'I can calculate the motion of heavenly bodies, but not the madness of people.'
From The Globe and Mail | Saturday, July 21, 2012
Human nature has been the driving force behind repeated market crashes and financial crises over the past 300 years. Ora Morison takes a look at some of the financial fiascoes that resulted in panic and massive losses. By ORA MORISON
Fear and greed, fundamental influences on human behaviour, mean we are destined to repeat these financial mistakes in the future, said Stephen Foerster, a finance and economics professor at the Richard Ivey School of Business at the University of Western Ontario in London, Ont. “The game does not change and neither does human nature,” he said. A short history of major financial crises over the past few hundred years:
Dutch Tulip Mania, 1637
The trade of rare tulip bulbs that produced distinctively coloured flowers reached manic proportion in the Netherlands. Traders bid up prices so high that people borrowed huge sums to buy bulbs they believed or were told would appreciate even further. By 1610, a single tulip bulb of a new variety could be given as a dowry for a bride. When unjustifiably high prices came crashing down, the bulbs were bust.
South Sea Bubble, 1720
The British South Sea Company, which had King George I as its governor, planned to take over British national debt incurred during a war with Spain. The company expected to compensate itself for taking on these debts through appreciation in its share price. Company promoters promised huge dividends and bribed prominent individuals to show interest in the stock, which did see a huge rise in 1720. By the fall, however, overinflated prices collapsed, and the ensuing panic brought down shares in other companies as well. An inquiry into the event showed at least three ministers in the House of Commons had accepted bribes. Sir Isaac Newton himself invested during the bubble and lost €20,000 pounds in the ordeal.
The Panic of 1907
An earthquake in San Francisco in 1906 led to devastation in the city and kept gold from reaching major financial centres. This triggered the bankruptcy of two brokerage firms in the U.S., compounding a growing distrust of the American financial system at the time, which was tied to increasing economic and social inequality. The bankruptcies triggered a six-week long run on the banks in the fall of 1907.
Savings and Loan scandal, 1985
Following financial deregulation in the United States in the 1980s, small, local banks that offered home loans were permitted to make more complex, riskier financial transactions to compete with larger commercial banks. This ultimately pushed many local banks into bankruptcy, setting off a bank run as consumers feared their deposits would evaporate. The U.S. government did insure many of the customers deposits, and was forced to bail out the local banks to the tune of about $150-billion.
Long Term Capital Management, 1998
When Russia defaulted on government bonds in 1998, global investors fled to the safety of U.S. government debt. The result was a catastrophe for New York-based Long Term Capital Management LP, a hedge fund that made billion-dollar bets, mostly with borrowed money, on the interest rate spread between risky bonds and U.S. Treasury bills. Safety-seeking investors drove down the price of securities held by Long Term Capital and pushed up the value of U.S. Treasury bills. The Fed and major financial institutions bailed out the hedge fund for $3.65-billion when it became clear that its bad bets threatened commercial banks that lent to the fund, as well as the banks’ customers.
Subprime mortgage crisis, 2007-08
Home prices in the U.S. skyrocketed as lenders used “teaser” rates to entice consumers into “subprime mortgages,” enabling them to purchase homes at prices they could otherwise not afford. When these consumers were burned by unaffordable double-digit rates that kicked in later, the housing market collapsed, leaving banks around the world with “toxic” debt. This debt, which investment banks had purchased in bundles and then sold to investors as low-risk investments, had plunged in value. Shares on the Dow Jones industrial average tanked 33.8 per cent in 2008 and most of the world was in deep recession by the end of that year, which triggered the ongoing euro crisis.