EXPERT WITNESS: This time is NOT different: part three of three

By Dr. John F. Sase

with Gerard J. Senick

"This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy-makers can look at to access risk--if only they do not become too drunk with their credit bubble-fueled success and say, as their predecessors have for centuries, 'This time is different.'"

-Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009)

In this three-part series, we are exploring the economic history of financial crises, events that continue to occur. Throughout the ages, both rich and poor countries have muddled their way through a vast range of crises. These have included sovereign-government defaults on both domestic and foreign national debts, banking and financial market panics, and collapses due to both piracy on the high seas and subprime mortgage meltdowns. In addition, there has been monetary inflation, due to everything from species-currency debasement, which reduced the gold and silver content of coins in favor of more base metals in recent centuries, to the modern corollary of printing more paper money within a network of sovereign fractional-reserve central banks. In this month's column, we present the third and final part of "This Time Is NOT Different," which is an overview of the financial crises and their causes since the Great Depression. In addition, we review two of the most famous financial meltdowns of the past four hundred years.

The Tulip-Bulb Craze

One of the most famous bubbles in history is the Dutch Tulip-Bulb Craze of the early seventeenth century. Due to its recency, we know more about this economic crisis than most. The Tulip Craze reflects simple idiocy coupled with the stupidity of crowd mentality.

Though most of us identify tulips with Holland, they were not indigenous to that country. Originally, tulips came to Holland from Turkey in 1593, imported as a luxury good. The bulbs rapidly became popular, though expensive, garden items. However, given their new environment, many bulbs succumbed to a disease that we have identified as one of the family of Potyvitidae viruses. Twentieth-century biochemistry has described it is a color-breaking virus that is transferred by feeding insects.

Popularly, we know this disease as the Mosaic Virus. This causes the petal pigmentation to break into flame-like multi-colored stripes. In the early 1600s, the Dutch prized these patterns. Since tulip bulbs are perennials, the same bizarre patterns reappeared each successive season. In short, the bulbs preserved their uniqueness and perceived value due to a scarcity of the patterns that were the most prized.

As with any rare product of fixed supply, increased demand caused a rise in the market price. In response to this market performance, bulb merchants stockpiled the most popular patterns and held them back from the market artificially as the merchants anticipated the increasing demand for the bulbs. In effect, the phenomenon of "Tulip Mania" resulted from hoarding, which led to an escalation in prices.

The Tulip-Bulb Craze peaked from 1634 to early 1637. In order to invest in bulbs, all classes of Dutch citizens liquidated real estate and other good stores of value. This unrivaled purchasing frenzy caused bulb prices to reach astronomical levels.

As market demand outran the current supply of investment capital, speculators developed a method of call options. These options required only a down-payment in the rising market. As long as bulb prices continued to rise, speculators could multiply their recognized wealth with an option that was only 20% of the purchase price. In January 1637, the last month of wild activity, margin-buying spurred bulb prices to rise twenty-fold. However, the bubble finally burst: The market price did not reflect the firm-foundation value. During the following month, prices plummeted more than twenty-fold.

As the market tumbled, the equity positions of investors evaporated, causing most of them to lose their options. In turn, speculators failed to make their own margin calls. Panic ensued. Next, investment firms fell into bankruptcy as they failed to honor their call options. Faced with a collapsing financial market, the Dutch government intervened and attempted to settle contracts at 10% of their purchase amount. Unfortunately, market prices continued to fall, dropping below the government price-floor until bulb prices settled to that of a common onion.

The Tulip Craze mimicked the behavior of other bubbles that have occurred to the present day. First, market speculation built slowly with a gradual ascent in prices. Second, the number of investors increased, fueling the progressive speculation. Third, speculators introduced margin-buying that helped the market to grow exponentially. Fourth, as the bubble developed, the market rose rapidly to spiked prices. Fifth, the bubble burst and market price collapsed rapidly due to a contemporaneous failure to meet margin calls.

The South Seas Bubble

Next, we will look at the British crisis known as the South Seas Bubble, a crisis that stands as the first major manipulation of financial markets. In addition, the South Seas Bubble is the first crisis for which we have extensive detail. Until the Crash of 1929, this bubble endured as the classic example of opportunistic self-enhancement in a virtually unregulated market. Greed always has found a way.

The South Seas Company was formed by Parliament as a British trade concession in 1711. This was a monopoly for Britain to cover trade with areas of the Pacific that were under British rule. At the time, the company was a startup firm with no sales and no earnings, only with great prospects. However, the real prospects for the directors centered on market manipulation and insider trading rather than trade opportunities in the South Seas of the Pacific.

In the early eighteenth century, Britain had entered its period of imperial prosperity. Due to national affluence, many British subjects searched for investment opportunities that that were open to them. However, stock ownership remained a matter of privilege that was limited mostly to the aristocracy. Furthermore, women could not inherit land due to entailment laws (regarding the passing of landed estates to male heirs), although females could own stock at that time. However, savings accumulated amid the prosperity. A pent-up demand for stock developed because of wide accessibility along with the added benefit that dividends that were paid out of profits went untaxed. This situation also played well for the British Crown because it sought new opportunities for restoring faith in the failing financial health of the government.

The South Seas Company formed as Parliament granted the enterprise a monopoly concession for all trade in in the South Seas along with loaned capitalization of £10 million pounds sterling. Publicly unknown at the time, members of Parliament and other government insiders had bought the capitalization bonds for South Seas at £55. Once the company went public, these investors exchanged each unit at par for £100 of stock in the South Seas Company. The game was afoot.

The company maintained a high profile of prosperity. However, its inexperienced directors quickly entered into the slave trade, a venture at which they failed. South Seas maintained its stock price in the market despite this misfortune as well as a war with Spain, shipments of goods that were misrouted and lost, competition for capital from the similarly situated Mississippi Company in France, and bonuses paid to the directors in the form of stock dividends that diluted the value of company shares.

Nevertheless, the situation improved in 1719. Britain signed the Peace of Utrecht, a treaty with Spain that enabled British trade with Mexico. This Spanish possession offered gold in exchange for woolen goods and bolts of cotton cloth. Given this newfound prosperity, the directors of South Seas offered to fund the entire British national debt of £31 million. When the bill was introduced in Parliament, stock prices doubled promptly while backers of the bill received a "gift" of free stock.

Five days after the bill became law, South Seas offered a new issue of stock at £300 per share. While stock prices continued to escalate, the company offered a second issue at £400. This one rose to £550 per share within a month. At mid-year, the directors offered yet another new issue at 10% down, with no payments for one year. Share price continued to rise to £1,000. Still, South Seas could not meet investor demand for their stock. The feasibility of the scheme became secondary as the Greater-Fool Theory took over--speculators would purchase shares, prices would rise, secondary buyers would appear, and the speculators would profit in the after-market.

By the summer of 1720, the directors realized that their astronomical share price bore no relationship to any real prospects of earnings. The directors liquidated their own shares. The news of their divestiture leaked out quickly. Share price collapsed and a market panic ensued. The British government narrowly averted the complete erosion of public credit. In response to this threat, Parliament passed the Bubble Act that forbade issuance of stock certificates in any company. This law stayed on the books for more than a century afterwards.

In addition, Britain implemented other measures in order to restore confidence. The government confiscated the estates of company directors in an attempt to remunerate South Seas Company investors. In addition, the government allocated the remaining shares of South Seas stock to the East India Company and the Bank of England. Other propositions put forth in Parliament included placing bankers in sacks filled with snakes and throwing them into the Thames River!

In summarizing this bubble, let us analyze the events. First, there was a pent-up demand for investment opportunities. Second, the government sponsored a trade-concession monopoly. Third, inexperienced management failed to create real value. Fourth, war and the entry of new competition exerted external pressures. Fifth, graft occurred, which involved members of Parliament in an effort to pass legislation that was advantageous to a private company. Sixth, dilutive stock dividends and new (dilutive) stock issues were sold on generous terms and margins while insiders manipulated trading that included the dumping of shares.

Back to the Future

We ended Part Two of this series by discussing the Wall Street Crash of 1929. Following the Crash, the United States and its major trading partners experienced a decade of severe economic downturn that led to the Second World War. Though production surged during the War, a full recovery of the stock market was prolonged. While it is fair to say that it took Wall Street over twenty years to regain its level of 1929, it is unfair to look at the Great Crash as any single event.

During the years following World War II, markets experienced a growing participation of institutional investors. Wall Street held a widespread belief that these institutions had risen above the madness of the crowd. However, professional investors participated subsequently in several distinct speculative movements from the 1960s through the 1990s.

The 1960s

The Soaring Sixties marked a return to the former depths of market depravity. Contention arose between Greybacks who had survived the Crash of 1929 and the Great Depression and the Young Turks, fresh out of the best business schools. From 1959 to 1962, the market saw more new issues than in any previous period. The behavior of investors rivaled that of the South Seas Bubble in intensity and fraud. Often, we refer to this period as the "Tronics" Boom as it was marked by electronic and silicon names. During these years, a simple name change by even a shoelace company to something like Powertron Ultrasonics could double its share price in respect to its actual earnings within a matter of days.

During this era of new stock issues, the Securities and Exchange Commission (SEC) uncovered extensive market manipulation and fraud. The underwriting investment banks withheld shares to keep the market "thin," thus generating rapid price increases in the after-market. In addition, they sold considerable portions of new issues to broker-dealers who held back their shares. This situation evolved into financial debauchery in which more than 80% of new shares were allocated to insiders rather than made public.

In order to avoid ensnarement by the SEC, issuers distributed adequate prospectus with warning labels resembling the ones present on cigarette packs. A typical caveat read "This company has no assets or earnings and will be unable to pay dividends in the foreseeable future. The shares are highly risky." In response, the SEC took the position that, though it could warn fools, the commission could not prevent neophyte investors from handing over their money. Nevertheless, manipulators would not have flourished without the prevalence of public greed.

By 1962, the boom had gone bust as the merry-go-round broke down. The SEC suspended the largely fringe brokerage firms that were responsible for the bubble that soured the sixties.

The Conglomerate Boom

The third great merger trend struck the U.S. economy from the 1950s to the early 1970s. Acting along traditional lines, many companies sought to combine horizontally with firms that were involved in the same business or vertically with suppliers or customers. However, a new wave of conglomerate mergers occurred as firms combined with companies in completely unrelated industries. This diversification was an overt attempt to protect the new bands of firms from financial fluctuation by combining companies that enjoyed sales curves that ran countercyclical to one another.

In compliance with anti-trust laws, most large firms are restricted from acquiring or merging with other companies within the same industry. The firm seeking an acquisition or merger could do so more easily across industries. However, executives and board members with financial expertise rather than operating skills discovered that the acquisition process itself could produce growth in the Earnings per Share of a company. On the downside, they discovered too late that a bubble driven by conglomerate mergers would develop during the late 1960s.

This Conglomerate Bubble proceeded like a chain letter: When the acquisitions stop, someone got burned. However, such tactics worked for a while because investors in the 1960s tended to be more interested in steady, rapidly rising earnings and less concerned with how the sausage was made during a bubble that reeked of the Public Relations messages of promoters.

From 1967 to 1969, conglomerate mergers led to incidences in which the ratio of Share Price to Earnings as well as the Share Price itself rose exceedingly high in a manner not dissimilar to that of the Dutch Tulip-Bulb Craze. However, the beginning of the end for the Conglomerate Bubble occurred when electronics-producer/defense-contractor Litton Industries announced lower-than-expected quarterly earnings in January 1968. Even though Litton continued to remain profitable, its lackluster performance triggered a selling wave of conglomerate stocks that fell 40% by the following quarter.

Next, the Federal Trade Commission (FTC) launched an investigation of conglomerate mergers in July of that year. In its wake, market prices fell again. During this aftermath, the SEC and the Financial Accounting Standards Board (FASB) called for clarification of reporting methods and standards for conglomerates. This call triggered another large sell-off that resembled the collapse of the South Seas Company.

In summary, let us review the characteristics of the Conglomerate Bubble. First, there were management difficulties in attempts to juggle diverse product lines. Secondly, the new financial math of conglomeration was far from transparent and led to expressions of viable concerns by regulators and other parties. Third, acquiring companies needed to have larger earnings multiples than those firms in the shrinking supply of target companies. Fourth, conglomeration eventually resulted in lower earnings and flat Price-to-Earnings ratios. Fifth, in turn, lower earnings led to the shedding of unrelated, poor-performing acquisitions, often to buyers resembling Gordon Gekko, the nefarious magnate played by Michael Douglas in Oliver Stone's "Wall Street" movies.

Throughout the next few decades, a series of relatively minor bubbles occurred. Each one expressed its own unique variations on the common theme of bubbles. However, the core of the Conglomerate and other bubbles continued to follow the same progression as had all prior financial crises--a slow build followed by a rapid ascent to an unsustainable peak before a sudden collapse.

The 1970s and 1980s

In the late 1960s, the 1970s, and beyond, we have experienced crises fueled by Concept Stocks, ones whose current valuation appears out of line with traditional valuation metrics. The most significant crises happened during the era in which mutual funds proliferated and in which investors bet on fund managers rather than on the stocks themselves. Furthermore, the fund holdings tended to be stocks that possessed an exciting concept and generated great near-term performance.

As many of these funds soured in the seventies, investment wisdom returned to sound principle. Once again, solid Blue Chip stocks came into vogue as investor expectation turned toward long-term benefits. The enticement of a one-time decision for Large-Caps (large-capitalization stocks) attracted conservative institutional investors who had strict fiduciary duties for the management of the savings of others. Unfortunately, well-packaged stupidity sounded like wisdom as a wave of institutional speculation focused on the Blue Chips. Nevertheless, these actions seemed reasonable at a time in which inflation was under control, the Vietnam War was ending, and Richard Nixon had been elected President. Meanwhile, investors began to ponder answers to questions that included "What is OPEC?" and "Who are these new upstart competitors posing a threat to American manufacturing?" The Nifty Fifty (the largest of the S&P 500) had begun to decline, even though their share prices held steady due to the madness of crowds. Soon, investors realized that stocks were overpriced and that it was the market--not the companies--that constituted the problem. Subsequently, fund managers began to sell their holdings in the four dozen Blue Chips.

The 1980s roared in like a lion as investors hungered for new castles in the air. Like the return of the king in J. R. R. Tolkien's "The Lord of the Rings," new stock issues made a triumphant re-entry. In 1983, the craze of new issues surfaced as the hottest game in town. However, after a stampede toward these Small-Caps (small-capitalization stocks), their value plummeted 90%. Within this atmosphere, biotechnology stocks festered into a new bubble. The promise of gene-splitting within the biotech revolution reflected itself in share price. The poster children of this biotech movement included Genentech, which watched its share price triple in the first twenty minutes of trading. However, Product Asset Valuation posed potential problems in the form of allusive approval by the Federal Drug Administration (FDA), unitary patent rights, and the siphoning of profits by large firms that quickly acquired the biotech start-ups. Within this framework, the large firms had no need to offset their now-declining older products. As a result, the industry often considered positive sales and earnings to be a drawback rather than a benefit. In the end, biotech stocks had lost 75% of their value.

What does all of this mean? Under the Castle-in-the-Air Theory, the evaluations of securities affect their pricing. Therefore, investors should remain wary of hot new issues because they tend to underperform the market, though their stock prices increase abruptly during trading.

Japan in the 1990s

Though the major financial bubble of the early 1990s occurred in Japan, it should have served as a warning - a specter - for the United States in the late 2000s. The Japanese disaster centered on real estate and stocks. During this bubble, real estate prices increased seventy-five-fold. On paper, this gain represented 20% of the entire wealth in the world. For added perspective, economists often cite that selling the Imperial Palace could have paid for the entire State of California.

Simultaneously, share prices for Japanese firms soared skyward, having increased a hundred-fold over the preceding thirty-five years. Increasing share prices were out of sync with the underlying firm-foundation values of Japanese companies. On average, we expect the Price-to-Earnings ratio to be 15:1. In other words, if a share of stock earns $1 per year, the market would value that share at $15. However, during the bubble in Japan, Price to Earnings had reached 60:1--four times the normal average.

What caused the bubble in Japan? In respect to stocks, a significant driver was provided by the practice of distorting profits by overstating depreciation while reporting earnings that excluded the poorer performance of subsidiary companies. As a result, adjusted earnings and dividends appeared to be much larger than for foreign counterparts even while actual Japanese profitability declined. In the real-estate market, high rents reflect high population density, restrictive land-use laws, and other conditions. The value of a property and its rent tend to reflect one another at prevailing rates of return. If the expected return on a property is 10% per year and the annual rent is $10,000 ($833 per month), then the property should be worth about $100,000. However, rental income rose far slower than real-estate prices in Japan during the early 1990s. Let us say that rent is only $667 per month. If the property is valued at $100,000, then the rate of return sinks to 8%.

In addition to problems in the Japanese domestic stock and real-estate markets, a strong Yen made it difficult for Japan to export products because of unfavorable exchange rates. The historically low Japanese interest rates had begun to rise in 1989. This led to a borrowing frenzy and a liquidity boom that precursed the mortgage refinances and equity lines in the United States through the early 2000s. The Japanese central bank responded by restricting credit and raising interest rates. However, these actions contributed to the bursting bubble, a market collapse, and a decade-long recession for Japan.

Surfing the Internet

At the turn of the millennium, we experienced the largest bubble that ever had occurred up to that time. What distinguished the Internet Bubble from others was its association with both new technologies and new trade opportunities. Essentially, the Internet and its offspring created a cyber-marketplace that significantly changed the way that we do business. Also exceptional is the fact that this bubble set new records. It emerged simultaneously as the greatest creator and the greatest destroyer of wealth: $8 trillion of market value evaporated over a period of months.

During this economic episode, Goldman Sachs proclaimed that investor sentiment was not a long-term risk. Unfortunately, this sentiment proved to be a short-term risk with dire consequences for many investors and companies. The NASDAQ Stock Exchange (originally the National Association of Securities Dealers Automated Quotations) listed the lion's share of Internet and related technology stocks. This is significant because the NASDAQ Index tripled during the boom as Internet-company Price-to-Earnings ratios climbed to over 100:1. However, the new millennium did not show kindness to the market. With the exception of a slight surge after 9/11, stock prices fell steadily - more than three-fold by early 2002.

For the two preceding decades, the broad-scale high-tech industry recorded gains greater than 18%. By 2000, investor expectation for the future reached 25% or higher. However, the earnings of Cisco and JDS Uniphase grew at 15% per year, even though Cisco surpassed a Price-to-Earnings ratio of greater than 100:1. The stock market seemed to be on steroids.

Unfortunately, Cisco lost 90% of its value when the bubble burst. Other companies, such as Amazon, Lucent Technologies, and Yahoo, lost between 93% and 99% + of their value from the high-water mark of 2000 to the low tide of 2001-02.

Security analysts at Merrill Lynch, Morgan Stanley, and Salomon Smith Barney provided much of the hot air for the bubble. They based their success on their ability to steer lucrative investment banking business to their firms by promising ongoing, favorable research coverage that would support the Initial Public Offerings (IPOs) in the aftermarket.

Analysts pushed the line that traditional valuation metrics lose relevance during the big-bang stage of an industry, which is a time to be reckless, though rational. Individual stock prices soared while security analysts refrained from biting the hands that fed them--those of their corporate CFOs. Traditionally, analysts rated ten "buys" for every one "sell." However, during this bubble, the ratio of buys-to-sell neared 100:1. "Investment gurus" marching in lockstep helped to convince the public that investing was easy. When the bubble burst, celebrity analysts or others in their firms faced lawsuits, investigations, and SEC fines--even death threats.

By 2001, the United States Secret Service and the SEC had commenced prosecution of more than 5,000 cases in respect to the market structures and conducts that led to the collapse. Sadly, most of their original files were destroyed along with their Manhattan offices in Building 7 of the World Trade Center when it collapsed in the late afternoon of 11 September 2001. As a result, we never may know the extent of the fraud and market manipulation that accompanied fee-based underwriting, cheerleading research and analysis, and the infectious greed that contributed to this very destructive bubble.

A Final Word

Today, we struggle through the end-game/aftermath of the most recent bubble fueled by Mortgage-Backed Securities, Collateralized Debt Obligations, and other inventions of the best and the brightest "quants" (quantitative analysts) on Wall Street. As we search to understand the causes, let us take away a few lessons that history has provided. In this three-part column, we have traced the causes and effects of financial crises from the days of the Sumerian Empire through the present. We have stood back and observed the grand progression of time through the three most recent cultural ages. With the assistance of a group of nineteenth- and twentieth-century polymaths, we have uncovered the nitty-gritty of events in economic history.

We have learned the lesson that human behavior runs contrary to rational and efficient behavior during economic crises. More and more credulous investors must be found to keep the merry-go-round turning. However, though markets occasionally can be irrational, we must not abandon our age-old sense of firm-foundation values. In every economy throughout history, the market eventually corrects itself, albeit slowly and inexorably. Throughout the ages, anomalies have arisen and markets have become irrational, attracting unwary neophyte investors who get bloodied. However, everything comes out in the wash as true values are recognized again by the human participants, eventually.

As we conclude "This Time Is NOT Different," let us draw a bit of wisdom from Benjamin Graham, the English-born American author, economist, and professional investor. In his "Security Analysis" (McGraw-Hill, 1934), Graham explains that

1. Financial markets are not voting booths but weighing instruments.

2. The ways and means of valuation have not changed over time.

3. Every piece of real, personal, and intellectual property is worth only the benefit that flows from it.

4. Like any other economic crisis, this time is NOT different.

What do financial crises mean to attorneys? The potential negative impact on incomes that result from both major and minor affects the survival of legal practices. Some clients may not be able to afford counsel, much less to pay them. Even for attorneys who take cases on a contingency-fee basis, there may be problems. Recall the movie "The Rainmaker" (American Zoetrope, 1997): In this film, which is based on the book of the same name by John Grisham, Matt Damon and Danny DeVito play attorneys who sue a large insurance company. They win the case. However, as the company immediately declares bankruptcy, they are unable to collect the financial award decided by the jury. Finally, attorneys who understand financial crises can prepare themselves, their investments, and their practices to survive and prosper. We hope that our readers possess the common sense to avoid the madness of crowds and the grasping for castles in the air. Finally, we hope that our journey through economic history has been a revelatory and enjoyable one for all of our readers.

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A PDF copy of this article as well as Parts One and Two is posted at http://www.saseassociates.com/legalnewscolumn.html. We continue to post videos related to our monthly column on www.YouTube.com/SaseAssociates.

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Dr. John F. Sase of SASE Associates, Economic Consulting and Research, earned his MBA at the University of Detroit and his Ph.D. in Economics at Wayne State University. He is a graduated of the University of Detroit Jesuit High School. Dr. Sase can be reached at (248) 569-5228 and by e-mail at drjohn@saseassociates.com.

Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a Supervisory Editor at Gale Research Company (now Cengage) for more than 20 years. Currently, he edits books for publication and gives seminars on writing. Mr. Senick can be reached at (313) 342-4048 and by e-mail at gary@senick-editing.com.

Published: Wed, Jul 18, 2012