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Examining Credit Crunches Around The World

February 26 2009| Filed Under » , , , , , , , ,


Whether they're called credit crunches, panics, or financial crises, large negative moves in financial markets have been occurring since free-market trading began. In the markets, emotion sometimes overcomes reason and rational decision-making gives way to greed or fear. Excessive greed leads to bubbles and sows the seeds for future panic. As the history of the financial markets has shown, panic in the markets can often lead to a crash. Let's take a look at some of the most notorious market bubbles and crashes around the world.

Early Market Crashes
Perhaps the most famous example of an early market bubble is the Dutch tulip craze of the 1630s. Tulips had been introduced into the country 30 years earlier, and were widely sought after for their beauty as well as the scarcity of certain unique color patterns. As more and more speculators began crowding into the market, prices rose and a market bubble built to the point that some rare tulip bulbs were worth as much as a house on a canal. As some speculators began selling their tulips, prices fell, and as more tulip owners rushed to lock in their profits, a downward spiral occurred. In short order, tulips were once again priced similarly to other plants or vegetables, but the sharp decline resulted in large losses for many people and caused an economic depression.

In the early 1700s, Great Britain experienced a bubble of its own when the South Sea Company purchased a monopoly on trade in the Orient and the company saw its share prices rise exponentially. When it was later discovered that company officials had sold all of their personal holdings, prices plummeted and the government was forced to step in to stabilize the market. These government interventions have become a hallmark of financial crises.

In 1907, the United States suffered a panic of its own. Prompted by a recession, a declining stock market, and the failure of an attempt to corner the stock of the United Copper Company, customers began to question the safety of the New York trust companies. Anxious depositors rushed to their banks to withdraw their savings, but because the banks didn't have enough money on hand to satisfy all their customers, panic ensued and banks began to fail. This run on the banks was only mitigated when J.P. Morgan personally organized an effort to stabilize the banking system. The Bank Panic of 1907 prompted the U.S. government to create the Federal Reserve System (FRS) several years later. (To learn more, read The Kingpin Of Wall Street: J.P. Morgan.)

Stock Market Crash of 1929
Perhaps the most well-known market crash occurred in 1929 in the United States. Following an enormous run-up in stock prices during the Roaring '20s, valuations were at extreme levels and speculation was rampant. Panic set in as the market declined throughout the months of September and October, culminating in Black Tuesday on October 29, 1929. News accounts famously tell of bankrupt stockbrokers leaping from the roofs of buildings. Ultimately, the market would fall 89% from its highs and would still be lower in the 1950s than it had been before 1929.

Economists debate how much of an influence the market crash had on the ensuing economic slowdown, but October 29, 1929, is commonly cited as a starting point for what would become the worst global depression of the twentieth century. (For more, see The Crash Of 1929 - Could It Happen Again?)

The 1980s
In the 1980s, bubbles and crashes began to occur with greater frequency. As oil prices soared in the 1970s, oil exporting nations deposited their newfound wealth in international banks, which turned around and lent the money to rapidly developing Latin American countries. When interest rates rose in the early 1980s, investors began to suspect that the Latin American countries would have difficulty repaying their debts. These fears were confirmed in 1982 when Mexico informed the United States that it would be unable to repay its debt. Banks subsequently refused to refinance other Latin nations' debt, leading to more defaults. These defaults threatened the solvency of some of the largest U.S. banks, prompting the U.S. government to assist in restructuring Latin American debt.

The 1980s also saw the savings and loan (S&L) crisis in the U.S. Following deregulation in the industry, S&Ls began paying higher interest rates on short-term deposits and investing in riskier assets. In particular, the S&Ls invested heavily in questionable real estate deals, which appeared attractive during the bull market of the 1980s. As losses in the industry mounted, the federal government formed the Resolution Trust Corporation (RTC) and orchestrated a rescue of the industry. While the government's actions prevented a financial collapse, more than 500 S&Ls ultimately failed and the country suffered a severe recession in 1990 and 1991. (For more insight, see Digging Deeper Into Bull And Bear Markets.)

The 1980s witnessed two of the greatest bull markets of the century in U.S. equities and in Japanese equities and real estate. The U.S. bull market crashed on Black Monday in October 1987 as the stock market suffered its worst ever one-day loss, falling 22.6%. The cause of the crash is still debated, but excessive valuations and overconfidence among market participants played a role. The crash itself was exacerbated by new computerized trading programs and margin calls. Although the one-day decline was extremely severe, aggressive actions by the Federal Reserve helped assure the solvency of the financial system. The U.S. economy avoided a recession and ultimately, the crash proved to be a momentary pause in a long-term bull market.

Japan's crash was less dramatic but the results were far worse. The Japanese bubbles were so enormous that by the late 1980s it was estimated that the real estate underneath the RoyalPalace in Tokyo was worth more than the entire state of California. Although Japan's markets never suffered a short-term decline of the magnitude seen in the United States in 1987, when the equity and real estate markets reversed course, the country's banking system was severely damaged and the economy entered into a prolonged recession. In 2008, Japanese stocks remain more than 75% below the highs seen in 1989.

The 1990s
The 1990s also saw a number of market crashes. In 1994, Mexico again experienced financial difficulties after devaluing its currency. Economic chaos threatened Mexico, but Treasury Secretary Robert Rubin worried about the effect this might have on the United States, and engineered a controversial bailout for Mexico.

A more severe emerging market crisis unfolded in 1997 after Thailand defaulted on its currency, the Thai baht. Panic swept across Asia as speculators attacked the region's currencies and sold its stocks. Many Asian countries entered a severe recession and the crisis soon spread beyond Asia, eventually reaching Russia in the summer of 1998. As Russia's economy hovered on the edge of bankruptcy, the International Monetary Fund (IMF) put together a bailout package designed to save the former superpower.

In the United States, the 1990s proved to be a remarkable bull market in stocks. In particular, the technology-heavy Nasdaq market soared. U.S. taxi drivers quit their jobs in order to become day traders. However, the crisis in Asia reached the United States when the hedge fund Long-Term Capital Management (LTCM) began to fail in 1998. It was believed that LTCM's collapse could threaten the stability of the international financial system. The New York Federal Reserve gathered the heads of the largest Wall Street banks and orchestrated a bailout of LTCM, thereby averting the danger of a systemic collapse of the financial system. (For related reading, see Massive Hedge Fund Failures.)

The late 1990s and early 2000s also saw another debt crisis in Latin America when Argentina, at the time one of the biggest borrowers of emerging market debt, defaulted on its obligations. The default led to a depression in Argentina and prompted large losses for emerging market investors.

Today
Much of the money that left the stock market after the Nasdaq crash eventually found its way into the real estate market, prompting the speculative housing bubble in the United States that occured during 2003-2006. The bursting of that bubble precipitated the credit crisis of 2007-2008 and presented the greatest threat of systemic failure of the global financial system since the 1930s. However, what we can learn from history's crashes is that markets can and do recover if given enough time - even if it's only to crash again.
by

Brian Perry

Brian Perry
Brian Perry is the author of From Piggybank to Portfolio: A Financial Roadmap for New Investors (2011) and also serves as a portfolio manager/strategist at an asset management firm. Brian has contributed numerous articles to investment industry publications, is a frequent speaker at investment conferences and charity events, and has appeared on NBC news to discuss the financial markets. Brian previously worked as a fixed income trader for an investment bank, where he was responsible for trading government, corporate and emerging market securities. Brian has a bachelor’s degree in finance from Villanova University, an MBA in international business from National University, and a master’s degree in international affairs from the Fletcher School at Tufts University. He also holds the designation of Chartered Financial Analyst (CFA).
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