A History on Financial Crashes and Bubble Bursts: Part 1

In 2008 we witnessed a global recession that affected tens of millions of people worldwide. Names like Freddie Mac and Lehman Brothers, and terms like housing bubble, liquidity crisis, over-leveraged, commodity boom dominated global headlines. Stock markets worldwide lost trillions of dollars in value, banks worldwide collapsed and millions of people were eventually left homeless.

Newcomers to the world of finance are often unaware that financial crashes and bubbles have occurred many times, the first of which dates back to the 1600s. This article explains several of the largest financial crashes and bubbles that occurred from 1637-1837.

The Tulip Crash of 1637

Tulip mania was a period during the Dutch Golden Age when contracts for tulip bulbs reached extremely high prices and then collapsed. The Tulip Crash is widely considered to be the first ever speculative bubble. Gordon Gecko, the famed financial villain in the film Wall Street 2: Money Never Sleeps, actually displayed a poster depicting a graph of the Tulip Mania event in his office.

Tulips were introduced to Europe from the Ottoman Empire in the mid-16th century and became very popular in the Netherlands - then known as the United Provinces. Tulips grew in popularity quickly, becoming a luxury item and status symbol, and to this day remain a symbol of the Netherlands.

Tulips only bloom for about five weeks in the spring and the bulbs can be uprooted and transported for only four months a year, which was the only time of the year when purchases of the tulips were made (and can be referred to as a spot market, when products are physically delivered.)

Contracts for tulips similar to those of modern-day futures were traded throughout the rest of the year, which promised the delivery of tulips at a specified date in the future at an agreed upon price. As the flowers grew in popularity, professional growers began to pay higher prices for the bulbs. At the peak, the bulbs from tulips were selling for a modern-day price of over $100,000, which was more than 10 times the annual income of the average skilled laborer.

An official futures market was established at the end of 1636, where contracts to buy bulbs at the end of the season were bought and sold amongst individuals. The futures market was short-lived, as speculators flooded the market, buying contracts only with the intent to sell at a higher price and no intention of ever accepting real deliveries.

In February 1637, tulip prices crashed abruptly when the vast majority of holders of the contracts started to question if a flower can hold such artificially high value. Buyers of contracts wanted to bail out and cash in profits while the getting was good. Of course, when sellers flood any market and drastically outnumber buyers, a crash ensues.

The trading of tulips was brought to a halt as the market officially collapsed. Holders of futures contracts were left with a very expensive piece of paper, and tulip bulb owners held a commodity which was worth a fraction of what they paid for it.

South Sea Company Bubble (1720)

The South Sea Company was a British company that was granted exclusive trading rights in Spanish South America. In 1717, the company issued public debt to finance activities and raised 2 million pounds. The company also exchanged equity with the British government in exchange for portions of the national debt.

The company released reports of extravagant resources and profits from trading with Spanish South America, and the stock was trading at 128 pounds in January 1720. The company continued to borrow from the government and investors began flocking in to invest. The company released a report of shareholders that read like a “who’s who” of Britain, and included heads of governments, affluent individuals, aristocrats and other royalties.

The South Sea Company was now Britain’s most desired investment, despite the company lacking any proof of its claims to riches. The stock reached 550 pounds in May 1720, leading to frenzied buying. It seemed everyone from peasants to aristocrats who were not already in the market wanted in, and if they couldn’t buy shares in the The South Sea Company than they would search for any other company that advertised itself similarly. The markets had become mainly speculative and shares rose to artificially high prices. The South Sea Company was now trading at over 1,000 pounds in August.

Like the previously mentioned financial bubble, sellers flocked the market and wanted out. By the end of 1720, The South Sea Company was trading below 100 pounds a share. Other companies that were also caught up in the buying frenzy had also crashed. Individuals that bought on margin were forced to declare bankruptcy. Banks that loaned cash to purchase shares on margin were also faced with bankruptcy. Wealthy aristocrats and bankers were also financially ruined.

Sir Isaac Newton, one of the greatest minds of all-time personally lost over 20,000 pounds and was quoted as saying: “I can calculate the motion of heavenly bodies, but not the madness of people.”

The Panic of 1837

The early 1830s was a great era of economic prosperity for the United States. Millions of acres of public land were sold by the government to farmers and individuals. The Second Bank of the United States, which acted as nations the central bank, was found to be full of corruption and United States President Andrew Jackson had it shut down in 1833.

As a result, the banking system became heavily unregulated, and lending spiked to the highest level ever. Small farmers, merchants, manufacturers and especially individual speculators all borrowed heavily.

Investors jumped at the opportunity to own all the land that the government was selling. They flooded the market with borrowed funds with the intent to purchase many parcels of lands that were expected to increase in value in the coming years. These investors, known as speculators, had no interest in personally settling on the land. Business owners also chose to ignore their business debt and borrowed heavily in order to purchase parcels of land, believing that the rate of return would offset the interest on current debts.

By 1836, land sales were ten times greater than in 1830. Having noticed this dangerous trend, President Jackson issued an Executive Order known as the Specie Circular, which required all land purchases be made strictly in gold and silver, rather than the bank notes that were often being printed by private banks.

President Jackson argued that the banks paper money held no value on its own as it simply “represented” some sort of arbitrarily accepted value, versus the intrinsic value of gold and silver.

The effect of this Executive Order proved to be disastrous. Banks did not hold sufficient supplies of gold and silver and land sales plummeted. Banks began to call in loans, and many speculators defaulted on their payments. The market began to crash, as speculators all over the country began selling the land they had just bought in hopes of recuperating some cash to pay off the bank loans. Construction companies were unable to continue with their obligations, resulting in the failure or incompletion of the railroad and canal projects.

This effectively served to destroyed every land speculator’s hope of profits and introduced a nightmare scenario that no one envisioned. As author Edward Shepherd noted in the biography of inaugural President Martin Van Buren: “In Pensacola Florida, lots which today [1888] are worth $50 each, were sold for as much as lots on Fifth Avenue, in New York, which today are worth $100,000 apiece.”

New York City was hit the hardest as losses from banks totaled over $100 million. Almost 1 in every 2 banks in the entire country were ruined. The economy entered a recession which would take 5 years to get out of.

Stay tuned for part 2 of our series on major crashes!

By Jayson Derrick, from: http://www.benzinga.com/general/politics/12/02/2375853/a-history-on-financial-crashes-and-bubble-bursts-part-1