

Source: Adapted from The National City Bank of New York Newsletter, November 1929, p. 154. Summary of new profits in published reported covering third quarter and nine months. D: Deficit.

Mfg. And tracking Railroads Tel. and tel. Other utilities

Tobacco Miscellaneous

5 21

272 132 89 95

Railway equipment Real estate Restaurant chains Shipping Textile products

3 5 5 2 5

+14.1

+15.7 +11.5 +9.9 +17.0

+8.6 +25.0

+11.8 +38.0 +· +97.6 0.4

$2,679,934

$1,039,655 819,855 199,208 621,216

7,042 20,181

18,507 2,750 3,021 1,441 3,288

$3,223,620

$1,315,983 962,248 214,649 730,740

8,265 26,308

22,151 5,495 3,698 4,044 3,982

+20.3

+26.7 +17.4 +7.8 +17.5

+17.4 +30.4

+19.6 +100.0 +22.4 +180.0 +21.1

Appendix 2

Tables 10.14, 10.15, and 10.16 are adapted from the Stock Market Study, hearings before the Committee on Banking and Currency, U.S. Senate (Washington, DC: U.S. Government Printing Office, 1955), pp. 40, 41, 110, 111. The information for the tables in the stock market study was supplied by G. Keith Funston, president, New York Stock Exchange, 1955.

Table 10.14 Two Stock Market Indices Year

Standard & PoorÊs Composite (1935 39 100)

Dow Jones Industrials

1922

71.5

91.0

1923

72.9

95.6

1924

76.9

104.4

1925

94.8

137.2

1926

105.6

150.9

1927

124.9

177.6

1928

158.3

245.6

1929

200.9

290.0

Table 10.15 Stock and Bond Yields, 1922 1929 Year

Stocks

Bond

1922

5.37

5.10

1923

5.40

5.12

1924

5.25

5.00

1925

4.75

4.88

1926

5.24

4.73

1927

4.72

4.57

1928

3.82

4.55

1929

3.84

4.73

Note: In terms of yields, the comparison is between MoodyÊs 125 industrial stocks and MoodyÊs Aaa corporate bonds.

DISPELLING THE MYTHS OF 1929 Table 10.16 Price Earnings Ratios (1922 1929) Year

Ratio

1922

13.8

1923

9.3

1924

10.7

1925

8.9

1926

10.5

1927

13.5

1928

14.2

1929

16.3

Note: MoodyÊs industrial stock price earnings ratios for the same periods (annual averages).

139

Chapter 11

THE U.S. GOVERNMENT ACCUSES . . .

The former vice governor of the Federal Reserve Board and then vice president of Marine Midland Corporation of New York, Edmund Platt, was reported on July 4, 1933, as saying that the Senate investigation was „in charge of a clever prosecuting attorney from New York who knows nothing of economics and whose purpose appeared to be to discredit all bankers and to make things appear wrong that are not wrong.‰ ·New York Times, July 4, 1933 In the above statement, Mr. Platt was referring to the attorney, Ferdinand Pecora. Pecora aggressively questioned Wall Street bank executives including both Charles E. Mitchell and Albert H. Wiggin. More about Pecora later in this chapter. It would have been satisfying to those who suffered losses if the government could have named and punished the persons responsible for the 1929 stock market crash. In the 1930s, attempts were made to do this. We will review two important executives of 1929 attacked by the powers in Washington. These were: Charles E. Mitchell, chairman of National City Bank and Albert H. Wiggin, chairman of Chase National Bank.

This chapter will focus on Mitchell and Wiggin. These are the two names one finds in Galbraith (1961) and other similar exposés of the „evil excesses‰ of Wall Street in 1929.1

142

BEATING THE BEAR

In 1933, the U.S. Senate Committee on Banking and Currency held hearings on stock exchange practices.2 Two of the major targets were Charles E. Mitchell and Albert Henry Wiggin. Charles E. Mitchell was the president of the National City Bank in 1929. Ferdinand Pecora was the counsel of the subcommittee conducting the hearings and later the author of a book (1939).3 In order to better understand the Mitchell case, it is necessary to review briefly events of March 1929, when the crash did not occur. CHARLES E. MITCHELL On March 25 and 26, 1929, stock prices were down drastically and call money had risen to 20 percent. On March 26, the market dropped 9.6 percent on a volume of 8,246,000 shares (the volume was much greater than the 6 million shares traded the day before and the day after). Starting in February, 1929, the Federal Reserve had discouraged its member banks from making loans to finance securities. It looked as if a crash was in process. On March 26, MitchellÊs National City Bank stepped in and made loans available to brokers. The bank announced it was ready to lend $25 million on the call market. The loans were to be made at rates of 16 percent and higher. A newspaper carried an article that quoted Mitchell as telling the Federal Reserve Board to „go to hell.‰ Mitchell later denied the quote, but Congress believed it. Senator Carter Glass blasted Mitchell: „He avows his superior obligation to a frantic stock market over the obligations of his oath as a director of the New York Federal Reserve Bank‰ (New York Times, March 29, 1929, p. 1). Senator Glass carried this view of Mitchell well into the thirties. President Hoover also disapproved of MitchellÊs actions, later writing that Mitchell „issues a defiance and engages in an attempt to mitigate the policy of the Federal Reserve Board‰ when the board was seeking to „abate‰ the „menacing spectacle of excessive stock gambling‰ (Hoover, 1952, pp. 18 –19).4 The subcommittee of the U.S. Senate Committee on Banking and Currency studying stock exchange practices in 1929 attacked MitchellÊs March 1929 actions in helping prevent a crash at that time. For example, Senator Brookhart stated to Mitchell, „If you had let it collapse in March, that would have saved hundreds of thousands of dollars to people who invested later on.‰ Thus Mitchell, who helped avert a selling panic in March, was blamed for the severity of the October crash (Stock Exchange Practices, 1933). Failing to find any indictable offense for his March 1929 managerial actions, the subcommittee sought to find evidence of stock manipulation

THE U.S. GOVERNMENT ACCUSES . . .

143

by Mitchell. They would like to have shown that Mitchell profited from the tremendous run-up in price of National City BankÊs stock. For example, the investigating committeeÊs counsel Ferdinand Pecora ( Pecora, 1939, pp. 110 –11) writes, „National City Bank stock, which had a par value of $100, was pushed up and up until it reached dizzy heights.‰ The reference to par value indicates that Pecora was not a student of finance (he was legal counsel of the subcommittee). Pecora does not reveal who pushed up the stock price. He also writes, „For the proud privilege of owning these shares, worth $140,000,000 at their highest book value, the public paid the stupendous sum of $650,000,000.‰ The reference to the book value of a bank stock with the bank heavily engaged in investment banking activities does not enhance our confidence in PecoraÊs financial sophistication. The implication was that Mitchell „pushed up‰ the price of the stock, and the high market value was in some sense morally or criminally wrong. The stock reached a high of $580 in September 1929 before it began its slide. Senator Brookhart questioned Mitchell about his National City Bank stock transactions. Unfortunately for Brookhart, Mitchell responded to the question „In what years did you buy?‰ with „I bought the largest amount of stock in 1929.‰ In answer to „Before or after the collapse?‰ Mitchell responded „In the midst of the panic.‰5 Senator Brookhart also found out that Mitchell bought at $375 a share (the stock went down to $16 in 1933). Pecora asked whether Mitchell had sold any substantial portion of his holdings of National City Bank stock in 1929. Mitchell had purchased 28,300 shares in October 1929 and sold 10,000 shares, leaving him a net ownership of 53,300 shares. In 1933 when the stock fell to $16, he held more than 53,300 shares. Rather than proving that Mitchell was manipulating the market, Brookhart and Pecora extracted from his testimony that he was the number one victim of the stock market increase (buying at $375 and higher) and then the decrease in National City Bank stock. It becomes obvious to an impartial observer that Mitchell deserved praise for the ethics of his market transactions in his bankÊs stock, not censure. The testimony at the hearing then shifted to a topic where Mitchell was more vulnerable, the sale of stock to his wife for tax purposes. Here the government had a worthwhile target, but they chose the wrong battle, a criminal trial. Galbraith (1961, p. 155) writes, „By comparison with the National City the troubles of the Chase were slight.‰ But there were no troubles at National City Bank. There was a disagreement with regard to MitchellÊs tax return but not a problem that had to be resolved in federal court in a criminal case.

144

BEATING THE BEAR

The counsel for the subcommittee, Ferdinand Pecora, was born in Sicily and was brought to the United States at age five. In 1933, he was 51 years old. His full-time college education consisted of one year at St. Stephens College. He then went to work at a law office to help support six young siblings while attending law school part time. In 1909 he was accepted to the bar at age 27. He had a fine record of public service, working as a district attorney, and then left for private practice. In January 1933, he was approached by Chairman Norbeck to act as counsel for the Senate committee. The salary was $255 a month (a good salary but not comparable to the wages of the people he was to question). In May 28, 1933, there were published reports („innuendoes‰) of „slurs on Pecora‰ but nothing of significance was ever revealed. It would appear that someone did not like him. This list would soon get larger. It is interesting that three of the major characters in this drama had lived the American dream up to 1929. Wiggin was chairman of a bank that was soon to be the worldÊs largest bank. He went to work as a clerk on graduating from high school. Sam Insull controlled a $3 billion public utility empire. He went to work as an apprentice clerk at age 14 in England. It is noted above that the prosecutor, Pecora, came to the United States at age 5 and at age 15 had to stop his full-time education. If only the three of them could have gone to a pub for a couple of beers rather than performing their sad dramas in court and public inquiries. On January 30, 1933 (New York Times, January 31, 1933, p. 11), Ferdinand Pecora, counsel of the Senate subcommittee of the Committee on Banking and Currency, subpoenaed Charles E. Mitchell to testify. On February 2 the Times ( p. 25) reported that the Senate inquiry aimed to show that the banks caused the boom and that the marketing of their own stock contributed to inflated stock prices. Mitchell was particularly at fault since he „took a go-to-hell‰ attitude toward the Federal Reserve Board in March 1929, when the board attempted to restrain the boom. The subcommitteeÊs chairman, Senator Norbeck, stated, „Some of the large banks were highly responsible for the wild stock market boom‰ and „It was just a polite way of robbing the public.‰ MitchellÊs testimony led to the front-page headlines (Times) on February 22, 1933: „Mitchell Avoided Income Tax in 1929 By $2,800,000 Loss‰ and „Got $3,500,000 in 3 Years.‰ The $3,500,000 were bonuses received by Mitchell from the bank. Senator Couzens (p. 12) described Mitchell as „a better salesman than a financier‰ without implying that he was a bad financier but acknowledging his appealing personality. The February 23, 1933, Times ( p. 1) revealed that „National City Lent $2,400,000 to Save Stock of Officers. Bank Charged Them No Interest. Sold Out the Customers.‰ There were 100 officers so protected, but not

THE U.S. GOVERNMENT ACCUSES . . .

145

Mitchell. He borrowed from J. P. Morgan & Co. The same paper ( p. 27) had an article in which Senator Wheeler of Montana „assails Mitchell.‰ On February 25, 1933 there was another front-page headline, „Federal Inquiry on National City and Insull Starts. Law Violations Sought.‰ Given the 1929 stock market crash, somebody had to be guilty of something. On February 27, 1933 (again p. 1), „Mitchell Offers to Quit National City Bank. Letter of Resignation Up for Action Today.‰ The next day the resignation of Mitchell was accepted by the bankÊs board. Presidentelect Franklin Roosevelt advised the banker to retire. A Times editorial ( p. 18) with the heading „Better Banking‰ said the „resignation was inevitable.‰ Thus with no crime, even hinted at, other than differences of opinion regarding MitchellÊs tax bill, Mitchell was driven from his position by vague accusations that he and his bank caused the stock market boom and bust. Pecora released a statement to the press that „any public misunderstanding created by Mr. MitchellÊs testimony was due to Mr. Mitchell himself.‰ Next Pecora went after the marketing by National City Bank of $90 million of Peru bonds issued in 1927 and 1928. National City had a net gain of $687,000 on the transactions, and in 1931 the investors lost when the bonds stopped paying interest. The accusation was that the bank had acted contrary to advice given by South American experts against participation in Peruvian bond flotations. In 1921, the vice president in charge of the Lima branch (Claud W. Calvin) of National City Bank described the Peruvian financial situation as being „positively distressing‰ and said the countryÊs treasury was „ flat on its back.‰ In May 1923, National City rejected participating in a $6 million Peruvian bond issue proposal because there was too much risk. In July 1923, the bank again rejected a Peruvian bond proposal because of risk. In 1925, Mr. Calvin (see above) sent a letter to the bankÊs New York office saying that there was so much progress under President Leguia that he felt the underwriting should be reconsidered (Times, February 28, 1933, p. 6). National waited two years before it joined the Seligman syndicate. The factors that swung the decision were CalvinÊs report and the fact that the bonds were to be secured by a tobacco monopoly. In 1927 National City Bank agreed to join a syndicate to market a $15 million issue (NationalÊs share was $5 million). The syndicate was headed and managed by J. W. Seligman & Co., a leading Wall Street firm. The stated purpose of the issue was to refinance outstanding binds (these bonds had not been marketed by National). Thus, if the new bonds had not been issued the holders of the old bonds would have suffered an equivalent loss.

146

BEATING THE BEAR

One factor cited by Pecora as evidence of excessive risk was that the Peruvian government budget had been balanced in only 3 of the 10 years from 1914 to 1925! What would Pecora have said about the last 40 years of U.S. federal government budgets? PeruÊs president wanted a consolidation of the countryÊs external debt, and he promised the underwriters a stabilized currency and a balanced budget. In 1931, there was political unrest and a major revolution in Peru, and the Peruvian bonds failed to pay interest in May 1931. In 1933 Peru was at war with Colombia. The bonds went down further in price. National City admitted to „an honest mistake.‰ The implication that National City Bank (and Mitchell) were culpable is unfair. It was not unreasonable for National City to market Peruvian bonds in 1927 and 1928. If there were criticisms they should have been made in 1927 and 1928 at the time of the deals rather than in 1933 based on the wisdom offered by hindsight. There is no question that the bonds were risky at the time of issue, but an optimist could rationally buy the bonds based on the reports that were available. The Times, October 9, 1929 (p. 53), had an article with the heading „Loan Record Made by Latin America.‰ The total borrowings by Latin American countries in 1928 were $344,598,000 of which $106,400,000 was refunding of loans held by Americans. The article cited the Bolivia–Paraguay boundary dispute and the credit situation in Brazil and stated, „These developments detracted somewhat from the yearÊs generally favorable trend.‰ As part of the favorable trend it said, „A law was enacted in Peru creating the Mortgage Bank of Peru.‰ On March 3, 1933 ( p. 25), the Times reported „Profit in Mergers.‰ A merger leading to the combination of several airplane manufacturers into Boeing Air led to a National City Bank fee of $2,499,250. The common stock was issued to friends and officers of the National City Bank. Mitchell indicated that the offering was „ too speculative‰ for a public offering. If the stock had been offered to the public and had gone down. the hearings would have been more productive. The hearings did bring out that in violation of Federal Law, National City Bank did hold bank stock for a short period of time ( p. 25 of the March 3, 1933 Times). In his inaugural address, Roosevelt stated ( p. 1, March 5, 1933), „Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.‰ He did not identify who was „ unscrupulous,‰ but Mitchell was the man making the front page of the Times during the moment of RooseveltÊs taking office. President Roosevelt, newly inaugurated, gave the stock practices hearings new vigor with a statement upholding the banking inquiry with an objective to eliminate „ bad banking practices.‰

THE U.S. GOVERNMENT ACCUSES . . .

147

On March 17, 1933 the Times had an article dealing with a report to the Senate Committee on Banking and Currency. The report concluded that pools can control prices and that one of the techniques used by speculators was „selling against the box.‰6 The report said corrective legislation was required. The Times ( March 18, 1933, p. 1) reported that Attorney General Cummings was „Hunting Law Violations.‰ President Roosevelt was quoted as asking him „vigorously to prosecute any violation of the law.‰ The next dayÊs headline ( p. 1): „Mitchell Will Face Grand Jury Inquiry.‰ The accusation was that he illegally evaded an income tax payment in 1929. In 1929 Mitchell purchased 28,300 shares of the National City Bank stock at prices of approximately $369 a share (Times, March 19, 1933, p. 1). His motivation was either to support the stock price (his position) or to take advantage of the drop in price (from its high of above $580). Also in 1929, he „sold‰ 18,300 shares to his wife at a price of $212, thus he had a loss of $2,872,306 that he then took as a deduction on his 1929 tax return. Since he reported a gain on sale of other stock of $1,388,238, the $1,484,068 net loss resulted in a deduction against salary and other incomes. Three days after the grand jury inquiry was announced there was the headline „Mitchell Arrested as Tax Evader‰ (Times, March 22, 1933, p. 1). The government wanted a $657,152 payment. An interesting sidelight is that the Federal Marshall (Mulligan) had to borrow a car from his brother to drive the arrested Mitchell to the court house. Bail was set at $10,000. The assistant U.S. district attorney directing the arrest was Thomas E. Dewey. On March 23, 1933 (p. 1), the headline was „Mitchell Evidence Goes to Grand Jury‰ and on March 25 (p. 1) „Mitchell Indicted.‰ On April 14, the indictment was changed to include MitchellÊs 1930 tax. On April 22, there was a second change. The tax total was reduced by $40,000 (the government had calculated wrong). On April 26, a third change was made. The government claimed Mitchell had $666,666 of additional income (Mitchell said he owed the money, thus it was a loan and not income). On May 12 (p. 1) the trial began. Max D. Steuer, MitchellÊs lawyer, described Mitchell as a „ruined patriot‰ and noted that he „lost $25,000,000 protecting bank and country‰ (May 17, p. 1). Mitchell owned 53,300 shares of bank stock at the end of 1929. A price drop of $469 would lead to a $25 million loss. National City BankÊs stock dropped more than $469 from its 1929 high to its 1933 low ($580 –16 = $564). The 18,300 shares „sold‰ to his wife by Mitchell were pledged with J. P. Morgan & Co. as collateral for a loan of $6 million (at times the loan exceeded $10 million) to finance the stock purchases. In addition, Mitchell

148

BEATING THE BEAR

had mortgaged his three homes to help pay for the stock purchased in 1929. As evidence that there had been a sale, the defense revealed that: 1. Mitchell and his wife both wrote letters indicating a sale and purchase. 2. The internal revenue agent was shown the letters and knew the nature of the transaction. The agent approved MitchellÊs tax return. 3. A tax lawyer advised Mitchell that the transaction was valid.

As evidence that there was not a sale, the prosecution revealed that: 1. The letters did not have on them a stamp indicating a transaction had taken place. 2. The wife (Elizabeth Rend Mitchell) did not pay any cash for the stock, though she had considerable wealth. 3. Mitchell sold the stock to his wife for $212 and bought the shares back at $212 when the stock had dropped to $421Î2 in 1932. 4. J. P. Morgan & Co. was not told of the sales ( May 18, p. 1), even though the stock was collateral for MitchellÊs loan.

Obviously, there was sufficient reason for the government to reject the tax loss deduction. However, given the fact that the nature of the transaction was known and approved by the internal revenue agent, there was no valid reason to bring criminal proceedings against Mitchell. One interesting (p. 1) headline (May 24, 1933) was „MitchellÊs Wife Missed Big Profit.‰ She could have made $800,000 by selling in 1930. On February 14, 1930, the stock was selling at $256. Thus she could have made $44 profit per share if she sold. All she had to do was sell at the stockÊs post-1929 high! This revelation to the Times came from U.S. Attorney Thomas E. Dewey. MitchellÊs lawyer made clear that MitchellÊs 1929 tax return had been approved by the Internal Revenue Service and that „the agent looked at copies of the ÂDear CharlesÊ and ÂDear ElizabethÊ letters defining the stock sale and asked for the originals‰ (June 1, 1933, p. 1). Was the $666,666 received from National City income? While the $666,666 had originally been intended as income, „the company had formally notified Mr. Mitchell that the payment had been rescinded and that the amount was to be repaid later‰ (June 1, 1933, p. 11). Later it was established that the amount was to be paid out of his future earnings, and Mitchell did not have to repay it out of his depleted assets. The 18,300 shares of National City Bank stock sold to his wife had been bought October 29, 1929 (June 6, 1933, p. 18). Mitchell said he

THE U.S. GOVERNMENT ACCUSES . . .

149

considered selling in the market, but he did not because the market was thin and the sale would „accentuate decline.‰ He consulted with Harry Forbes, a tax lawyer, who indicated that the sale to his wife was proper. Forbes testified that he did give the advice (June 9, 1933, p. 12) as long as the sale was „unconditional and in good faith.‰ Mitchell justified the exclusion of the $666,666 as taxable income since another bank officer, Stanley A. Russell, had an exclusion of $170,000 created by the same transaction approved by the Internal Revenue Service; thus Mitchell concluded that he could do the same as Russell. In closing testimony, Steuer said „Mitchell Is Victim‰ (June 20, 1933, p. 8), and Medalie described MitchellÊs position as „Sanctimonious Rubbish‰ (June 21, 1933, p. 11). On June 4 the jury debated 10 hours without reaching a verdict. Mitchell, if found guilty, faced a 10-year prison term (June 22, 1933, p. 1). On June 23, 1933, page 1, the headline was „Mitchell Cleared, Weeps at Verdict; Ovation in Court.‰ The verdict was reached after the jury was out for 25 hours. Most of the observers (including the Times reporter) expected a conviction. The judge had told the jury that the $666,666 was not income if it had to be paid or if it was to be paid out of future incomes, and Mitchell thought he had to pay it. The next day Mitchell left for a long rest. The trial had lasted almost six weeks. The prosecution had taken three weeks, the defense two, and three days were spent selecting the jury. Mitchell lost 25 pounds during the trial (thus some good came of the trial process). Immediately after the acquittal, the federal government sued for delinquent taxes. It wanted the tax loss from the „sale‰ to MitchellÊs wife rejected, the $666,666 included as income, the interest on the taxes that should have been paid, and a penalty for failure to pay. The tax court (Board of Tax Appeals) decided that Mitchell should pay $1,384,223. This included a penalty of $364,354 plus interest. A tax lien of $1,384,223 was filed by the government (June 29, 1936, p. 3). The Second Circuit Court of Appeals (May 11, 1937, p. 3) decided that Mitchell should pay the tax that would have been paid without the tax loss from the sale, but not the penalty (because of the previous criminal acquittal). The tax court and the circuit court agreed the stock sale was „not genuine‰ (May 11, 1937, p. 3). There was no immediate payment by the purchaser (his wife). The circuit court decided the $666,666 was income since the amount could be paid „from amounts that should become due to them in the future.‰ The recipients were not obliged to pay, and they never attempted to do so. However, the penalty did not have to be paid, since Mitchell had been acquitted of criminal charges by the jury.

150

BEATING THE BEAR

The tax case went to the Supreme Court. MitchellÊs counsel told the Supreme Court (January 15, 1938, p. 4) that „he gave up 30 million in Ê29 to Âstem [the] tide.ʉ The government called him a „tax evader‰ and wanted compensation for investigating fraud. In October 1937, the Supreme Court decided that Mitchell had to pay the $728,709, and on March 8, 1938, it decided that the 50 percent fine of $364,354 that had been disallowed by the Second Circuit Court of Appeals had to be paid. The penalty verdict was handed down by Judge Louis Brandeis (there was one dissent). The Court decided that there was no double jeopardy (March 8, 1938, p. 2), and the outcome of the criminal case did not determine the amount of the tax to be paid. On December 28, 1938, Mitchell settled his income tax bill for 1929. The government evaluated his assets, and the „$1,384,222 lien was settled for undisclosed sum.‰ A government official said that the deal was „a compromise that gave Mr. Mitchell a good break.‰ There were many faults with the process followed by the government. Most people will conclude that Mitchell should have been asked to pay the tax, assuming the „sale‰ to his wife did not actually take place. The $666,666 of income (or loan) was a judgment call, but its omission was not a criminal offense, given that there was precedent for excluding it. Mitchell should not have been forced from his position as chairman of National City Bank because of these tax payment disagreements. Finally, the government should not have settled for less than the amount that the Supreme Court decided was the appropriate amount. While MitchellÊs assets may not have been sufficient to pay the tax lien, his prospective incomes would be sufficient. In 1935, Mitchell was appointed chairman of the investment banking firm of Blyth & Co. and was earning enough income so that he would obviously be able to pay his tax debts if given sufficient time. To his credit, despite the severity of his financial difficulties, Mitchell refused to go into bankruptcy. He ultimately paid off his loans to J. P. Morgan & Co. (they did not press him during his period of difficulties). It can also be said that he paid his taxes (we do not know the amount). My preference would have been that he pay all except the penalty (the jury said he was not guilty of fraud). It is clear that Mitchell did not have a strategy for manipulating his bankÊs stock. It is also clear that he thought the stock was a good buy in October 1929 (he bought). In October 1929, he made statements for the press that the market was not too high. He seemed to believe what he said. Mitchell obviously was close to going over the line with his tax manipulations, but he deserved praise for his handling of his investments in 1929 from an ethics viewpoint. His investment strategy was flawed from

THE U.S. GOVERNMENT ACCUSES . . .

151

a theoretical viewpoint (not enough diversification and bad timing), but there is not a hint of manipulation or self-serving trading. In December 1939 (December 15, 1939, p. 39), Mitchell testified as an expert witness on the investment banking industry before the Temporary National Economic Committee of Congress. He denied that there was an investment banking monopoly in 1929 but admitted that if the National City Bank had not been forced to divest itself of its investment banking unit, it would have achieved a monopoly position. Thus he implicitly supported the Banking Act of 1933. C. C. Mitchell received a bachelor of arts degree from Amherst College in 1899. On graduation, he went to work as a clerk for Western Electric for $10 per week. He then studied banking and became a vice president of National City Bank in 1916 and chairman of the board in 1929. In 1931, testifying before the Senate Finance Committee, Mitchell warned about dire consequences in Germany unless the debt payment schedule resulting from the World War was drastically revised. In 1932, Mitchell talked to New York CityÊs Board of Estimate. The New York Times (October 23, 1932, VIII, p. 2) carried a glowing article on MitchellÊs attempt to instill fiscal responsibility in the board. With reference to Mitchell, it stated, „He had the reputation of being one of the frankest straight-from-the-shoulder talkers of all the financial executives whose opinions are worth quoting.‰ This was a very respected person. He resigned (under pressure) from the National City Bank in 1933, five days after testifying before the Senate committee. In 1935, he was elected chairman of Blyth & Co., after a year as an independent financial consultant. He died on December 17, 1955, at the age of seventy-eight. The New York Times obituary included the statement, he „defrauded the Government of $850,000 in income taxes.‰ A jury said he did not. His testimony was a „factor in the passage of the Banking Act of 1933, which prohibited banks from continuing in the business of underwriting new security issues‰ (Times, December 18, 1955, p. 37). It is not obvious that his testimony should have affected the passage of this act. In 1933, there were at least 19 New York Times first-page articles dealing with Mitchell. The attention received by Mitchell should have been motivated by a real revelation as to the causes of the 1929 boom and crash, but it was not. MitchellÊs criminal trial was a sad example of excessive prosecutorial zeal on the part of an agency of the federal government. ALBERT H. WIGGIN Albert H. Wiggin was the president of Chase National Bank in 1929. He did three very strange things in 1929 or before. First, a subsidiary

152

BEATING THE BEAR

of Chase (Metpotan Securities Corporation) engaged in frantic trading activities that made little profit from 1928 to 1932. The total profit was less than $160,000, not including the opportunity cost on the capital used. Second, three corporations owned by Wiggin or his family engaged in longer term investing in Chase stock and made a gain of over $10 million. Third, between September 23 and November 4, 1929, Wiggin sold short 42,506 shares of Chase stock. Galbraith, Pecora, Malkiel, and the 1933 New York Times all cite the selling short of his own bank stock as an outrageous action. I disagree. Between September 23 and November 4, 1929, Wiggin sold short 42,506 shares of Chase stock and made a profit of $4 million. Selling short the stock of the company of which you are president is obviously in bad taste (at a minimum). However, the facts are more involved. During the period of short sale, Wiggin was long many more shares than were sold. He was „selling against the box.‰ At the same time that he made a profit of $4 million from selling short, he had much larger losses from the shares he owned. In 1932, Chase cut its dividend from $4 to $2.25 per share, and the stock dropped to below $20. In January 1933 Wiggin, who was to be 65 years old on February 21, retired from Chase. The January 9, 1933, Times ( p. 5) had a heading „Retiring Chase Head Sees Credit Restoration and Recovery Nearing.‰ His views were sought and respected. On October 18, 1933, the Times ( p. 5) reported that „Wiggin Heads Banker Club.‰ Even retired, he was elected club president by his peers.

Chapter 12

THE PRIME CAUSE OF THE 1929 CRASH: THE PUBLIC UTILITY SECTOR

The utility shares again broke wide open and the general list came tumbling down almost half as far. ·„20 Utility Stocks Hit New Low Mark,‰ Washington Post Intrinsic values are reasonably well defined for regulated public utilities. The general rule applied by regulatory authorities is to allow utilities to earn a fair return on an allowed rate base. The fair return is defined to be equal to the utilityÊs weighted average cost of capital. There are several reasons why a public utility can earn more or less than a fair return, but the target set by the regulatory authority is the weighted average cost of capital. If a public utility has an allowed rate equity base of $X and is allowed to earn a return of r (rX in terms of dollars), after one year, the firmÊs equity will be worth X + rX or (1+r)X with a present value of X. The return required by the market is r, as well as the allowed return. The present value of the equity is equal to the present equity rate base, and the stock price should be equal to the present equity rate base, and the stock price should be equal to the equity rate base per share. Thus the market value of a properly regulated public utilityÊs stock should normally be reasonably close to the book value per share. There can be time periods in which the utility can earn more (or less) than the allowed return. The reasons for this include regulatory practices that differ from the above, regulatory lag, changes in efficiency, changes in the weather, changes in the mix and number of customers, and

154

BEATING THE BEAR

prospects of deregulation. Also, the cost of equity may be different from the allowed return because of inaccurate (or incorrect) calculations or changing capital market conditions. Although the stock price may differ from the book value, we would not expect the stock price to be very much different from the book value per share for very long if the regulatory process is as described. There should be a tendency for the stock price to revert to the book value for a public utility supplying an essential service where the rate commission is effectively allowing a fair return to be earned. Although the Federal Power Commission v. Hope Natural Gas Company case (1944) had not yet been decided, the Bluefield Water Works v. P.S.C. (1923) was a historical fact in 1929. Bluefield is one of the primary cases defining the regulatory process for determining a fair return on regulated assets. Thus in 1929 there were limits on abnormal profits for a regulated firm. In the year 1929, public utility stock prices were in excess of three times their book values. Sooner or later this price–book value relationship would have to decrease unless the regulatory authorities continued their past practices or there existed a stream of investors who would buy the utility stocks even at their high prices. The decision made by the Massachusetts Public Utility Commission in October 1929 applied to the Edison Electric Illuminating Company of Boston, and the stock market reaction to the decision made clear that neither of these improbable events was going to happen. The October 19 issue of the Commercial and Financial Chronicle identified the main depressing influences on the market to be the indications of a recession in steel and the refusal of the Massachusetts Public Utility Commission to allow Edison Electric Illuminating Company of Boston to split its stock. The explanations offered by the commission made the situation worse (the stock was not worth its price and the companyÊs dividend would have to be reduced). The Boston Daily Globe featured this story on both October 12 and October 16. The Washington Post (October 17, p. 1), in explaining the October 16 market declines (an Associated Press release), stated, „Professional traders also were obviously distressed at the printed remarks regarding inflation of power and light securities by the Massachusetts Public Utility Commission in its recent decision.‰ This news release was widely circulated. Consider the following values for the Dow Jones Stock Indices (month ends) for 1929 (Wigmore, 1985, p. 637): 1929 High Low

Industrials 381.17 198.69

Railroads 189.11 128.07

Utilities 144.61 64.72

THE PRIME CAUSE OF THE 1929 CRASH

155

The highs were all in September and the lows in November 1929. The low prices as percentages of the high prices were: Industrials Railroads Utilities

52% 68% 45%

In 1929, the utilities dropped the furthest from the highs for the three groups. A comparison of the beginning of the year prices and the highest prices is also of interest.

January 1929 1929 high

Industrials 317.51 381.17

Railroads 158.54 189.11

Utilities 97.92 144.61

The high prices as percentages of the January prices and the growth in the value percentages were: Ratio Industrials Railroads Utilities

Growth 120% 119% 148%

Percentage 20% 19% 48%

The growth in value for utilities during the first nine months of 1929 was over twice that of the other two groups. The following high and low prices for 1929 for a typical set of public utilities and holding companies is illustrative of how severely public utility prices were hit by the October 1929 crash (New York Times, January 1, 1930). All the companies listed lost at least 52 percent of their market value. Picking on the utility segment of the market as the cause of a general break in the market in October is not a sufficient explanation of the stock market crash. But if we combine a besieged utility segment with leveraged investment trusts that had been purchased on margin, we have the beginning of a viable explanation for the crash. Remember, the investment trusts were heavily invested in utility stocks. Public utilities helped fuel the large stock price increases from January to October 1929. The Economist (November 23, 1929, pp. 976–77) computed an index for 34 public utilities. The index was 200 at the beginning of the year, reached a maximum of 330 (a 65 percent increase)

156

BEATING THE BEAR

Firm

1929 High Price

1929 Low Price

1753Î8

641Î4

0.37

15

0.21

American Power & Light American Superpower

1

71 Î8

Low-Price Dividend by High Price

Brooklyn Gas

2481Î2

99

0.44

Buffalo, Niagara & Eastern Power

128

611Î2

0.48

Cities Service

681Î8

Consolidated Gas Co. of N.Y.

1831Î4

Electric Bond and Share

20

0.29

801Î8

0.44

189

50

0.26

Long Island Lighting

91

40

0.44

Niagara Hudson Power

303Î4

111Î4

0.37

Transamerica

673Î8

201Î4

0.30

in September, and then fell to 170 by the end of October (a 48 percent decrease from the high). The Dow Jones Utility Index was 97.92 at the end of January and reached a high of 144.61 in September. This was a 48 percent increase. Prices then fell to 88.27 in December, a 39 percent decrease. Although the exact measures of percentages of increase and decrease depend on the dates used and firms making up the index, there is no question that utility stock prices were explosive in 1929, both on the upswing and on the collapse. THE MASSACHUSETTS TRIGGER On August 2, 1929, the New York Times reported that the directors of the Edison Electric Illuminating Company of Boston had called a meeting of stockholders to obtain authorization for a stock split. On Saturday, October 12, the Times reported ( p. 27) that the Massachusetts Public Utility Commission had rejected the stock split. The heading said: „Bars Stock Split by Boston Edison. Criticizes Dividend Policy. Holds Rates Should Not Be Raised Until Company Can Reduce Charge for Electricity.‰ Boston Edison lost 15 points for the day even though the decision was released after the closing. The stockÊs high for the year was $440 and the stock had closed at $360 on Friday October 11. The Massachusetts Public Utility Commission (New York Times, October 12, p. 27) stated that it did not want to imply to investors that this was the „forerunner of substantial increases in dividends.‰ They stated that the expectation of increased dividends was not justified. They offered

THE PRIME CAUSE OF THE 1929 CRASH

157

„scathing criticisms of the company‰ (October 16, p. 42) and concluded (p. 42) that „The public will take over such utilities as try to gobble up all profits available.‰ On October 15, the Boston City Council advised the mayor to initiate legislation for public ownership of Edison. On October 16, the department announced it would investigate the rates being charged by Edison, and on October 19 it set the dates for the inquiry. On Tuesday October 15, there was a discussion in the New York Times ( p. 41) of the Massachusetts decision in the column „Topics in Wall Street.‰ It „excited intense interest in public utility circles yesterday and undoubtedly had effect in depressing the issues of this group. . . . The decision is a far-reaching one and Wall Street expressed the greatest interest in what effect it will have, if any, upon commissions in other States.‰ Boston Edison had closed at 360 on Friday October 11, losing 15 points before the rejection announcement was released. It dropped 61 points at its low on Monday (October 14), the first trading day, but closed at 328, a loss of 32 points. On October 16, the Times ( p. 42) reported that Governor Allen of Massachusetts was launching a full investigation of Boston Edison, including „dividends, depreciation, and surplus.‰ One major factor that can be identified leading to the price break for public utilities was this ruling by the Massachusetts Public Utility Commission. The only specific action was that it refused to permit Edison

Table 12.1 Edison Electric Illuminating Company of Boston Trades before the Decision, October 1–11, 1929 Date (October 1929)

Volume (Shares)

High

Low

Close

1

34

365

365

365

2

109

365

360

360

3

68

365

360

360

4

63

362

360

360

5

33

360

360

360

6

Sunday

7

155

360

358

360

8

535

395

360

390

9

76

390

380

380

10

207

380

375

375

11

247

3751Î2

360

360

158

BEATING THE BEAR

Electric Illuminating Company of Boston to split its stock. Most finance academics would argue that the primary effects of a stock split would have been to reduce the stock price by 50 percent and double the number of shares outstanding, thus leaving the total stock equity value unchanged. The event was not economically significant, and the stock split should have been easy to grant. But the commission made it clear it had additional messages to communicate. For example, the Financial Times (October 16, 1929, p. 7) reported that the commission advised the company to „reduce the selling price to the consumer.‰ Boston was paying $0.085 per kilowatt hour and Cambridge only $0.055. The Boston Daily Globe (October 16) reported on page 1 that a $600,000 rate cut was planned. There was also talk, as well as news reports, of public ownership and a shifting of control. The next day (October 17), the Financial Times ( p. 3) reported, „The worst pressure was against Public Utility shares,‰ and the article heading read „Electric Issue Hard Hit.‰ EDISON ELECTRIC ILLUMINATING COMPANY OF BOSTON During the first 11 days of October, Boston Edison stock closed at between 360 and 390. The largest amount of trading was 535 shares on October 8 (Table 12.1). Table 12.2 shows the trading for the next 11 days. The high for the Monday after the news of the commissionÊs decision

Table 12.2 Trades after the Decision, October 12 – 23, 1929 Date (October 1929)

Volume (Shares)

12

A Holiday

13

Sunday

14

7,850

High

330

Low

299

Close

328

15

1,982

324

310 Î2

310 1Î2

16

2,241

309

290

290

17

1,265

304

290

303

18

617

303

300

300

299 Î2

290

290

19 20

289

1

1

Sunday

21

896

295

285

293

22

226

298

292

296

23

624

293

280

280

THE PRIME CAUSE OF THE 1929 CRASH

159

was 30 points lower than FridayÊs close. During the day the stock went as low as 299 (a 61-point day) and closed at 328. On October 23, it closed at 280. Table 12.3 shows the stockÊs performance through Black Thursday (October 24) and Black Tuesday (October 29). The stock fell from $280 on October 23 to $250 at the end of the month (the low for the month was $240). The total price drop from the October 1 price of 365 to 250 on October 30 was a 31.5 percent drop. For October 1 to October 23, there was a 23.3 percent drop. Thus the largest amount of Boston EdisonÊs price decline preceded the market crash (there was a $115 price drop, of which $85 or 74 percent took place before the crash). There is no question that the stock price of Edison Electric Illuminating Company of Boston was greatly affected by the Massachusetts Public Utility CommissionÊs decision and pronouncements. Other public utilities were also affected. For example, from October 10 to October 16, American Power & Light fell 14.7 percent, American Superpower fell 12.0 percent, and Electric Bond and Share fell 12.9 percent. Remember that Black Thursday was still a week away from the closing prices on October 16. The October 17, the Wall Street Journal ( p. 1) identified the October 16 price drop as a break in utility stock prices. „The price structure of several leading active utility issues crumbled under a combination of professional attack and liquidation yesterday.‰ The article then referred to the decision by the Massachusetts Public Utility Commission: „It was pointed out in some quarters that the stand taken by the commission held possibilities of changing the public attitude towards the utility shares, which it has been recognized have been discounting prospects to an unusual degree.‰ The article concluded that the events would harm utility expansion plans. On October 18 there was an editorial in the Wall Street Journal ( p. 1) on the unfairness of the Massachusetts Table 12.3 Trades during the Crash, October 24 – 31, 1929 Date (October 1929)

Volume (Shares)

High

24

1,290

285

276

25

365

280

275

26 27

232

280

Low

Close 273 275

1

275 Î2

278

Sunday

28

473

278

240

240

29

1,840

250

240

250

30

1,547

250

240

250

160

BEATING THE BEAR

ruling, especially the commissionÊs criticism of the utilityÊs depreciation accruals (the Journal pointed out they exceeded the requirements of the commission). OTHER REGULATORY FACTORS Massachusetts was not alone in challenging the utilities. The Federal Trade Commission, New York City, and New York State were all challenging the status of public utility regulation. The New York governor ( Franklin D. Roosevelt) appointed a committee on October 8, 1929, to investigate the regulation of public utilities in the state. The committee stated (New York Times, October 17, p. 18): „This inquiry is likely to have far-reaching effects and may lead to similar action in other States.‰ Both the October 17 and October 19 issues of the Times carried articles regarding the New York investigative committee. Professor James C. Bonbright of Columbia University, a Roosevelt appointee, described the existing process as a „vicious system‰ (October 19, p. 21) and said that consumers were ignored. The chairman of the Public Service Commission, testifying before the committee, wanted more control over utility holding companies, especially management fees and other transfers. The Wall Street Journal of Tuesday, October 22 ( p. 1) was highly critical of BonbrightÊs jump to a conclusion, with his „vicious system‰ comment, after the study had barely started and his „impatience to arrive at predetermined results.‰ On page 3 it was noted that „Utilities Sell 24 Times Net.‰ This was down from 35 in July and August. The New York committee also noted the increasing importance of investment trusts: „Mention of the influence of the investment trust on utility securities is too important for this committee to ignore‰ (New York Times, October 17, p. 18). They conjectured that the trusts had $3.5 billion to invest, and „their influence has become very important‰ ( p. 18). In New York City, Mayor Jimmy Walker, accused of graft, was fighting back with statements that his administration would fight aggressively against utility rate increases, thus „proving‰ that he had not accepted bribes (New York Times, October 23). It is reasonable to conclude that the October 16 stock market break was related to the news from Washington, Massachusetts, and New York concerning public utility regulation, although the head of a New York Stock Exchange house had a simpler explanation: „More sellers than buyers‰ (New York Times, October 17, p. 38). On October 17, the New York Times (p. 18) reported that the Committee on Public Service Securities of the Investment Banking Association

THE PRIME CAUSE OF THE 1929 CRASH

161

had warned against „speculative and uninformed buying.‰ The committee published a report in which it „asks care in buying shares in utilities.‰ On Black Thursday, October 24, the market panic accelerated. Volume was 12 million shares on the NYSE and 6 million shares on the Curb. The market dropped from 305.87 to 272.32 (a 34-point drop, or 11 percent) and closed at 299.47. The declines were „led‰ by the motor stocks and public utilities. THE PRICES OF UTILITY STOCKS At their September price height, public utilities were very aggressively priced. Consider the following measures (Wigmore, 1985, p. 39) for five operating utilities, which were typical: 1929 Price–Earnings Ratio High Price for Year Commonwealth Edison Consolidated Gas Co. of N.Y. Detroit Edison Pacific Gas & Electric Public Service of N.J.

Market Price / Book Value 35 3.31 39 3.34 35 3.06 28 3.30 35 3.14

Public utility holding companies had even larger price–earnings ratios and market-to–book value ratios than did operating utilities. As of September 1, 1929, all common stock listed on the New York Stock Exchange had a value of $82.1 billion. The utilities industry represented $14.8 billion of value, and utilities were 14.8/82.1 = 18 percent of the value of the outstanding shares on the NYSE. Utilities were a significant fraction of the stock market. Given that the above firms were all regulated utilities; if they were allowed to earn no more than a „fair return,‰ we would have to conclude that public utilities at the beginning of October 1929 were overpriced. A public utility allowed to earn a fair return should sell approximately at its book value (rate base) if the market expects it to earn a fair return. When a public utility is selling at over three times book value, investors are expecting the firm to earn massive abnormal profits, inconsistent with logical regulatory policies and theories. The public utilities in September 1929 were very aggressively priced, and · given the announcements from the regulatory authorities and political figures in October 1929 · a prudent investor would have had a difficult time justifying an investment in these firms at the September 1929 prices.

162

BEATING THE BEAR

THE PUBLIC UTILITY MULTIPLIERS Public utilities were a very important segment of the stock market; even more important, any change in public utility stock values resulted in larger changes in the equity wealth of investors. In 1929 there were three important multipliers meaning that any change in a public utilityÊs underlying value would result in a larger value change in the market and in the investorÊs value. Consider the following hypothetical but representative values for a public utility: Book value per share for a utility $ 50.00 Market price per share of utility $162.50* Market price of investment trust holding stock (assuming a 100% premium over market value) $325.00 *Based on a price-to–book value ratio of 3.25 (Wigmore. p. 39).

If we were to eliminate both the utilityÊs $112.50 market price premium over book value and the investment trustÊs premium over market price of the stock, the market price of the investment trust would be $50 without a price premium. The loss in market value of the stock of the investment trust and the utility would be $387.50 (with no premiums). The $387.50 is equal to the $112.50 loss in underlying stock value and the $275 reduction in investment trust stock value. The public utility holding companies were even more vulnerable to a stock price change, since their ratio of price to book value averaged 4.44 (Wigmore, p. 43). Assume the following situation: Book value per share for a holding company Market price per share (4.44 times book value) for the holding company stock Market price of investment trust holding stock (assuming 100% premium over market value)

$ 50.00 $222.00

$444.00

If we were to eliminate the two premiums over book value, the loss in market values of the underlying stock and the investment trust stock would be $566. This assumes the trust lost its premium and traded at liquidation (net asset) value. For simplicity, we assumed the trust held all the holding company stock. The effects shown would be reduced if the trust held only a fraction of the stock. However, we also assumed that no debt or margin was used to finance the investment. Assume the individual investors invested only $222 of their

THE PRIME CAUSE OF THE 1929 CRASH

163

money and borrowed $222 to buy the investment trust stock costing $444. If the holding company stock went down from $222 to $111 (selling for 2.22 times book) and the trust still sold at a 100 percent premium, the trust would sell at $222 and the investors would have lost 100 percent of their investment, since the investors have a $222 asset and owe $222. At a price of $111, the holding company would still be selling at an inflated 2.22 times book value. The vulnerability of the margin investor buying a trust stock where the asset is utility holding company stock is obvious. Remember, the trust can also be highly leveraged (primarily by the use of preferred stock). The impact on the several layers of leverage was enormous. Consider the following example. Assume that a utility with assets of $2 million has $1 million of stock equity and $1 million of debt. The $1 million of stock is owned by a holding company with $700,000 of debt and $300,000 of stock. The $300,000 of holding company stock is held by an investment trust financed with $100,000 of common and $200,000 of preferred stock. The $100,000 of common is financed by the individual investor with $50,000 of margin debt and $50,000 of investor equity funds. Thus $50,000 of investor equity funds is supporting $2 million of operating assets owned by a public utility. If the $1 million of utility stock decreases $100,000 in value to $900,000, the value of the holding companyÊs stock becomes $200,000, since there is $700,000 of debt. The value of the investment trustÊs common stock is reduced to zero (the $200,000 holding company stock value all goes to the preferred stock). Only a very small change in the value of the public utilityÊs stock is required to wipe out the investor in the investment trust if one considers all the layers of leverage. In this example, a 5 percent ($100,000) reduction in the utilityÊs asset causes the equity investors to lose 100 percent of their investment. It was not any one layer of leverage that was excessive but rather the cumulative effect of the leverages at all levels. In 1929 there were frequently several layers of holding companies and investment trusts, each layer introducing more leverage. Investment trusts liked to invest in public utilities, since utilities paid relatively high cash dividends and enabled the investment trusts to pay dividends. A DIFFERENT INTERPRETATION One conclusion to this point could be that public utility stocks were overpriced prior to October 1929. This implies a lack of rationality on the part of the investors. Let us consider a different interpretation. As long as the regulatory commissions allowed stock investors to earn abnormal returns, it was rational for the investors to pay more than book

164

BEATING THE BEAR

value for the stock of the utilities. As soon as there were indications in Massachusetts, New York, and Washington that the regulatory commissions in the future would allow only a fair return on the capital invested in the utility, the stock prices had to fall to be closer to book value. Actually, by 1933, the utility stock prices fell far below book value, reflecting both an overreaction on the part of the investing community to the events of the fall of 1929 and a changed economic environment. Some of the drop in utility prices occurred in 1932 and 1933, when it became obvious that the new Democratic administration in Washington was going to be unfriendly to utility investors and would protect the interests of consumers with a great deal of zeal. THE LARGE AMOUNT OF LEVERAGE The amount of financial leverage (both debt and preferred stock) used in the utility sector was enormous. Assume that a utility purchases an asset that costs $1 million and that asset is financed with 40 percent stock ($400,000) and 60 percent debt. A utility holding company owns the utility stock and is also financed with 40 percent stock ($160,000). An investment trust owns the holding companyÊs stock and is financed with 40 percent stock ($64,000). An investor buys the investment trustÊs common stock using 50 percent margin and investing $32,000 in the stock. Thus the $1 million utility asset is financed with $32,000 of equity capital. When the large amount of leverage is combined with the inflated prices of the public utility stocks, the holding company stocks, and the investment trusts, the problem is even more dramatic. Continuing the above example, assume that the $1 million asset is again financed with $600,000 of debt and $400,000 common stock, but the common stock has a $1.2 million market value. The utility holding company has $720,000 of debt and $480,000 of common. The investment trust has $288,000 of debt and $192,000 of common stock. The investor $96,000 of margin debt. The $1 million asset is supporting $1,704,000 of debt. The investorÊs $96,000 of equity is very much in jeopardy. On December 27, 1929, the Times ( p. 32) had all listed stocks at $63.6 billion and gas and electric operating companies at $3.83 billion and gas and electric holding companies at $3.58 billion (as of December 1929). Together these utilities were then 11.7 percent of the stock market, and the market value of the holding company stocks was approximately as large in total as that of the operating companies. A tombstone (a published advertisement listing the involved investment banks and relevant facts regarding the securities) published in the Wall Street Journal (October 1, 1929, p. 17) advertised the issuance of 1 million

THE PRIME CAUSE OF THE 1929 CRASH

165

shares of stock at $58 a share for the United States Electric Light & Power. The tombstone showed that this investment trust owned 74 different utility securities. Although this trust had wide diversification within the one industry as described above, the investors had a large amount of risk. CONCLUSIONS Assuming that they were to be allowed to earn only a fair market return, utility common stocks were overvalued at the beginning of October 1929. The Dow Jones Utility Index ( Wigmore, 1985, p. 637) was 97.92 in January and had gone up to 139.61 by the end of September (a 43 percent increase). Neither the earnings nor the prospective regulated earnings (represented by the book value per share) would have justified this price increase unless the regulatory commissions were very friendly to utilities. Compounding the problem was the leverage used by the utilities, the holding companies, the investment trusts, and the investors. A small change in market price of a utility stock would trigger a massive change in the value of the equity securities held by individual investors. In October, investors were bombarded with news reports indicating an adverse change in the regulatory environment, and the prices of utility stocks fell like a rock. The values of the utility holding companies and the investment trusts (heavily invested in utility stocks) were also hit very hard. In 2008, the downward movement in real estate prices triggered a financial crisis. In 1929, a change in the attitudes of the regulators of public utilities triggered the October 1929 stock market crash. The causes of the stock market crashes of 1929 and 2008 were shockingly similar. The use of excessive financial leverage was common to both crashes. In 2008, the excessive use of debt leverage was made more dangerous by the extensive use of short-term debt. The debt had to be rolled over, even if the financial markets were not receptive, or the financial institution would be in severe financial difficulty. Without governmental assistance and without the ability to roll over the credit, the result was likely to be bankruptcy (for example, Lehman Brothers).

Chapter 13

LESSONS TO BE LEARNED

I have known bulls to make money and I have known bears to make money, but I never knew of a hog making money. ·Forbes, December 15, 1929 „. . . it is a sort of customersÊ manÊs chantey to encourage customers to step into and out of the market a little livelier.‰ ·Fred Schwed, Jr., Where Are the CustomersÊ Yachts? We Attempt to Stop the Orgy of Speculation ·Title of Chapter 2, The Memoirs of Herbert Hoover There is a great deal of evidence (including the investment decisions of some very bright, well-informed people) leading us to conclude that the high level of the stock market before the 1929 crash was not the result of excessive speculation by gamblers but rather due to a well-founded optimism on the part of a well-informed investment community. And if the market was not too high, then why did it fall drastically in October 1929 and then again in 1930, 1931, and 1932? It is clear that the drop in real prosperity in the business community was the ultimate factor that caused subsequent drops in stock market prices in the years 1930–1932.

168

BEATING THE BEAR

What caused the October 1929 stock market drop? Let us consider the various events that are likely to have contributed to it: 1. The increase of the discount rate from 5 to 6 percent in August by the Federal Reserve Bank of New York in a situation where the interest rate–sensitive construction industry was already weak. 2. The increase in the persistent gap between the borrowing cost to finance common stock investments and the dividend yield of stocks relative to the increase in the discount rate. 3. If one removes the prospect of price appreciation, the investment in common stock was not attractive compared with alternatives. The Federal Reserve was acting effectively to remove the prospect of future price appreciation. 4. New broker loans were becoming scarce because of the New York BankÊs awareness of the relentless pressure from the Federal Reserve Board to restrict loans to finance speculation. 5. The Hatry scandal triggered the recall to England of funds invested in the United States and, in addition, increased nervousness. If it could happen in England, it could happen in the United States. 6. The Bank of England raised its discount rate from 51Î2 to 61Î2 percent on September 28. It had already been raised from 41Î2 to 51Î2 percent earlier in the year. This decreased the relative attractiveness of investments in the United States. 7. Some businesses (e.g., construction) were reporting signs of weakness. 8. The Massachusetts Department of Public Utilities denied the Edison Electric Illuminating Company of Boston its request to split its stock. More important, they declared that the stock was not worth its price and predicted a decrease in the companyÊs dividend. The stock fell by more than $100 a share. This is my number one choice. 9. The statements by important people, including the secretary of the treasury, that stocks were too high and there was excessive speculation.

The various actions by the Federal Reserve Board and member banks to restrict credit had taken hold. There was bound to be a change in market psychology sooner or later, given the war on speculation, and in October 1929 there was a major change in the sentiment of the market. There were a lot of reasons why one could expect the market level to decrease. All the reasons were manufactured by government decision makers except for the Hatry scandal. Even the turndown in construction activity could be attributed to higher interest rates and more restrictive credit. The people who wanted to „get the speculators‰ finally got the speculators, but they also got both the small investors and the large investors,

LESSONS TO BE LEARNED

169

foreign and domestic. A few of the „bear crowd‰ sold short and became extremely wealthy. Irving Fisher lost $5 million and his house. Conventional wisdom in 1929 in Washington, D.C., was that the market level was too high and had to come down. Members of Congress exerted pressure to bring down the New York speculators, and they succeeded. The view had become pervasive that speculators were driving the market: „The stock market continues to prove more attractive to speculators than to investors. Anyone who desires to buy for income finds to-day few suitable stocks among those which have been most in the limelight. He must, rather, follow Mr. MellonÊs advice and buy bonds.‰1 An important banker was quoted as saying: „I have scrapped every theory I used to hold. Old-time reasoning can no longer be applied · except with unhappy consequences. I donÊt pretend to be able to analyze the whyfor and wherefor of all that has happened. Nor do I pretend to know what the outcome is going to be. I have, however, ceased to try to go contrary to existing realities but am now governed by them and not by theory.‰2

This implies that even the important banker had now become a speculator. Before the 1929 decline, J. S. Lawrence stated: „we come to the ugly conclusion that the Board either shares or has been moved by the unreasoning prejudice against the stock market and that it feels that the prices at which most stocks are selling to-day are too high. Animated by a wholly righteous zeal, it has seized its scepter of power.‰ He also maintained that the boardÊs direct policy was „based upon nothing more substantial than provincial prepossessions against Wall Street and a Calvinistic repugnance to gambling.‰3 After the collapse of the market, there was general agreement (existing to this day) that speculators had driven up the stock values excessively and a fall was inevitable. There were some weird explanations. For example, Fortune magazine in February 1930 blamed the bust on the extraordinary industrial activity and profits of the first six months of 1929. In October 1930, Trowbridge Callaway, president of the Investment Bankers Association, addressed his group in New Orleans. He chose to take the obligatory crack at speculation. „The orgy of speculation which clouded the countryÊs vision has passed and clearer thinking is now the rule rather than the exception. Old-fashioned standards for judging values are again back in vogue, and as investment bankers we can do our part to direct the savings of the country into constructive and dependable lines. . . . With your help and wide influence, normal

170

BEATING THE BEAR

confidence can be more readily restored and the fundamental law of supply and demand be brought into balance.‰4 Even the president of the New York Stock Exchange, in a speech given on January 25, 1930, declared that „the primary cause of the panic was undoubtedly the high level of prices which so many American share issues had attained. . . . It is obvious, however, that the high level of share prices last August rendered the stock market vulnerable to a considerable price decline.‰5 Myron C. Taylor, head of the U.S. Steel Corporation, spoke on the subject of the stock market decline to Carnegie Institute students. He indicated that stocks had risen excessively and then fell excessively in October: „Second only to the folly of the speculative frenzy that lifted securities to levels far beyond any warrant of supporting profits to the industry or of yield to the investor, has been the crisis through which we have just passed, when another evil effect of mass psychology overwhelmed the nation.‰6 Owen D. Young, chairman of the General Electric Company and probably the most outstanding industrial statesman of the decade, agreed with Taylor that in November 1929 the market was oversold: Those who voluntarily sell stocks at current prices are extremely foolish. Our banking position is extraordinarily strong. Our general financial conditions never were sounder. Industry, not burdened by excessive inventories, is in excellent shape physically and financially. General business has been prosperous. Of course, if the frenzy in the stock market should be carried much further, it will inevitably injure business. But there is no reason in the world why it should be carried further. It has already been carried nonsensically far.7

Most important for the health of the stock market, Herbert Hoover, the newly elected president of the United States, declared war on speculation. As early as 1925, Hoover publicly warned of the dangers of speculation.8 Hoover quoted Adolph Miller, who approved of HooverÊs positions: „The Board only began issuing warnings when Mr. Hoover was about to take office, and it was safe to do so then because the Board knew that Mr. Hoover, from 1926 on, had been protesting that the money policy of the Reserve System was certain to bring about disaster and calamity. Mr. Hoover, before and after he took office, was struggling desperately to curb credit extravagance. He wanted to deflate the utter extravagance then rampant, and his every influence in the Presidency was in that direction.‰9 Hoover not only launched the Federal Reserve attack on speculation (by way of Adolph Miller) but also did much more: I, therefore, resolved to attack the problem from several directions in addition to securing cooperation from the Federal Reserve System.

LESSONS TO BE LEARNED

171

To create a spirit of caution in the public, I sent individually for the editors and publishers of major newspapers and magazines and requested them systematically to warn the country against speculation and the unduly high price of stocks. Most of them responded with strong editorials. This had no appreciable effect, however. Secretary of the Treasury Mellon and others, at my request, issued repeated statements urging the public to convert their stocks into bonds and advising other forms of caution. This also had no effect.10

Hoover had a conversation with Governor Roy Young, in which Young „agreed to use the full powers of the Board to strangle the speculative movement.‰11 Hoover had an obsession with stopping stock market speculation: „We did at one time almost secure a stranglehold on the stock market when the Reserve Banks had so tightened the call-loan situation that a moment arrived when there was no money available to the market. A break seemed inevitable. But Charles E. Mitchell, President of the National City Bank of New York, announced that in this emergency his bank would furnish the deficient credit.‰12 There are many other examples in HooverÊs Memoirs of his war against speculation. There is no question that if stocks had fallen and nothing else had happened, Hoover would appropriately have claimed credit for stopping speculation. No one was to claim credit for what happened to the U.S. economy after October 1929. Unfortunately, after October 1929, facts regarding the economy were about to turn bad, and the market, which had been oversold in the fall of 1929, would be hit hard in the coming three years as business activity slowed to a crawl. Historians have tended to focus on the speculative boom in the stock market, ignoring the real prosperity of the period from 1925 to 1929: „ The easy-money policy of the Federal Reserve System after 1925, intended to turn back the flow of gold from Europe to the United States, was mainly responsible for the speculative rise in the stock market. The collapse of that market in October 1929, is ordinarily taken as the beginning of the world depression. In fact, however, the speculative boom had obscured downward tendencies in production and prices of manufactured goods and raw materials. In the United States construction had fallen off from the summer of 1928. Distressed farmers had been clamorous for years.‰13 MYTHS OF 1929 The first and most important myth in 1929 was that the stock market was obviously too high, driven up by speculators. Since the market went up, it was too high. There was little effort (other than by Fisher and by Lawrence)

172

BEATING THE BEAR

to evaluate the level of the market compared with the profitability of the corporations and the growth in that profitability. It is far from obvious that the market was too high in October 1929. Both investors and speculators were buying stocks, and it was difficult if not impossible to distinguish between the two types of buyers. The second myth is related to the first; namely, that the market was too high, and thus it was inevitable that it would decline drastically. The market did decline, but it is possible that the decline was caused by the actions of the federal government (including the Federal Reserve Board) and statements by its officials. There was a great deal of focus on broker loans, because they fueled the speculators who were driving up stock prices with margin buying. It is far from obvious that broker loans were excessively high. They proved to be safe loans from the viewpoint of the lenders. The lenders required sufficient „margin‰ to make them safe loans. Concerns regarding the safety of broker loans was a myth. It was a myth that the high level of stock market prices jeopardized the nationÊs prosperity. There was also considerable worry that Wall Street was stealing credit from farmers and industry. The effect of Wall Street credit on real components of the economy was assumed to be a negative factor that had to be controlled.14 This issue was completely misunderstood by the Federal Reserve Board. Although speculators were broadly attacked, few defined what they meant by „speculation‰ and why it was bad. The myth was that the speculators were a significant factor in setting the level of the market and that they harmed the other people. Short selling, investment trusts, and pools all received credit for either causing or accelerating the stock price decline. There is no evidence that any of these three factors contributed to the October decline. If we had to choose a possible culprit from among these three, it would be short selling, but unfortunately the empirical evidence is not available for proving or disproving its importance. One continuing myth is that evil (dishonest) manipulation fueled first the upswing and then the collapse. Although it can be shown that there were practices which either exhibited bad judgment or else were not completely ethical, it cannot be shown that these practices were significant either in setting the level of the market or in causing the market turn in October 1929. The biggest myth was that speculators had to be taught a lesson and that this lesson became the primary economic objective of both the Federal Reserve Board and the president of the United States. Congress did not disagree with the objective of „getting the speculators.‰

LESSONS TO BE LEARNED

173

Why was it such an obsession to „get the speculators‰ of the New York Stock Exchange? The need to „strangle‰ the speculative movement bordered on a hatred of a portion of humanity, those that invested (speculated?) on the New York Stock Exchange. Bernard Baruch, testifying before a senate committee, offered a friendly definition of speculator: „I was very active in the stock market before World War I. I was what you would call a speculator, but I have my own definition of a speculator. That is one who observes the future and acts before it occurs.‰ He also offered an evaluation of the predictive capability of economists: „The only economic doctor is an economist and they go to him and say, ÂProfessor, what about so and so?Ê And these men can take facts and figures and bring them together, but their predictions are not worth any more than ours. If they were, they would have all the money and we would not have anything.‰15 One relatively minor myth is that the Great Crash occurred in October 1929. In fact, most of the stock price losses took place in 1930 and 1931. HOW THE 1929 CRASH COULD HAVE BEEN AVOIDED The 1929 crash might possibly have been avoided if: 1. The Federal Reserve Bank had been more generous regarding the money supply. 2. The public utility commissions of each state had made it clear prior to 1929 that electric rates were not to be raised solely to justify stock prices that far exceeded a utilityÊs book value. 3. The President and Congress recognized that verbal attacks on speculators were not justified, given the healthy state of the real economy. However, the constant attacks did make investors in stocks nervous and vulnerable to any bad financial news.

HOW THE 2008/2009 CRASH COULD HAVE BEEN AVOIDED The list of changes that could have resulted in no stock market crash in 2008 / 2009 is somewhat longer, but it includes measures that were not easy to implement in 2007–2008. 1. Maintain higher lending standards for real estate loans so that fewer subprime mortgages are issued. 2. Have the credit rating agencies do a better job of defining very risky loans.

174

BEATING THE BEAR

3. Have investors refrain from relying solely on the loan ratings but instead actually evaluate the quality of loan packages by looking at the underlying loans. 4. Counterparties who pay in case of default swaps evaluate the creditworthiness of the other counterparties who are assuming different levels of defaults. 5. Have investors in risky mortgage bonds control the amounts of loans and also limit the amount of debt they use to finance the investments. Also, use long-term debt and not short-term debt, requiring continuous roll-over (frequent borrowing to stay afloat). 6. Have the Federal Reserve refrain from encouraging too low a set of interest rates. For example, real estate activity is stimulated by low long-term interest rates. Was there excessive stimulus? 7. The collapse of the mortgage market (defaulting of the mortgage payments), the failure of credit default swaps to ensure risk free investing, and the resulting failure of AIG (insurance), investment banks, and commercial banks resulted in a drying up of business credit. Faster and more effective action by the Fed might have decreased the consequences to the overall economy.

As the opening sentence of this section states, measures such as those outlined above are not easy to implement. THE ACCUSATIONS HAVE STARTED (2009) Once a boom has gone bust, authors soon seek the causes of the disruption in economic activity. In 2009, several authors (best unnamed) picked the villain to be the widely accepted efficient market hypothesis ( EMH ). This theory states that the prices of widely traded securities reflect all readily available information. It does not state that todayÊs price will also be equal to tomorrowÊs price. Given the failure of credit agencies and investors to evaluate correctly the riskiness of sub-prime mortgages, the use of excessive short-term debt to finance these risky investments and the failure of government agencies to regulate these credit markets, there is a need to find explanations for these failures. But there is also a need to look further than the EMH theory, which is not guilty of facilitating these errors. A general theory of human beings seeking excess returns and satisfactions is likely to be a more satisfactory path. LESSONS TO BE LEARNED (1929) First, the balance between stock market optimism and pessimism is very delicate. In 1928 and 1929, the optimism was steadily eroded by negative

LESSONS TO BE LEARNED

175

statements regarding speculation, which were made by important people and government bodies. Consider a balance scale that is almost in balance while pieces of hay are being added to the high (light) side. Finally, one straw will cause the light side to become the heavy side. So it is with optimism and pessimism when the optimism is met by only persistent announcements of coming doom. Second, there is the problem of mob psychology. A shifting investor sentiment is catching and there is a snowball effect. Why is there a snowball effect on one day and not another? We do not know; thus the forecast of the next market turn is uncertain. Third, even the best and the brightest minds can be wrong as to what is going to happen next in the stock market. Irving Fisher and John Maynard Keynes were both completely wrong in the fall of 1929. They were not wrong in their analysis but rather in their forecast of future market prices. They could not predict the marketÊs psychology. Fourth, a major event such as a stock market crash gives rise to investigations and recommendations. There are likely to be too many emotions and political considerations tied to the investigations for them to be useful. The investigators are too close to the events to see the causal relationships. Objectivity is lacking and justice and understanding are likely to prevail only after a long period of time. Fifth, the attempt to use the money supply to control the stock market affected real business activity in ways that were not anticipated. The failure to anticipate the results of actions is always present. For example, building a very strong defense establishment might guarantee peace, but it might also wreck the competitive economic position of the country. Sixth, margin buyers and speculators (including the short sellers) were blamed for the overpriced market and the resulting collapse. This widely accepted belief was not proved, and today it is not likely to be taken seriously as an important factor in a stock market price decline. Seventh, the period of 1929 to 1932 and beyond indicated that there could be long periods of time during which common stock would prove to be undesirable investments. This is a strong lesson for diversification of investments. Finally, major events can occur that are distorted by reporters of history to be something that they are not. The 1920s were not an orgy of speculation, but the attempt „to get the speculators‰ might well have helped cause the Great Depression of the 1930s. A conclusion that the stock market was too high in September 1929 and thus crashed is much too simple an analysis and is not based on the facts. It is possible that the market was too high when the Federal Reserve decided it was too high, and then other events triggered the start of the decline,

176

BEATING THE BEAR

which was accelerated by the withdrawal of nonbank loans from the broker call loan market and the relatively high cost of loans compared to dividend yields. First NationalÊs observations of the economic scene at the end of 1929 are of interest: „The essential fact, wherein the present differs from most periods of great stock market declines in the past, is that business itself is healthy and has not been involved in over-expansion with the stock market · which means that an attack of acute indigestion in securities, while it may cause business a severe headache, should not seriously cripple the patient.‰16 But the Federal Reserve, the Senate, and the business press all declared that the market was too high and that speculation needed to be controlled. Even E.H.H. Simmons, the president of the NYSE, stated that there had been excessive speculation. In September, broker loans reached a high of $8.5 billion, and this received a lot of attention (excessive speculation had to be stopped). Once the market turned down, the nonbank broker loan money melted away and the price decreases fed on themselves as investors were sold out by their creditors. In September, the Hatry scandal in England received a large amount of press and there began an outflow of foreign capital from the stock market. In addition, the action and statements of the Massachusetts Public Utility Commission received a lot of attention (discouraging investment in public utilities). Also in October, actual measures of production output were turning down. In the spring of 1930, the reports of real trouble in American industry gave stock market investors a valid reason to change their expectations and for the market to fall. But one needs a heavy case of 20 – 20 hindsight to be able to define the market as being overvalued as of October 1929 or November 1929. Most of us would not have predicted the market turn in October 1929. But even if we had predicted that turn, we probably would have bought in November and December 1929 and would have been ill prepared for the additional collapse in the spring of 1930. Also, we would probably not have bought common stock in 1933 and would have missed the largest upturn in the history of the market (in the depths of the Great Depression). The facts are that it is not obvious that the market was too high in October 1929 (or October 1987 or March 2008) or too low in 1933. The obviousness only occurs after the fact. Although we can explain many of the statements and actions of the participants in terms of the „normal prejudices of the period,‰ that is not an excuse for the actions taken in 1929. There were voices of reason that could have been listened to and which might have changed history. In that

LESSONS TO BE LEARNED

177

spirit consider the following enlightened editorial from the October 24, 1929, Brooklyn Daily Eagle: Predictions That Fail On Tuesday Charles E. Mitchell, president of the National City Bank and a high authority in financial matters, expressed the opinion that the stock market decline „had gone too far.‰ On the same day Professor Irving T. Fisher, head of the department of economics at Yale University, another expert of wide repute, declared that the prices of stocks were low, that there was no real cause for the slump in value which they had suffered, and that quotations were far behind real values. This morning the aggregate value of stock market issues stood several billions below what it was when these experts made their optimistic statements. The big crash came yesterday, when paper values slumped by about $4,000,000,000. The last hour was the worst, 2,600,000 shares being thrown overboard for whatever they would bring. If anyone wants proof that the market is „unpredictable,‰ recent experience should provide it. President Mitchell and Professor Fisher may both be right. We will know more about that in another six months. But it must be obvious that anyone who bought stocks on their say-so with the expectation of immediate profits has been grievously disappointed. And anyone who has purchased stocks on margin at any time during the last eight weeks is also in an unhappy position. The time may soon be here when the investor who buys stocks outright can get them at bottom prices. But for the next few days the high authorities who venture predictions will make it plain that they are not saying what may happen from one day to the next.17

HENRY KAUFMAN (2009) Henry KaufmanÊs The Road to Financial Reformation makes the point that if a bank is too big to fail, it should be strictly regulated ( p. 115).18 Kaufman also believes in a separation of banking and commerce. No banking operations for Walmart. On the other hand, nationwide banking should be authorized ( p. 126). CONCLUSION The development of the securitization process for mortgages facilitated the process of expanding the subprime mortgage market from 1990 to 2009. The financial community would take 10,000 bad credit mortgages and by redefining the allocation of the cash flows from these 10,000 mortgages (the priority of payment) the financial institutions would be able to sell AAA, AA, A (etc.), investment-grade securities derived from the bad

178

BEATING THE BEAR

credit mortgages. Of course, the residuals (to receive payment after the investment-grade securities had received their contractual flows) would be much worse than the cash flow from the average of the overall portfolio. One could argue that this was merely equivalent to rearranging the chairs on the deck of the Titanic as it sailed the North Atlantic. But if the investors were attracted to the investment grade tranches and they could still be sold at a profitable price, it is likely that the securitization process expanded the market for subprime mortgages. Certainly Wall Street firms acted as if they thought that securitization facilitated the sale of subprime mortgages.

Chapter 14

POST-CRASH INVESTMENT STRATEGIES: BEATING THE BEAR MARKET

Wall Street booms because business is solidly prosperous. Wall StreetÊs buoyancy is the reflection of national prosperity and confidence to which its wondrous financial mechanisms potently contribute. Everyone is willing to invest in or bet on the prosperity of the United States. ·The Magazine of Wall Street, October 19, 1929 It is practical to define a bear market as a stock market that is at a level significantly lower than the marketÊs recent high. One obvious way to beat a bear market is to sell stocks short when they are at maximum prices. But there are two problems with this strategy. First, the stocks might go up rather than down. Second, not all investors are inclined to sell stocks short, given the large losses associated with stock prices going up rather than down after the sale. An alternative to selling short is to sell all currently held stocks in anticipation of a rapid decline in the stock indices. But what if your forecast is wrong? Also, selling all stock has the consequence of realizing for tax purposes all the accumulated capital gains on the portfolio. The tax bill could be large. A third alternative is to stop buying stocks until the bear market decline has ended. The problem here is that it is very difficult (impossible?) to forecast when the stocks are going to stop falling and start going up. In October 1929, Irving Fisher and John Maynard Keynes, possibly the worldÊs two leading economists of the time, were both surprised when

180

BEATING THE BEAR

stocks stopped climbing in the fall of 1929 and stock prices collapsed. They both thought that stocks were reasonably priced in October 1929 and were a good buy in that November and December. Keynes lost a lot of money for himself and his friends. Fisher lost all his wealth including his home. Both eminent economists thought December 1929 was the rock bottom for the market, but in fact (with hindsight) we know that stock prices would continue to fall until well into 1932. In fact, most of the stock price drops of the 1929 crash occurred after December 1929. In October 2008, the author of this book had a large amount of cash resulting from the acquisition for cash of the Anheuser–Busch corporationÊs stock equity by Inbev. As the stock market fell, especially financial services stocks, I bought financial firms I liked and knew well at bargain level prices. Three months later, these bargain prices turned out to be peaks that were not to be realized again in my lifetime. Fortunately, late in 2008, I remembered Fisher and Keynes and their actions in 1929 and stopped buying stocks. Beating the 2008 bear market for me was to stop buying in the fall of 2008. The gains from selling Anheuser–Busch stock were more than balanced by losses from the financial stocks bought in the summer and fall of 2008 (Lehman Brothers, Citigroup, Merrill Lynch, Wachovia, etc.). A GOOD SOLUTION BUT . . . There is a good solution for beating the bear market, but the individual investor cannot implement it. A healthy economic environment with corporations making profits and growing will result in a bull stock market and the disappearance of bear investors. THE LESSONS There are several lessons to be taken away from both the 1929 and 2008 bear stock markets. Lesson 1 is that the initial stock price decreases may not have been justified by the economy or the firmsÊ profit performances. Thus there is a tendency to say, now is a buying opportunity. But soon the firmsÊ unsatisfactory operating results catch up with the lower stock prices and the stock prices, rather than being too low, start looking too high. Lesson 2 is that it may be tempting to buy stocks when the bear market starts, but the basic investment strategy rules still apply. The number 1 investment rule is to diversify. This means that one should not only invest in stocks but also place some resources in assets that are not highly correlated with the level of the stock market.

POST-CRASH INVESTMENT STRATEGIES

181

Lesson 3 is learned from both 1929 and 2008. One might think that the stock market level is justified by the financial performance of the firms and the economy. But history proves that major stock price surprises do occur, and most of us are not bright enough to judge when declines in stock prices are going to be seen. Are your portfolio asset mix and your wealth needs consistent with a 50 percent surprise decline in stock prices? The fact is that the stock price level is volatile and your investment strategy should be consistent with that fact. The reasons for the volatility may not be discovered until well after the prices decline. In 1929, the October stock crash was triggered by the collapse of public utility stock prices, after a decision by the Massachusetts public service commission and attempts by the Hoover administration to stop stock speculation. The decision by the Massachusetts public service commission and its consequences were surprises to the average investor in the stock market. In 2008, real estate prices stopped going up. The average investor in stocks was not aware that for a number of years banks had made loans to house buyers who did not have sufficient resources or incomes to buy the real estate. These transactions gave rise to a large number of subprime mortgages. In addition, bond rating agencies were lax (generous?) in their reviews of the creditworthiness of the mortgage paper (or collateralized debt obligations) that resulted from the issuance of the subprime mortgages. Thus favorable credit ratings were given to debt securities that were not good credit risks. Some firms that bought this risky paper engaged in credit default swaps (CDSs), where they paid a fixed fee each period to some entity (say AIG); they would then be paid by the swap counterparty only if the mortgage was not paid. The buyers of these CDSs failed to notice that the counterparty of many swaps tended to be one counterparty. When real estate prices stopped going up, the borrowers stopped paying on mortgages where the total owed was larger than the value of the property on which the mortgage was taken ou. The counterparty in the CDSs was then unable to pay, given the very large number of defaults, and banks were left with bundles of nearly worthless mortgages. Given that the mortgage investments were frequently financed with more than $30 of debt for each dollar of equity, it did not take many defaults to cause banks to have severe financial difficulties. Banks had a surplus of bad assets and were not eager to add to their collection of risky unliquid assets; thus the credit markets froze. With no credit, business activity shrank rapidly and a recession began. What started as a financial sector stock price decline rapidly spread to other sectors as the lack of credit and growing pessimism caused the entire stock market to fall more rapidly and severely than it had ever fallen.

182

BEATING THE BEAR

Thus, in 1929, a decision by one stateÊs public service commission regarding a stock split (one share of common stock was to become three shares) · which, in itself, had zero real financial significance · triggered the great 1929 crash. In 2008, the offering of mortgages to unqualified buyers, sloppy credit analysis by credit rating agencies, and the use of excessive short-term leverage by investing banks led to defaults of subprime mortgages, which then triggered a financial panic. The average investor in common stock in 2008 did not realize that this set of events was laying the foundation for a 50 percent drop (and more) in stock prices. CONTINUATION OF LESSONS AND ILLUSIONS Lesson four for investors, the financial markets always have risk. Lesson five, the basic financial risk is magnified by the financing of assets with debt, especially short-term debt. Lesson six, if not constrained by law, some profit-seeking financial entities will use too much debt and the financial institutions will fall into difficulties. There are also three illusions held by many. One is that future risk can be very accurately estimated. The second is that risk can be hedged and thus be completely eliminated. We cannot accurately estimate and completely avoid risk. While one can think the risk is perfectly hedged, in actual fact the counterparty absorbing the risk is also subject to the risk of not being able to pay; thus the hedge may not be completely effective. The third illusion is that another country may be at risk, but we are safe (economically self-contained). The period 2008 – 2009 has shown how intertwined most or all countries are. ACHIEVING THE WEALTH TARGET In 2003, my investment portfolio reached a level that I thought was adequate for the future needs of my family. In addition, the tax laws favored stock investments that were not protected by tax-deferral provisions. Such gains on stocks (dividends and capital gains) were taxed at 15 percent, while tax protected investment vehicles, when taxed, were taxed at 35 percent. Given the tax laws and a desire not to be exposed to large potential losses from common stock price shocks, I converted my major asset (my retirement amount with College Retirement Equities Fund) from stocks to a variety of other investments. All my choices were not optimal (e.g., an investment in a Real Estate Investment Trust was less than optimal), but in general, given the 2008 crash, my decisions overall turned out to be reasonable.

POST-CRASH INVESTMENT STRATEGIES

183

PROPOSED REFORM·2009 In 2009, the Department of the Treasury published a position paper titled Financial Regulatory Reform.1 We can expect the laws that Congress will pass to follow some of the suggestions supplied by the Treasury. The objectives of the proposals (p. 2) are as follows: „We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation, and that is able to adapt and evolve with changes in the financial market.‰ The five key objectives of the reforms are ( pp. 3–5): 1. 2. 3. 4.

Promote robust supervision and regulation of financial firms. Establish comprehensive supervision of financial markets. Protect consumers and investors from financial abuse. Provide the government with the tools it needs to manage financial crisis. 5. Raise international regulatory standards and improve international cooperation.

The above proposals are described as being essential ( p. 4), but „More can and should be done in the future.‰ Everyone can agree that something should be done to prevent the recurrence of the fall 2008 financial panic and the resulting harm to the worldÊs economy. The problem is that there is a tendency to overreact and pass legislation that excessively restricts the freedom of the financial markets. This was the result of the financial legislation passed by Congress in the 1930s, and unless we are careful (and thoughtful), it could be the result of legislation to correct the 2008 – 2009 turmoil in the financial markets. BEATING THE BEAR: LESSONS FROM THE 1929 CRASH APPLIED TO TODAYÊS WORLD We live in a world of uncertainty. One cannot invest in common stock and expect with certainty that all will be well for all time. Both 1929 and 2008 teach us the lesson that the stock market can experience severe decreases in value. Although the market might ultimately recover the losses and prove the most desirable investment alternative, the recovery period might be too long for the average investor. This means that the average investor should be diversified sufficiently to withstand the shocks in value that history has proven that can and will occur.

184

BEATING THE BEAR

THE RECORD OF BEN BERNANKE (2008–2009) Ben Bernanke was chairman of the Federal Reserve during the period of 2008 – 2009. His performance received considerable praise (see Houriel Roubini, The New York Times Sunday Opinion, July 26, 2009, p. 12) and an equivalent amount of criticism (see Anna Jacobson Schwartz, The New York Times Sunday Opinion, July 26, 2009, p. 12). Both authors note that the Fed appropriately followed in 2008 and 2009 a monetary policy of extreme ease. Essentially, the Fed cut the funds rate to zero. Schwartz warns that the consequences of such a policy can be excessive investment and the creation of a bubble. But SchwartzÊs primary criticism was that Bernanke was silent when the Wall Street firms were buying high-risk securities with large amounts of low-cost debt. She is right, given the facts that were brought to light in 2008. But should Bernanke have known that the quality of newly issued mortgages had decreased and that credit rating agencies had relaxed their standards? It will be interesting to find out what information Bernanke had and what information he could have gotten had he requested it. TARP: SOME INCOMPLETE RESULTS The Troubled Asset Relief Program (TARP) was implemented in the fall of 2008. As of August 2009, a total of 22 banks had paid back the $40.6 billion of TARP funds they had received (Wall Street Journal, August 28, 2009). The federal government received $44.7 billion and earned an internal rate of return of 0.101 for a period of less than a year (0.1274 on an annualized basis). Of course, the story on the profitability of half of the TARP funds is not yet written. But we can be optimistic that the federal government will make a reasonable return on its TARP investments (leaving out the auto industry). It should be remembered that the objective of TARP was not to make profits for the federal government but rather to stabilize the financial and credit offering systems. However, it would be nice for the economy if a profit for the U.S. government were to be seen. PERSPECTIVE AND CONCLUSIONS Writing about the panic and crash of 2008 – 2009 as it occurs is somewhat limiting. It is likely that scholars 10 years or more from now will see things that we are too close to in 2009 to analyze properly. But it is possible that this book can help to build a foundation for those future scholars. In any event, I tried.

NOTES

INTRODUCTION 1. Herbert Hoover, The Memoirs of Herbert Hoover (New York: Macmillan, 1952), p. 5.

CHAPTER 2 1. Senate Committee on Banking and Currency, BrokersÊ Loans (Washington, DC: U.S. Government Printing Office, 1928), p. 1. 2. Ibid., p. 2. 3. Ibid., p. 69. 4. Ibid. 5. Ibid. 6. Ibid., p. 77. 7. Ibid. 8. Ibid. 9. Ibid., pp. 79–80. 10. Ibid., p. 80. 11. Ibid., p. 96. 12. Committee on Banking and Currency, House of Representatives, Stabilization ( Washington, DC: U.S. Government Printing Office, 1929), p. 111. 13. Ibid., p. 118. 14. Ibid. 15. Ibid., p. 121. 16. Ibid. 17. Ibid.

186

NOTES

18. Ibid. 19. Ibid., p. 396. 20. Ibid., p. 412. 21. The National Cyclopedia of American Biography, vol. 22 (New York: James T. White, 1932), pp. 75 –76.

CHAPTER 3 1. C. P. Kindleberger, Manias, Panics, and Crashes ( New York: Basic Books, 1978), p. 17. 2. For a set of a priori reasons casting doubt on the importance of sunspot variables and why these are not good reasons for ruling out self-fulfilling expectations, see M. Woodford, „Three Questions about Sunspot Equilibria as an Explanation of Economic Fluctuations,‰ American Economic Review, May 1987, pp. 91– 93. 3. R. P. Flood and P. M. Garber, „Market Fundamentals versus Price-Level Bubbles: The First Tests,‰ Journal of Political Economy, August 1980. 4. Ibid., pp. 745–70. 5. J. Carswell, The South Sea Bubble (Stanford, CA: Stanford University Press, 1960). 6. Viscount Erleigh, The South Sea Bubble (London: Peter Davies, 1933), p. 39. 7. M. Friedman and A. J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 234. 8. L. V. Chandler, Benjamin Strong, Central Banker (Washington, DC: Brookings Institute, 1958). 9. The Federal Reserve Bulletin, March 1929, p. 175. 10. Investment Bankers Association of America, Proceedings of the Nineteenth Annual Convention of the Investment Bankers Association of America (Chicago, 1930), p. 3. 11. Friedman and Schwartz, Monetary History, pp. 297–98. 12. The Federal Reserve Bulletin, April 1929, p. 249. Different sources will give different rates but the same magnitudes. 13. Friedman and Schwartz, Monetary History, p. 298. 14. The National City Bank of New York Newsletter (April 1929), p. 49. 15. The National City Bank of New York Newsletter (June 1929), p. 75. 16. Ibid., p. 76. 17. G. Sirkin, „The Stock Market of 1929 Revisited: A Note,‰ Business History Review (Summer 1975), p. 231. 18. Arthur E. Nilsson, my former colleague at Cornell University, presented this fable in an unpublished paper entitled „Making Securities Secure.‰ 19. Bogart and Kemmerer, Economic History, p. 816. 20. F. L. Allen, The Lords of Creation (New York: Harper, 1935), p. 353.

CHAPTER 4 1. M. Friedman and A. J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 241.

NOTES

187

2. B. Strong, as quoted in L. V. Chandler, Benjamin Strong, Central Banker (Washington, DC: Brookings Institute, 1958), 3. A. C. Miller, „Federal Reserve Policies: 1927–1929,‰ American Economic Review (September 1935), pp. 447– 48. 4. Ibid., p. 454. 5. William Hard, WorldÊs Work (June 1929), p. 48. 6. Quoted in „Behind the Scenes with the Federal Reserve Board,‰ WorldÊs Work (June 1929), p. 49. 7. Herbert Hoover, The Memoirs of Herbert Hoover (New York: Macmillan, 1952), pp. 10 –14. 8. Miller, „Federal Reserve Policies,‰ pp. 453 – 54. 9. William Allen White, A Puritan in Babylon, 1939, p. 370, as quoted in Chandler, Benjamin Strong, p. 443. 10. Chandler, Benjamin Strong, p. 465. 11. The thinking of Miller and Hamlin is illustrated by the following Hamlin entry (February 11): „Miller reminded me that Governor Norman at our lunch said his purpose in coming over was to pay his respect to Governor Harrison of Federal Reserve Bank of New York·never mentioning Governor Young of the Federal Reserve Board!‰ Norman went to Washington only because Harrison had strongly recommended it. 12. Miller, „Federal Reserve Policies,‰ p. 456. 13. Friedman and Schwartz, Monetary History (Princeton, NJ: Princeton University Press, 1963), p. 260. 14. Cited in Hoover, Memoirs, pp. 18 –19. 15. Committee on Banking and Currency, Stock Exchange Practices (Washington, DC: U.S. Government Printing Office, 1934), p. 18. 16. Miller, „Federal Reserve Policies,‰ p. 456. 17. E. K. Burger and A. M. Leinbach, „Business,‰ The Magazine of Wall Street (June 15, 1929), p. 289. 18. P. M. Warburg, The Federal Reserve System: Its Origin and Growth (New York: Macmillan, 1930), pp. 512–514. Ex-Senator Owen, one of the framers of the act establishing the federal reserve system, was one of the proponents of this position. 19. Friedman and Schwartz, Monetary History, p. 290. 20. Appendix 2 is made up of excerpts from the 1933 stock exchange practices hearings before a subcommittee of the U.S. Senate Committee on Banking and Currency.

CHAPTER 6 1. All market measures in this chapter are from P. S. Pierce, The Dow Jones Averages, 1885 –1985 (Homewood, IL: Dow Jones–Irwin, 1986). 2. H. OÊConnor, MellonÊs Millions (New York: John Day, 1933), p. 310. In fairness to Mellon, his statement was made at the request of Hoover. See H. Hoover, The Memoirs of Herbert Hoover (New York: Macmillan, 1952), p. 17.

188

NOTES

3. The New York Times, March 4, 1929, p. 3. 4. The Financial Chronicle, August 3, 1929, p. 683. 5. Forbes, August 1, 1929, p. 25. 6. The Magazine of Wall Street, August 24, 1929, p. 736. 7. The Financial Chronicle, August 10, 1929, p. 847. 8. The Financial Chronicle, September 7, 1929, p. 1505. The term „forced accounting‰ was used because the accounting was necessary to conform to the relatively new tax laws. 9. The New York Herald Tribune (September 6, 1929). 10. Preston Field, The Magazine of Wall Street (October 19, 1929), p. 1077. 11. Forbes, October 1, 1929, pp. 19 – 21. 12. The Commercial and Financial Chronicle (November 23, 1929). 13. C. P. Kindleberger, Manias, Panics, and Crashes (New York: Basic Books, 1978). 14. The Magazine of Wall Street (November 16, 1929), p. 91. 15. J. K. Galbraith, The Great Crash, 1929 (Boston: Houghton Mifflin, 1961), pp. 51 –70. 16. Hearings before a Subcommittee of the Committee on Banking and Currency United States Senate, Part 3 (Washington, DC: U.S. Government Printing Office, 1931), p. 480. 17. Forbes (November 15, 1929), p. 24. 18. Irving Norton Fisher, My Father, Irving Fisher (New York: Comet, 1956), p. 264. 19. J. Wanniski, „The Smoot–Hawley Tariff and the Stock Market Crash of 1929,‰ Midland Corporate Finance Journal (Summer 1987): p. 11. 20. Ibid., p. 13. 21. Committee on Banking and Currency, Stock Exchange Practices (Washington, DC: U.S. Government Printing Office, 1934), p. 7. 22. Ibid., p. 5.

CHAPTER 7 1. Daniel Gross, Dumb Money (New York: Free Press, 2009). 2. K. Kelly, Street Fighters: The Last 72 Hours of Bear Stearns the Toughest Firm on Wall Street (New York: Portfolio, 2009). 3. W. D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (New York: Doubleday, 2009). 4. Office of Inspector General, Office of Audits, SECÊs Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program (Washington, DC: U.S. Securities and Exchange Commission, 2008). 5. L. G. McDonald and P. Robinson, A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers (New York: Crown Business, 2009). 6. R. Lowenstein, When Genius Failed (New York: Random House, 2000), p. 234.

NOTES

189

7. D. Wessel, In Fed We Trust, Ben BernankeÊs War on the Great Panic (New York: Crown Business, 2009). 8. Paul Krugman, „School for Scoundrels,‰ The New York Times, Book Review, August 6, 2009, p. 11. 9. J. Fox, The Myths of the Rational Market (New York: HarperCollins), 2009.

CHAPTER 8 1. Committee on Banking and Currency, Stock Exchange Practices (Washington, DC: U.S. Government Printing Office, 1934), p. 9. 2. I. Fisher, The Stock Market Crash and After (New York: Macmillan, 1930), p. 41. 3. The Federal Reserve Bulletin, December 1929, p. 783. 4. E.H.H. Simmons, The Principal Cause of the Stock Market Crisis of Nineteen Twenty-Nine (New York: New York Stock Exchange, 1930), p. 10. 5. Fisher, The Stock Market Crash, p. 229. 6. Ibid. 7. The First National City Bank of New York Newsletter, November 1929, p. 164. 8. Ibid., p. 159. 9. Ibid., p. 164. 10. Stock Exchange Practices, pp. 31–32. Whitney was Richard Whitney, vice president of the NYSE in 1929. 11. Ibid., p. 42. 12. As shown in J. Edward Meeker, Short Selling ( New York and London: Harper, 1932), p. 251. 13. Ibid., p. 252. 14. M. Mayer, Wall Street: Men and Money (New York: Harper, 1955), p. 75. 15. F. R. Macaulay and D. Durand, Short Selling on the New York Stock Exchange (New York: Twentieth Century Fund, 1951 [mimeographed]). 16. Ibid., p. ix. 17. Ibid., p. xiv. 18. Fisher, The Stock Market Crash, p. 44. 19. The Commercial and Financial Chronicle, September 21, 1929, p. 1008. 20. The Commercial and Financial Chronicle, September 28, 1929, p. 1957. 21. The Commercial and Financial Chronicle, October 5, 1929, p. 2121. 22. The Federal Reserve Bulletin, December 1929, p. 757. 23. Fisher, p. 48. 24. For an interesting discussion of the effects of the availability of credit in financial markets on the real sector, see B. S. Bernanke, „Nonmonetary Effects of a Financial Crisis in the Propagation of the Great Depression,‰ American Economic Review (June 1983), pp. 257– 76.

190

NOTES

CHAPTER 10 1. R. G. Ibbotson and R. A. Sinquefield, Stocks, Bonds, Bills and Inflation: The Past and the Future (Charlottesville, VA: Financial Analysts Research Foundation). Appendix 2 to this chapter gives roughly the same relative magnitudes, but there are differences depending on the exact method of calculation. 2. Using the change from 1928 to 1932, we have: (1.908 – .540) ÷ 1.908 = .72. 3. J. K. Galbraith, The Great Crash, 1929 (Boston: Houghton Mifflin, 1961), p. 16, 29. 4. P. A. Samuelson, „Myths and Realities about the Crash and Depression,‰ Journal of Portfolio Management (Fall 1979): 9. 5. Ibid. 6. M. Friedman and A. J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1960), p. 247. 7. Ibid., pp. 241– 43. 8. I. Fisher, The Stock Market Crash and After (New York: Macmillan, 1930), p. 89. 9. Ibid, p. 90. Fisher points out · with a characteristic touch of humor · that an interest rate of 3.4 percent converts to a price earnings ratio of 33 to 1. 10. J. S. Lawrence, Wall Street and Washington (Princeton, NJ: Princeton University Press, 1929), p. 88. 11. The Federal Reserve Bulletin, August 1930, p. 494. 12. J. W. Kendrick, Productivity Trends in the United States (Princeton, NJ: Princeton University Press, 1961). 13. KendrickÊs last period of study was 1948 –1953. 14. Lawrence, Wall Street and Washington, pp. 177, 187. 15. Fisher, Stock Market Crash, p. 91. 16. Forbes (October 15, 1929): 95. 17. The Magazine of Wall Street, June 1, 1929, p. 197. 18. The National City Bank of New York Newsletter, October 1929, p. 197. 19. Barrie A. Wigmore, The Crash and Its Aftermath (Westport, CT: Greenwood, 1985), p. 572. 20. Ibid., p. 641. 21. Ibid., p. 648. 22. Forbes (October 1, 1929): p. 77. 23. E. K. Burger and A. M. Leinbach, „Business,‰ The Magazine of Wall Street, June 15, 1929, p. 289. 24. The Federal Reserve Bulletin, October 1929, p. 665. 25. H. Kaufman, The Road to Financial Reformation: Warnings, Consequences, Reforms (New York: John Wiley & Sons, 2009). 26. Ibbotson Associates, Stocks, Bonds, Bills and Inflation: 1988 Yearbook (Chicago: Ibbotson Associates, 1988), pp. 177, 162. The index is based on the record of 90 of the largest stocks (p. 27). 27. Burton G. Malkiel, A Random Walk Down Wall Street (New York: Norton, 1975), pp. 37, 38.

NOTES

191

28. J. B. Williams, The Theory of Investment Value (Cambridge, MA: Harvard University Press, 1938), p. 520. Williams states the stock reached an all-time high of $310 in 1929 (p. 523). We did not reconcile the difference between MalkielÊs and WilliamsÊs estimates, but it probably involves the valuation of rights attached to the stock. 29. Ibid., pp. 516 –17. 30. B. Graham and D. L. Dodd, Security Analysis (New York: McGraw-Hill, 1934), p. 6. 31. Williams, Theory of Investment Value, pp. 572 – 73. 32. Ibid., p. 512. 33. G. Sirkin, „The Stock Market of 1929 Revisited: A Note,‰ Business History Review (Summer 1975): 223–31. 34. Ibid., p. 226. 35. Ibid., p. 230. 36. Ibid., p. 231. 37. R. Sobel, Panic on Wall Street (New York: Macmillan, 1968), p. 368.

CHAPTER 11 1. Galbraith, J. K., The Great Crash, 1929 (Boston: Houghton Mifflin, 1961). 2. U.S. Senate Subcommittee on Banking and Currency, Stock Exchange Practice Hearings, (Washington, DC: U.S. Government Printing Office, 1933). 3. Pecora, F., Wall Street Under Oath (New York: Simon and Schuster; 1939). 4. Hoover, H., The Memoirs of Herbert Hoover (New York: Macmillan, 1952). 5. U.S. Senate Subcommittee, Stock Exchange Practice Hearing. 6. The term „selling against the box‰ refers to a process in which an investor owning stock, wanting to „protect‰ a gain, sells the stock short. If the stock goes down, the investor wins. It is a legitimate process (though not necessarily advisable).

CHAPTER 13 1. Forbes (October 1, 1929), p. 11. 2. Ibid. 3. J. S. Lawrence, Wall Street and Washington (Princeton, NJ: Princeton University Press, 1929), pp. 187, 245. 4. Investment Bankers Association of America, Proceedings of the Nineteenth Annual Convention of the Investment Bankers Association of America (Chicago: ABAA, 1930). 5. E.H.H. Simmons, The Principal Causes of the Stock Market Crisis of Nineteen Twenty-Nine (New York: New York Stock Exchange, 1930), pp. 3 – 7. 6. Forbes (December 15, 1929), p. 26. 7. Forbes (December 1, 1929), p. 68.

192

NOTES

8. Herbert Hoover, The Memoirs of Herbert Hoover (New York: Macmillan, 1952), p. 5. 9. Ibid., p. 13. 10. Ibid., p. 17. 11. Ibid., p. 16. 12. Ibid., p. 18. 13. Broadus Mitchell, Depression Decade, Volume IX, The Economic History of the United States (New York: Holt, Rinehart and Winston, 1961), p. 10. 14. For two academic discussions of this issue, see S. E. Harris, Twenty Years of Federal Reserve Policy (Cambridge, MA: Harvard University Press, 1933), pp. 596 – 611, and J. A. Schumpeter, Business Cycles (New York: McGraw-Hill, 1939), pp. 681–91, and 873 –77. 15. Stock Market Study, hearings before the Committee on Banking and Currency, U.S. Senate (Washington, DC: U.S. Government Printing Office, 1955), pp. 1002, 1003. 16. The First National City Bank of New York Newsletter (December 1929), p. 169. 17. Brooklyn Daily Eagle (October 24, 1929). 18. Kaufman, H., The Road to Financial Reformation: Warnings, Consequences, Reforms, (New York: John Wiley & Sons, 2009).

CHAPTER 14 1. Department of the Treasury, Financial Regulatory Reform, 2009.

BIBLIOGRAPHY

Allen, F. L. (1935), The Lords of Creation, New York: Harper. Balke, N. S., and R. J. Gordon. (1986), „Historical Data,‰ in The American Business Cycle, R. J. Gordon (ed.), Chicago: University of Chicago Press. Barsky, R. B., and J. B. DeLong. (1990), „Bull and Bear Markets in the Twentieth Century,‰ Journal of Economic History (June), 265 – 68. Bernanke, B. S. (1983), „Nonmonetary Effects of a Financial Crisis in the Propagation of the Great Depression,‰ American Economic Review (June), 257–76. Bierman, H., Jr. (1991), The Great Myths of 1929 and the Lessons to be Learned, Westport, CT: Greenwood Press. Bluefield Water Works v. P.S.C. 262, U.S. 679 (1923). Bogart, E. L., and D. L. Kemmerer. (1944), Economic History of the American People, New York: Longmans, Green. Brooklyn Daily Eagle, October 24, 1929. Burger, E. K., and A. M. Leinbach. (1929), „Business,‰ The Magazine of Wall Street (June 15). Carswell, J. (1960), The South Sea Bubble, Stanford, CA: Stanford University Press. Cecchetti, S. G. (1992), „Stock Market Crash of October 1929,‰ in The New Palgrave, P. Newman, M. Milgate, and J. Eatwell (eds.), London: Macmillan. Chandler, L. V. (1958), Benjamin Strong, Central Banker, Washington, DC: Brookings Institute. Committee on Banking and Currency. (1931), Hearings on Performance of the National and Federal Reserve Banking Systems, Washington, DC: U.S. Government Printing Office.

194

BIBLIOGRAPHY

Committee on Banking and Currency. (1933), Stock Exchange Practices, Washington, DC: U.S. Government Printing Office. Committee on Banking and Currency. (1934), Stock Exchange Practices, Washington, DC: U.S. Government Printing Office. The Commercial and Financial Chronicle. Crisp, J., et al. (1937), The Hatry Case, Eight Current Misconceptions, London: n.p. (Prepared by seventeen friends of Clarence C. Hatry. Most of the seventeen had impressive credentials.) DeLong, J. B., and Andrei Schleifer. (1991), „The Stock Market Bubble of 1929: Evidence from Closed-End Mutual Funds,‰ Journal of Economic History (September), 675 – 700. Erleigh, Viscount. (1933), The South Sea Bubble, London: Peter Davies. Federal Power Commission v. Hope Natural Gas Company 320, U.S. 591 (1944). The Federal Reserve Bulletin. The First National City Bank of New York Newsletter. Fisher, I. (1930), The Stock Market Crash and After, New York: Macmillan. Fisher, Irving Norton. (1956), My Father, Irving Fisher, New York: Comet. Flood, R. P., and P. M. Garber. (1980), „Market Fundamentals versus PriceLevel Bubbles: The First Tests,‰ Journal of Political Economy (August), 745 – 70. Friedman, M., and A. J. Schwartz. (1963), A Monetary History of the United States, 1867, 1960, Princeton, NJ: Princeton University Press. Galbraith, J. K. (1979), „The Great Crash,‰ Journal of Portfolio Management (Fall), 60 – 62. Galbraith, J. K. (1961), The Great Crash, 1929, Boston: Houghton Mifflin. Gordon, R. I. (1986), The American Business Cycle, Chicago: University of Chicago Press. Graham, B., and D. L. Dodd. (1934), Security Analysis, New York: McGraw-Hill. Hamlin, C. S. (1929), Hamlin Diary, Library of Congress, Washington, DC (unpublished). Hard, William. (1929), WorldÊs Work (June), 48. Harris, S. E. (1933), Twenty Years of Federal Reserve Policy, Cambridge, MA: Harvard University Press. Harrison, G. (1928 –1929), Papers, New York: Archives of the Federal Reserve Bank of New York (unpublished). Hatry, C. C. (1939), Light Out of Darkness, London: Rich and Cowan. Hearing Before a Subcommittee of the Committee on Banking and Currency, United States Senate, Part 3. (1931), Washington, DC: U.S. Government Printing Office. Hearings of House Committee on Banking and Currency on Stabilization. (1928), April–May. Hearings of Senate Committee on Banking and Currency on BrokersÊ Loans. (1928), February–March.

BIBLIOGRAPHY

195

Hoover, H. (1952), The Memoirs of Herbert Hoover, New York: Macmillan. Ibbotson Associates. (1988), Stocks, Bonds, Bills and Inflation: 1988 Yearbook, Chicago: Ibbotson Associates. Ibbotson, R. G., and R. A. Sinquefield. (1982), Stocks, Bonds, Bills and Inflation: The Past and the Future, Charlottesville, VA: Financial Analysts Research Foundation. Investment Bankers Association of America. (1930), Proceedings of the Nineteenth Annual Convention of the Investment Bankers Association of America, Chicago. Jones, F. W., and A. D. Lowe. (1935), „Manipulation,‰ in The Security Markets, New York: Twentieth Century Fund. Kendrick, J. W. (1961), Productivity Trends in the United States, Princeton, NJ: Princeton University Press. Kindleberger, C. P. (1978), Manias, Panics, and Crashes, New York: Basic Books. Lawrence, J. S. (1929), Wall Street and Washington, Princeton, NJ: Princeton University Press. Liu, T., G. I. Santoni, and C. C. Stone. (1995), „In Search of Stock Market Bubbles: A Comment on Rappoport and White,‰ Journal of Economic History (September), 647 – 54. Macaulay, F. R., and D. Durand. (1931), Short Selling on the New York Stock Exchange, New York: Twentieth Century Fund (mimeographed). Malkiel, B. G. (1975 and 1996), A Random Walk Down Wall Street, New York: Norton. Mayer, M. (1955), Wall Street: Men and Money, New York: Harper. McDonald, F. (1962), Insull: The Rise and Fall of a Billionaire Utility Tycoon, Chicago: University of Chicago Press. Meeker, J. E. (1932), Short Selling, New York and London: Harper. Miller, A. C. (1935), „Federal Reserve Policies: 1927–1929,‰ American Economic Review (September), 447–56. Mitchell, B. (1961), Depression Decade: Volume IX, The Economic History of the United States, New York: Holt, Rinehart and Winston. Moggridge, D. (1981), The Collected Writings of John Maynard Keynes, Vol. XX, London: Macmillan. Moggridge, D. E. (1992), Maynard Keynes, An EconomistÊs Biography, London: Routledge. The National Cyclopedia of American Biography. (1932), Vol. 22, New York: James T. White, 75–76. OÊConnor, H. (1933), MellonÊs Millions, New York: John Day. The October 1987 Market Break. (1988), A Report by the Division of Market Regulation, U.S. Securities and Exchange Commission (February). Pecora, F. (1939), Wall Street Under Oath, New York: Simon and Schuster. Pedersen, J. (1961), „Some Notes on the Economic Policy of the United States During the Period 1919 – 1932, in Money, Growth and Methodology, H. Hegeland (ed.), Sweden: C.W.K. Gleerup.

196

BIBLIOGRAPHY

Pierce, P. S. (1986), The Dow Jones Averages, 1885–1985, Homewood: Dow Jones–Irwin. Rappoport, P., and E. N. White. (1993), „Was There a Bubble in the 1929 Stock Market?‰ Journal of Economic History (September), 549 – 74. Rappoport, P., and E. N. White. (1994), „Was the Crash of 1929 Expected?‰ American Economic Review (March), 271 – 81. Samuelson, P. A. (1979), „Myths and Realities About the Crash and Depression,‰ Journal of Portfolio Management (Fall). Santoni, G. J. (1987), „The Great Bull Markets 1924 – 29 and 1982 – 87: Speculative Bubbles or Economic Fundamentals?‰ Federal Reserve Bank of St. Louis Review (November), 16 – 29. Schwed, F., Jr. (1940), „Where Are the CustomersÊ Yachts?‰ New York: Simon and Schuster. Shachtman, T. (1979), The Day America Crashed, New York: Putnam. Simmons, E.H.H. (1930), The Principal Causes of the Stock Market Crisis of Nineteen Twenty-nine, Philadelphia, PA: Transportation Club. Sirkin, G. (1975), „The Stock Market of 1929 Revisited: A Note,‰ Business History Review (Summer), 223 – 31. Sloan, A. P. Jr. (1963), My Years with General Motors, Garden City, NY: Doubleday. Sobel, R. (1968), The Great Bull Market, Wall Street in the 1920s, New York: Norton. Sobel, R. (1968), Panic on Wall Street, New York: Macmillan. Soule, G. (1962), Prosperity Decade, Volume VIII, The Economic History of the United States, New York: Holt, Rinehart and Winston. Stock Market Study. (1955), Hearings before the Committee on Banking and Currency, U.S. Senate. Washington, DC: U.S. Government Printing Office. Thomas, D. L. (1967), The Plungers and the Peacocks, New York: Morrow. Thomas, G., and M. Morgan-Witts. (1979), The Day the Bubble Burst, Garden City, NY: Doubleday and Company. U.S. Senate, Subcommittee of the Committee on Banking and Currency. (1933), Stock Exchange Practices Hearings, Washington, DC: U.S. Government Printing Office. Wanniski, J. (1987), „The Smoot-Hawley Tariff and the Stock Market Crash of 1929,‰ Midland Corporate Finance Journal (Summer), 6 – 23. Warburg, P. M. (1930), The Federal Reserve System: Its Origin and Growth, New York: Macmillan. White, E. N. (1995), „Stock Market Bubbles? A Reply,‰ Journal of Economic History (September), 655 – 65. Wigmore, B. A. (1985), The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929 – 33, Westport, CT: Greenwood. Williams, J. B. (1938), The Theory of Investment Value, Cambridge, MA: Harvard University Press. WorldÊs Work. (June 1929).

BIBLIOGRAPHY

NEWSPAPERS AND OTHER PERIODICALS The Boston Daily Globe, October 1929. The Commercial and Financial Chronicle, October 1929. The Economist, 1929, 1930. The Federal Reserve Bulletin. The Financial Times, September 1929 – January 1930. The First National City Bank of New York Newsletter, 1929 – 1930. Forbes, October 15, 1925. The Listener, 1929, London. The Magazine of Wall Street, 1929. The New York Herald Tribune, September 6, 1929. The New York Times, 1929 and 1930. The Wall Street Journal, October 1929. The Washington Post, October 1929.

197

INDEX

AAA ratings, 79, 80, 177 – 78 American Can Company, 71, 120 American International Group, Inc. (AIG), 80, 86, 87 American Telephone & Telegraph (AT&T), 127 – 28, 129 Babson, Roger W., 68, 106 Baker, George, Jr., 46 Bank loans, 62, 73, 99, 107 Bank of America, 86 – 87, 107 Bank of England, 106, 168 Banking Act (1933), 44, 60 – 61, 151 Bankruptcy filings, 80 – 82, 84, 91 – 92, 107, 165 Baruch, Bernard, 173 Basel banking standards, 80 Bear market: defined, 179; lessons from, 180 – 82; stock buying during, 179 – 80. See also Stock-market Bear Stearns, 80, 81 – 83, 107 Bernanke, Ben, 91, 184 Black Thursday (October 24, 1929), 1 – 5, 19, 70, 115, 159, 161 Black Tuesday (October 29, 1929), 70, 115, 159

Bluefield Water Works v. P.S.C., 154 Blunt, John, 21 Bonbright, James C., 160 Bonds: buying, 49, 56 – 57, 66, 107, 169; common stock vs., 66; as diversifying strategy, 68; financing, 96; government, 52, 71, 89, 93, 108, 118, 125; industrial, 118, 122; mortgage, 174; from Peru, 145 – 46; prices of, 58, 74; public utility, 125; ratings, 78, 79, 181; securing loans with, 9 – 10, 41; to stock, ratio, 128, 171; trading, 91; yields from, 138 Brandeis, Louis, 150 Broker loans. See Call rates/loans Buffett, Warren, 90, 100 Burger, E. K., 123 Bush, George W. (administration), 27, 79 Business credit, 13, 41, 57, 174 Call rates/loans (broker loans): cost of, 58, 60 – 62; decreasing, 23 – 24, 34, 71, 168; as excessive, 106, 118; financing, 22 – 24, 111; increases

200

INDEX

in, 10 – 11, 66 – 67, 69 – 70, 96, 97, 110, 176; investigation of, 9 – 10; investment percentage of, 98 – 99; rates for, 58, 176; renewal of, 67; speculation and, 22 – 24, 172 Callaway, Trowbridge, 24, 63, 169 – 70 Calvin, Claud W., 145 – 46 Capital gains tax, 120, 179, 182 Carnegie, Andrew, 66 Case, J. H., 111 Cash dividends, 15, 103, 119 – 20, 163 Chandler, Lester V., 22, 31 Chase National Bank, 141, 143, 151 – 52 Citigroup, 80, 85 – 86, 92 – 93, 107 Clearing House Committee, 42 Clews, Henry, 105 Closed-end mutual funds, 100, 101 – 2 College Retirement Equities Fund (CREF), 93 – 94 The Commercial and Financial Chronicle, 66, 67 – 69, 106, 154 Commodity prices, 6, 118, 133 Common stock: in bear market, 183; bonds vs., 66; borrowing cost of, 168; discount rate of, 126; government purchase of, 81; margins for, 97; portfolio mix of, 70, 85, 164; price decreases in, 73, 107, 182; in public utilities, 98, 165; shortselling and, 107; for steel industry, 129; of trusts, 101; value of, 9 – 10, 96, 125, 161, 164; yields, 122 Congress. See House Committee on Banking and Currency; Senate Committee on Banking and Currency Consolidated Supervised Entity (CSE) program, 82–83 Continental Can Company, 120 Coolidge, Calvin, 21, 31 Corporations: broker loans and, 111; earnings data for, 120, 130, 134 – 37; performance data, 15;

profit by, 78; securities from, 106; spending by, 81. See also specific corporations Credit: for banks, 46 – 47, 50 – 51; for business, 13, 41, 57, 174; discount rate and, 26, 36, 40, 45 – 46, 51; expansion of, 110; Federal Reserve Bank and, 42, 45 – 47, 58, 87; Federal Reserve Board and, 32, 37 – 38, 43, 63, 75, 98, 168; myths about, 25, 172; paying off, 78, 97, 165, 174, 181; policy, 39, 46; price of, 24; ratings, 18, 80, 86, 173, 181, 182, 184; restricting, 10, 17, 22 – 24, 59, 98, 106, 168, 170; for speculation, 12 – 14, 30 – 31, 50 – 60, 63, 67, 74, 111; unfreezing, 81, 85, 181 Credit default swaps (CDSs): counterparty risks with, 181; defined, 18; failure of, 78, 86, 174; fixed fees for, 181; for mortgages, 177 – 78; regulating, 107; subprime mortgages and, 80 CSE. See Consolidated Supervised Entity Cunningham, E. H., 12, 21, 34 Cuomo, Andrew, 81 Debt: borrowing and, 35, 46; common stock and, 101; defaulting on, 86; equity ratios, 89; excessive, 78, 83, 85 – 86, 165; FDIC guarantee for, 92; as financing, 122, 162; leverage from, 17, 78, 91, 108, 163, 164; long-term, 3, 174; low-cost, 184; on margin, 98, 105, 164; mortgage, 80 – 82, 94, 107, 174, 181; paying off, 84, 150; price-earnings ratio and, 4; reducing, 49; risks from, 87 – 88; for securities, 20, 118, 181; short-term, 174, 182 Department of the Treasury, 183 Derivatives, 89 – 90 Dice, C. A., 14 – 15

INDEX Discount rate: credit and, 26, 39, 40, 45 – 46, 51; defined, 23; Federal Reserve Bank and, 40 – 41, 45, 55 – 56, 57, 71, 110 – 11, 168; Federal Reserve Board and, 44, 48, 52, 57; fixing, 13; increasing, 23, 36, 40, 67, 106, 111 – 13, 168; priceearnings ratio and, 126; reducing, 22, 31, 71, 168 Dividends: cash, 15, 103, 119 – 20, 163; dispersing, 53; extra, 71; increasing, 15, 120, 130, 156; payment rates, 125 – 27; price-earnings ratio and, 5, 125; reducing, 85, 152; stock as, 103; stock prices vs., 68, 101, 103, 156; from trusts, 163; from utility stocks, 108; valuation model for, 129, 131; yields, 3, 97 – 99, 122 – 23, 128, 168, 176 Dodd, D. L., 129 Dow Jones Industrial Stock Index: in 2008, 77; in 1922–1929, 1 – 5, 43, 127; railroad index, 5, 154 – 55; recovery of, 19; utility index, 154 – 56, 165 Drew, Daniel, 105 Durand, David, 105 Earnings data, 120, 130, 134 – 37 Economic fundamentals, 117 – 18, 132 Economist, 5 – 7, 16, 64 – 65, 100, 155 Edison Electric Illuminating Company, 106, 154, 156 – 60, 168 Efficient market hypothesis (EMH), 174 The Evening World, 68 Factory production, 6, 118, 133 Fannie Mae/Freddie Mac, 49, 80, 95 Farming productivity, 118 Federal Advisory Council, 36, 48 Federal Deposit Insurance Corporation (FDIC), 92 Federal Power Commission v. Hope Natural Gas Company, 154

201

Federal Reserve Act, 12, 38, 50 Federal Reserve Bank: during 2000– 2009, 49; broker loans and, 66, 111; credit and, 42, 45 – 47, 58, 87; Federal Reserve Board vs., 29 – 30, 34 – 49, 52 – 54; government bonds and, 71; 1929 letter to, 50 – 51; real estate market and, 49; rediscount rate and, 40 – 41, 45, 55 – 56, 57, 71, 110 – 11, 168; speculative loans by, 22, 23, 29, 55 – 56, 109 – 11 Federal Reserve Board: broker loans and, 10 – 11; Citigroup rescue by, 80; credit and, 32, 37 – 38, 43, 63, 75, 98, 168; denouncement of, 59 – 60; discount rate and, 44, 48, 52, 57; easy money policies of, 17; Federal Reserve Bank vs., 29 – 30, 34 – 49, 52 – 54; interest rates and, 174; Long-Term Capital Management rescue by, 89 – 91; members before 1929, 21 – 22; role in 2008 crash, 91 – 92, 184; Senate hearings and, 61; speculation and, 9, 23 – 25, 29, 55 – 56, 74 – 75 Federal Reserve Bulletin: broker loans and, 98; credit and, 23, 43, 60, 63; production and, 5 – 6, 118; real economy and, 47; securities loans and, 38 – 39; speculative loans and, 38 Federal Trade Commission (FTC), 160 Financial & Industrial Securities Corporation, 103 Financial Times, 64 – 65, 158 First National Bank, 42, 46 – 47, 110, 176 First National City Bank, 99 – 100 Fisher, Irving: manufacturing sector and, 117; market boom and, 116; market prediction by, 175; priceearnings ratios and, 4; stock decreases and, 72 – 73, 169, 179 Flood, R. R., 20

202

INDEX

Florence, P. Sergeant, 116 Forbes, 6 – 7, 25, 70, 123 Forbes, B. C., 66 – 67, 70 Forbes, Harry, 149 Fortune, 86, 169 Friedman, M., 24 Funston, G. Keith, 138 Galbraith, John Kenneth, 2, 63 – 64, 72, 116 – 17 Garber, R. M., 20 General Electric (GE), 84 – 85, 107, 170 Glass, Carter, 10 – 12, 43 – 44, 54, 59 – 60, 62 Goldenweiser, E. A., 38 Goldman Sachs Trading Corporation, 72, 82, 90, 92, 101, 102 – 3 Government bonds, 52, 71, 89, 108, 118, 125 Government policies (2000 – 2009), 77 – 78, 87 Graham, B., 129 Great Depression, 20, 26, 74, 175 Greenspan, Alan, 17, 91 Gross, Daniel, 78 Gross national product (GNP), 5, 124 Guaranty Trust Company, 45, 46, 110 Hamlin, Charles S., 12, 13, 21 – 22, 33, 35 – 37, 112 – 13 Hard, William, 31 Harding, Warren G., 21 Harrison, George, 32 – 42, 44 – 48, 59 – 60, 109 – 11 Hatry investment firm scandal, 106, 113, 168, 176 Hawley-Smoot Act, 26 High-risk securities, 94, 95, 184 Holmes, Oliver Wendell, 32 Hoover, Herbert: discount rate and, 39 – 40; election of, 31, 32; speculation and, 44, 57, 65, 142, 170 – 71 House Committee on Banking and Currency, 9, 12

Ibbotson, R. G., 116 Industrial bonds, 118, 122 Industrial production, 6, 125, 129 – 32 Industrial Revolution, 119 Inflation: mortgage loans and, 78; reducing, 52, 65, 69; in securities prices, 11, 154 Insull, Sam, 141, 144, 145 Interest rates: increasing, 41 – 42, 48; long-term, 18, 49; lowering, 77 – 78, 174; real estate prices and, 17 – 18, 77 – 78; speculation and, 17 – 18, 52 – 54 Internal Revenue Service (IRS), 148, 149 Investment Bankers Association of America, 24, 63, 160 – 61, 169 Investment-grade securities, 177 – 78 Investors/investments: in 1929 stockmarket, 65 – 71; call loans and, 98 – 99; environment for, 65 – 71; lessons for, 92 – 93, 174, 181, 183; mutual funds, 89, 100, 101 – 2; outlook concerns for, 68; pools, 103 – 4, 147; psychology of, 175; speculation and, 100 – 104, 107; trusts, 71 – 72, 100 – 102, 163, 164; wealth target for, 182 J. P. Morgan Chase, 80 – 82, 92, 145, 147 – 48, 150 J. W. Seligman & Co., 145 James, George R., 21, 34, 36 Jarvis, Ian, 18 Kansas City Reserve Bank, 31 – 32 Kaufman, Henry, 177 Kendrick, J. W., 118 – 19 Keynes, John Maynard, 3, 15 – 16, 19, 116, 175, 179 – 80 Kindleberger, C. R., 20, 63 Krugman, Paul, 94 LaFollette, Robert, 10, 64 Latin American loans, 146

INDEX Lawrence, Joseph Stagg, 118, 119, 169 Lehman Brothers, 80, 81 – 84, 91 – 92, 94 – 95, 107 Leinbach, A. M., 123 Levy, I. M., 56 London Stock Exchange, 106 Long-Term Capital Management (LTCM), 89 – 91 Long-term debt, 3, 174 Long-term interest rates, 18, 49 Lowenstein, Robert, 91 Macaulay, F. R., 105 The Magazine of Wall Street, 6 – 7, 9, 67, 71, 98, 120, 123, 125 Malkiel, Burton G., 3, 4, 15, 63, 100, 127, 152 March 1929 panic: Banking Act and, 44, 60 – 61; conclusions from, 62; money rate decrease, 45; overview, 55 – 60; price of credit and, 24; Senate hearings over, 61; stock market crash and, 39, 41 – 47. See also Stock-market (1929) Margins: buyers of, 58, 96 – 100, 175; for common stock, 97; debt on, 98, 105, 164; NYSE and, 96 – 98 Market myths: before 1929, 21 – 22; during 1929, 115 – 17, 171 – 73; during 2009, 27; economic fundamentals and, 117 – 18; Hawley-Smoot Act and, 26; historical data vs., 25 – 26; market levels and, 125 – 27; overview, 19 – 21; production/ productivity and, 118 – 33; Sirkin study and, 131 – 32; stock prices/ value and, 127 – 30; stock speculation and, 22 – 25 Massachusetts Public Utility Commission, 156 – 60, 168, 176, 181 Mayer, Martin, 105 McGarrah, G. W., 46 Mellon, Andrew, 42, 45, 55 – 57, 169 Merrill Lynch, 82, 83, 86 – 87

203

Merton, Robert, 89 Miller, Adolph: credit and, 12 – 14; discount rates and, 111 – 12; speculative loans and, 21 – 22, 64; stock market crash and, 30 – 31, 33, 35 – 40, 44, 47; stock prices and, 75 Mills, Frederick C., 12 Mississippi Bubble, 20 Mitchell, Charles E.: March 1929 panic and, 52 – 54, 59 – 62; stock prices and, 142 – 43, 177; tax problems of, 143, 144, 147 – 50; testimony by, 142 – 51. See also National City Bank Mitchell, D. E., 40, 42 – 43 Morgan Stanley, 81, 92 Mortgage-backed securities, 83, 174 Mortgages/mortgage payments: defaults, 17, 49, 80, 174; loan requirements for, 79 – 80, 173; securities and, 78, 83 – 85, 89, 177 – 78. See also Subprime mortgages/ markets Mullins, David, 89 Mutual funds, 89, 100, 101 – 2 National Bank of Commerce, 34, 35, 126 National City Bank: call rates and, 24, 43, 52 – 53, 99; growth rate of, 126; lending practices of, 52 – 53, 59 – 62; marketing by, 145; Peruvian bonds and, 145 – 46; speculation and, 122 – 23; stock market crash and, 99 – 100. See also Mitchell, Charles E. Net profits data. See Earnings data New York Bank, 35 New York City Reserve Bank, 23, 99 New York Evening Post, 15 – 16 New York Stock Exchange (NYSE): Black Thursday, 1 – 2; broker loans and, 34, 66, 70; investment pools and, 103 – 4; margins and, 96 – 98; securitiesÊ value on, 96 – 97;

204

INDEX

short-selling and, 105; speculation and, 10, 31, 63, 64; stock market crash and, 74 New York Times, 6, 55, 157, 160 – 61 New York Times Magazine, 66 Newton, Issac, 21 Norbeck, Peter, 109 – 13, 144 Norman, Montagu, 35 Open Market Investment Committee, 34 Pecora, Ferdinand, 52 – 53, 61, 64, 104, 141, 143 – 44, 146. See also Senate Committee on Banking and Currency Pennsylvania Railroad, 130 Peruvian bonds, 145 – 46 Platt, Edmund, 11 – 12, 21, 33, 36, 38, 45, 141 Potter, William C., 45 – 46 Price-earnings ratio (P/E): in 2008, 77; Black Thursday and, 3 – 5; debt and, 4; discount rate and, 126; distribution of, 131; dividends and, 5, 125; growth in, 131; multipliers, 126; stock prices and, 85, 117 – 18, 122 – 23; for utility stocks, 161 Private equity lending, 79 Production/productivity (1920 – 1929), 118 – 33 Psychology of investment, 175 Public utility stocks/bonds: common stock and, 98, 165; dividends from, 108; Edison Electric Illuminating Company, 106, 156 – 60; electric rates and, 173; investing in, 108; leverage and, 164 – 65; Massachusetts Public Utility Commission, 156 – 58; multipliers, 162 – 63; as overpriced, 163 – 64; prices of, 154 – 55, 161, 181 – 82; rate equity base of, 153; yields, 125

Radio Corporation of America (RCA), 4, 58, 60 Real economy, 5 – 7, 175 Real estate: inflation of, 78; interest rates and, 17 – 18, 77 – 78; price declines, 17, 79, 181. See also Mortgages/mortgage payments Rediscount rate. See Discount rate Reynolds, Jackson, 42 Ripley, W. Z., 72 Risk vs. debt, 87 – 88 Robertson, Dennis, 116 Roosevelt, Franklin Delano, 65, 145 – 47 Ruth, Babe, 70 Samuelson, Paul A., 2, 116 – 17 Scholes, Myron, 89 Schwartz, Anna. J., 24, 184 Securities: credit for, 13, 57 – 58; debt for, 20 – 21, 118, 181; depreciation of, 53 – 54, 61; discount rate and, 22; discounting, 67; financing, 58, 64, 142; high-risk, 94, 95, 184; investment-grade, 177 – 78; investment pools and, 104; loans for, 39, 46; mortgage, 78, 83 – 85, 89, 177 – 78; price of, 11, 30, 98, 170, 174; ratings for, 79; selling, 20, 106; speculation and, 91, 97; utility, 164 – 65; value of, 74, 96, 101, 165 Securities Exchange Act, 97 Security and Exchange Commission (SEC), 82 – 83 Senate (U.S.), 3, 23, 63, 64 Senate Committee on Banking and Currency, 9 – 10, 97; Hamlin, Charles S. testimony, 112 – 13; Harrison, George L. testimony, 109 – 11; Miller, Adolph testimony, 111 – 12; Mitchell, Charles E. testimony, 142 – 51; Stock Market Study, 138 – 39; Wiggin, Albert H. testimony, 151 – 52

INDEX Short-selling, 104 – 5, 107 – 8, 172, 179 Short-term debt, 174, 182 Simmons, E.H.H., 176 Sinquefield, R. A., 116 Sirkin, Gerald, 25, 131 – 32 Sirkin study, 131 – 32 Smoot-Hawley Tariff Act, 74 Snowden, Philip, 64 – 65, 95 Social Security, 27 Soros, George, 107 South Sea Bubble, 20 – 21, 129 Speculation /speculators: broker loans and, 13, 22 – 24, 69; crash of 1929 and, 105 – 7; credit use and, 12 – 14, 30 – 31, 50 – 60, 63, 67, 74, 111; defined, 64 – 65; focus on, 127; Goldman Sachs and, 102 – 3; interest rates and, 17 – 18, 52 – 54; investment pools and, 103 – 4, 147; investment trusts and, 100 – 102; loans and, 55 – 57, 109 – 11; margin buying and, 97 – 100; market myths and, 22 – 25, 171 – 73; short-selling and, 104 – 5, 107 – 8, 172; Soros recommendation and, 107 Standard and PoorÊs (S&P) index, 101 Steuer, Max D., 147 Stock-market (1929): avoidance of, 173; causes of, 16 – 17, 30, 165, 175 – 76; forced accounting and, 68; investment environment of, 65 – 71; investment trusts during, 71 – 72; lessons from, 174 – 77, 180 – 83; market boom, 3, 7, 144; market crash, 3, 7, 26, 113, 115; myths of, 115 – 17, 171 – 73; overview, 1 – 5, 63 – 65, 70; predictions and, 177; real economy and, 5 – 7; reality of, 74; recovery from, 59, 71; short-selling and, 104 – 5; SmootHawley Tariff Act, 74; stock prices during, 105 – 7, 167 – 68. See also March 1929 panic; Market myths; Speculation /speculators

205

Stock-market (2008 – 2009): American International Group and, 80, 86, 87; avoidance of, 173 – 74; Bear Stearns and, 81 – 83; causes of, 78 – 79, 165; Citigroup and, 80, 85 – 86, 92 – 93; College Retirement Equities Fund and, 93 – 94; CSE program audit, 82 – 83; debt and risk with, 87 – 88; FDIC guarantee, 92; Federal Reserve board role, 91 – 92; financial markets during, 78 – 81; General Electric and, 84 – 85; government policies and, 77 – 78; Lehman Brothers and, 80 – 84; lessons from, 92 – 93, 180 – 82, 183; Long-Term Capital Management and, 89 – 91; Merryl Lynch and, 86 – 87; overview, 17 – 18; panic from, 78; shortselling, 107 – 8; Troubled Asset Relief Program and, 81; warnings ignored, 94. See also Market myths Stock Market Study, 138 – 39 Stock prices: bonds and, 56 – 57; for commodities, 6, 118, 133; comparisons of, 3 – 4; decreases in, 17, 42 – 43, 54, 62, 67, 110; dividends and, 68, 101, 103, 156; increases in, 17, 49, 117 – 18, 128 – 33; myths about, 25, 127 – 30, 172; priceearnings ratio and, 85, 117 – 18, 122 – 23; for public utilities, 154 – 55, 161, 181 – 82; speculation and, 57; with splits, 157 – 58, 182; values and, 67, 116, 119, 127 – 30 Strong, Benjamin, 22, 23, 30 – 34 Subprime mortgages/markets: Citigroup and, 85 – 86; credit default swaps and, 18, 78, 80; debt and, 81 – 82, 94, 107; default of, 17, 182; expansion of, 177 – 78, 181; financial requirements for, 77 – 78; real estate prices and, 49; riskiness of, 88, 173 – 74; value of, 84 Supreme Court (U.S.), 32, 150

206 Taylor, Myron C., 64, 170 Temporary National Economic Committee of Congress, 151 The Times, 14, 60, 144 – 48, 152, 156 – 57, 160, 164 Treasury bonds. See Government bonds Troubled Asset Relief Program (TARP), 81, 184 Trusts, 71 – 72, 100 – 102, 163 – 64 Tulip Bubble, 20 U.S. Electric Light & Power, 165 U.S. Government accusations, 141 – 42 U.S. Steel, 66, 68–69, 71, 129–30, 170 Utility stocks. See Public utility stocks/bonds Variety (magazine), 15

INDEX Walker, Jimmy, 160 Wall Street Journal, 5, 6, 17, 65, 102, 103, 159 – 60, 164 Wanniski, J., 74 Warburg, Paul M., 48 Wessel, David, 91 Western Electric Company, 128 – 29, 151 Wiggin, Albert Henry, 64, 141 – 42, 144, 151 – 52 Wigmore, Barrie, 4, 96, 97, 100, 123 Williams, J. B., 128 – 29 Willis, H. Parker, 10 Wingo, Effiegene Loeke, 14 Wingo, Otis, 12 – 14 Young, Owen G., 170 Young, Roy, 10 – 11, 13 – 14, 22; broker loans and, 10 – 11; credit and, 57; speculation and, 65, 171; stock market crash and, 21 – 22, 32 – 36, 38 – 44, 48, 60; testimony of, 13 – 14

ABOUT THE AUTHOR

HAROLD BIERMAN, JR. is the Nicholas H. Noyes Professor of Business Administration at the Johnson Graduate School of Management, Cornell University. A graduate of the U.S. Naval Academy, Annapolis, he received his MBA and his Ph.D. from the University of Michigan. A Cornell faculty member since 1956, Professor Bierman formerly taught at Louisiana State University, the University of Michigan, and the University of Chicago. He has also taught at INSEAD in Fountainebleau, France and KUL in Belgium. He was a visiting scholar at Cambridge University. He was a recipient of the Dow Jones Award from the American Assembly of Collegiate Schools of Business for his outstanding contributions to collegiate business education. He served as a financial consultant at Prudential Bache Securities in New York in 1986. His industrial experience includes consulting for Corning Glass Corporation, Eastman Kodak, Sun Oil Company, Exxon Oil Corporation, IBM, Emerson Electric, and Xerox Corporation. He has written thirty-two books, including The Capital Budgeting Decision (with Seymour Smidt), Financial Accounting, Managerial Accounting, Quantitative Analysis for Business Decisions, and more than a hundred-eighty journal articles.