Stock Market Crash Of 1929

Cheap and easy credit. That’s what the crash was really all about. Greed. And a big, bad bear market nobody could have imagined happening. Non-professional, retail investors were allowed to borrow some 90% of their investment portfolio to go buy new stocks beyond the stocks they already owned.

So...quick math: if someone invested $1,000 of their own hard-earned savings, and the stock tripled, like it did in the mid-’20s for a lot of easy money stocks, then that $1,000 would have become $3,000 in a short period of time. Duh. Great. But, in fact, margin rules were almost non-existent in the era. It was common to allow investors to have 3, 4, or 5 times their invested equity as borrowed margin. Or, said another way, on an initial $1,000 invested, many investors were stupidly allowed to buy $5,000 worth of stocks.

But let’s take a simpler approach. If an investor had been allowed to margin their account up to 90% of its value, then that investor, on $1,000 of their own capital, could have purchased $1,900 worth of that stock that tripled. Doing the math, 3 times $1,900 gets you $5,700. You pay back the $900 of margin that you borrowed against yourself, and you will have netted something like $4,800, albeit a little bit less, because you will have paid interest to the brokerage that allowed you to borrow money in this manner.

So, in the margin case, the $1,000 of your invested capital made you 4.8 times your money, rather than 3 times your money. And that’s way more dough to crow about. In those days, the extra $1,800 would have bought you, like...a house. So everything was great in 1926, 1927, 1928...when the market mostly, generally went up and provided easy money for the well-heeled investors who could play the game. And everyone was incentivized to keep the party rolling. Brokerages could charge fat commissions on transactions and nobody complained, because the market’s rise more than paid for those commissions. Brokerages could also charge big interest rates on borrowed margin, because the market’s rise masked all those costs. And everything ended up sweet and beautiful, as the prince married the princess, and they went off to their castle in the clouds.

Oh, but wait...then reality struck. One day, a not-so-kindly old woman offered Snow White the apple. She bit…and the market went down. And down. And down. Such that panic selling ensued, and more or less everyone who was on the hook to pay back borrowed money in the form of margin had their loans called immediately by the brokerages, as they lost more than everything...meaning that not only did the investors lose their investments, but the brokerages who had underwritten those loans themselves went bankrupt, because the stocks went down so far that even the margin limit covenants were violated.

On the stock purchased for $1,000 with the $900 of margin, that $1,000 worth of stock ended up being worth $500 or less, so even if the brokerage sold every share of that original $1,000 investment, now worth only $500, the $500 in original value remaining didn’t even come close to covering the $900 in margin the brokerage’s client took out in loans in the first place.

Yes, it sounds like the crazy, maddening crowds at work…and the crowds back then were mad. Everyone was buying on margin...and if you weren’t, well then you were just another sucker hauling bricks or ice or railroad ties for a living. Life was way easier when you could just phone in a stop order and play golf all day. So this was bad. And a half. And as part of the process of investors panicking, they lost trust in the financial system of America. Many investors then wanted to sleep on a pile of their hard-earned, saved $20 bills. They ran to the banks en masse, and asked for withdrawal money, which the banks didn’t have.

So the frame, then...was a failed stock market. Lack of trust in the banking system in America. No credit offered to pretty much anyone. And no adult supervision to get this country out of the deep financial hole it had dug. Well, along came FDR with the New Deal. He primed the pump in creating federal guarantees for banking deposits up to a certain amount. He also enforced vastly stricter regulations on banks, brokerages, and pretty much anything financial, such that, going forward, this country ran a dramatically more conservative balance sheet.

The result? Gradually, greed came to overtake fear, and the market slowly trundled northward.