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DEDICATION

For Wendi

CONTENTS

Cover Title Page Dedication

Preface

Panic | 1907

Crash | 1929

Black Monday | 1987

Meltdown | 2008

Flash Crash | 2010

Epilogue

Acknowledgments Source Notes

Index About the Author

Copyright About the Publisher

PREFACE

Crash. It’s a kinetic and evocative word and dramatic and frightening. It means there’s a story to be told, because when two cars collide or a plane plummets from the sky there’s rarely a single cause. When the stock market crashes, vast sums are lost and people’s lives are changed, often drastically. But equally dramatic are the stories leading up to the crashes in the stock market, because amid the wreckage there are heroes, people who recognized the causes and catalysts and warned us of the immense drop looming or who did their best to stop it once it was in motion.

We invest in the stock market for many reasons, each of them good, including funding retirements and educations. The irony is that in funding our retirement we create new jobs. In financing educations we create more technology to learn about. The impact isn’t felt just here; as those investments are deployed around the world, problems are solved, new industries are created, and international economies grow—the American investor has probably done more good in this world than anyone else, with the exception of the American soldier.

The stories of markets, including of the modern stock market crashes, are ultimately fascinating personal stories. Some people saw the crashes coming, some unwittingly sped up the drop, some were more malicious, and some were just stupid or reckless.

What’s engrossing, and a bit scary, is that most of the people responsible for the modern stock market crashes thought they were operating in the public good. From a president who wanted more power for himself and less

for “malefactors of great wealth”; to another public official who in an effort to help a friend fed a bubble that ultimately crashed; to academics who created an ingenious methodology that was supposed to wring most of the risk out of investing but instead manufactured an enormous new risk; to those who worked to make certain that every American could enjoy the satisfaction of owning his or her own home; and finally, to the ones who thought that automation would make trading less expensive and more efficient—those at the heart of these crashes were, without exception, warned that the courses they’d set were dangerous. We’ll read about the people and the warnings with the hope of learning to heed those warnings in the future.

But the subject isn’t just one of personal intrigue. The impact on investors has been profound. If one had invested $1 in the Dow Jones Industrial Average on December 31, 1899, it would have grown to $156.88 at the close of trading on the day of the last modern stock market crash. If that investor had avoided just one day, October 19, 1987, the balance would instead be $202.71. If that investor had avoided the five worst days, that balance would be $319.24, more than doubling his or her return.

Unfortunately, stock market crashes cost more than just money. They breed fear that causes people to refuse to invest, making it nearly impossible to finance creation of those jobs and advancement of those economies. And they create other unforeseen but enthralling problems. For example, it was a loss of confidence and refusal to invest in the early 1970s that led to the creation of the contraption that fueled the crash of Black Monday, October 19, 1987. We’ll learn the entire story.

For all the protections we put in place, stock market crashes are a function of the way markets, and the men and women who run them, operate. And that human element of the stock market is what makes crashes endlessly fascinating and also creates a unique prism through which we can view the prologue to the next crash while it is still likely years away. But as time passes, we forget the lessons learned, and as the particulars change, we lose sight of the fact that crashes don’t have a single cause that is easy to recognize before the damage is done. Instead every crash is caused by a unique confluence of usually personal events. Despite understanding this and

despite our best efforts, it’s impossible to crash-proof our financial system, just as it’s impossible to eliminate automobile accidents. No matter how well engineered the car, no matter how conscientious the driver, someone will be human, perhaps when assembling one of the thousands of critical parts, or when operating one of the thousands of critical parts, or perhaps in a combination of both. Or perhaps the weather will just be bad or the other driver will be drunk.

Confirmation that our stock market will crash again can be found in the understanding that markets continue to crash, even though the five modern stock market crashes are strikingly similar and should teach us something. They share important phenomena, and some of them should be obvious to us, including steep appreciation in the stock market. Precisely how the market appreciates is common to the crashes; two-year periods of particularly aggressive buying inside a robust decade are common just before most of the crashes. Less obvious commonalities also appear, including new financial contraptions that we are (overly) confident we understand, only to learn that they inject uncertainty and leverage into the stock market at its weakest moment. The government also makes its appearance, often in an effort to eliminate a real inequity like competition-killing industrial monopolies or abusive leveraged buyouts. But the government often chooses the worst possible moment to intervene, having waited until the financial stresses are finally too much for their constituencies. When an external catalyst—often natural or geopolitical—pushes the system past the tipping point the market crashes, and the warnings that are also common to each of the crashes seem remarkably prescient. Why didn’t we listen?

Given the commonalities, how do we keep getting ourselves into situations in which we convince ourselves that this time it’s different? Often it’s the nature of the contraption that convinces us that much of the risk has been wrung out of the stock market.

In the 1920s the investment trust promised professional financial management and diversification, both of which were thought to reduce or eliminate risk, but instead the investment trusts increased risk. In the 1980s a wonder of complex mathematics known as portfolio insurance promised to

provide a floor below which the value of a portfolio simply could not fall. Instead it increased the depth and velocity of the drop. Thirty years later, investment bankers and institutional investors were seduced by even more complex mathematics into believing that the value of mortgage-backed securities could not fall below a certain level.

While we watch these dangers build, the unknowable or unforeseeable element is the catalyst that will set it off. In 1907 it was as random as an earthquake, while in 2010 it was a riot in a place far away. Each of the catalysts initially seemed to have little, if anything, to do with finance. But our modern economies are intimately connected by finance—insurance in the case of an earthquake on our west coast or the price of crude oil and geopolitical turmoil in the Middle East, or the common European currency when it seems a country is dissolving into violence. These unpredictable catalysts take on critical financial importance.

The observable elements are necessary for a crash to occur but they aren’t sufficient. We should be able to recognize when a crash is possible even if we can’t be certain one will occur. If a catalyst is never introduced, the result will likely be years of poor stock market returns rather than the lightning bolt that creates chaos that destroys the fortunes of people who don’t know how they can recover.

It’s easy to believe the differences between our current financial world and that of even a few years ago—some call them advances—render another crash impossible. Unfortunately, it’s often those very changes that breed the next crash. In 1907 the simple act of paying an insurance claim could take weeks. To compensate for the losses incurred in the 1906 San Francisco earthquake, gold had to be loaded onto ships in London (the insurers were overwhelmingly British); they then sailed west. In the era before the 1914 opening of the Panama Canal, the trip would take weeks, and the only way to shorten it was to make port in Boston or New York and transfer the gold to a train that would set out on the multiday trip to San Francisco.

By 2010, the time required to consummate even the most complicated financial transaction had been reduced to a fraction of a second. Traders in Chicago or New York knew that they could effect a trade in about 20

milliseconds (one-fiftieth of a second). But 20 milliseconds was an eternity compared to what could happen when communications firms erected expensive microwave towers, which could shave 5 milliseconds off execution time. This often made all the difference in a market when the focus had shifted from what something was worth to how quickly it could be bought or sold.

This very advance in speed generated its own problem. As the system that relied on the speed of nearly instantaneous electronic trading was degraded, often without humans recognizing the delay, entirely new problems were created that led to a new kind of crash.

Einstein said that imagination is more important than knowledge because knowledge is limited to all we know and understand. He could have been referring to the causes of the past stock market crashes. On the other hand, imagination allows us to understand that even though the players have changed, the game is the same and we can imagine how the market will crash again.

This book tells the stories of what led up to the crashes of 1907, 1929, 1987, 2008, and 2010, the crashes themselves, and the elements shared by each past crash. Americans in the 1930s wondered if the stock market would ever regain the level reached on September 3, 1929. Even though the Great Depression, World War II, and a quarter century intervened, the stock market eventually reclaimed that level. The American stock market has always reclaimed its pre-crash level, but the danger isn’t that money is lost, it’s that time is lost as Americans turn from the market, reluctant to invest and participate in the recovery if lifestyles, retirements, and educations are at stake.

The stories are fascinating, but this book is also intended to give the American investor—one who, over time, has done so much good in this world—insight into the circumstances that can foster a crash. Forewarned is forearmed. If we’re paying attention.

PANIC 1907

After decades of gray men in gray suits, Americans woke on the morning of September 15, 1901, to find that possibly the single most energetic and vivacious of their 78 million strong—Theodore Roosevelt—was their new president after the assassination of William McKinley.

McKinley was elected twice and had been well liked. At fifty-eight, he was still a young man, even by the standard of the day. Only five foot seven, he was short but marked by a barrel chest, broad shoulders, and ample gut, in those days a sign of health and prosperity. He had three years left in his presidency, but on September 6, 1901, he was shot while standing in a receiving line at the Pan-American Exposition in Buffalo, New York. Just three days before, Leon Czolgosz, a twenty-eight-year-old anarchist, had paid $4.50 for a chromed .32-caliber Iver Johnson revolver. As he approached McKinley, Czolgosz fired twice, hitting the president in the chest and the gut. McKinley survived the initial attack and gracefully instructed his attendants to be careful when giving the news to his wife. Dr. Matthew Mann was the surgeon available at the fairgrounds, and despite the crude facilities and Mann being a professor of obstetrics and gynecology, the decision was made for Dr. Mann to operate immediately rather than transport the president to a local hospital. Even so, McKinley died eight days later, on September 14.

At the time of the shooting, Roosevelt was on a hunting trip in the

remotest stretch of the Adirondacks, thirty-five miles from the town of North Creek, New York. Rather than return to Washington, Roosevelt continued hunting and McKinley died while Roosevelt was still working his way over dark roads from the Tahawus Club hunting lodge to North Creek. Roosevelt was still forty-three days from his forty-third birthday when he was sworn in as president on September 14, 1901. When McKinley selected him to replace his first vice president, who died in 1899 from a string of heart ailments, Roosevelt was serving as governor of New York. Among the reasons he got the post was that the powers-that-be in New York State wanted Roosevelt out of the governorship and making his mischief elsewhere.

Roosevelt had been the ideal candidate for governor of New York when he returned from the Spanish-American War as a hero. Never mind that some of the hero-making had been more Roosevelt’s premeditated doing than sheer gallantry on the battlefield, although there was much of that. Roosevelt was a master of self-promotion. There was so little room on the ship taking his regiment to Cuba that only Roosevelt and the senior officers of the “Rough Riders” were able to bring their mounts—many of the Rough Riders had to walk into battle. But Roosevelt made sure there was room on board for reporters, photographers, and even a couple of early, crude movie cameras, despite the objections of the United States Army.

The war lasted less than four months, but the experience seemed to teach Roosevelt that every subsequent professional and political conflict should be charged with the drama and righteousness of this armed combat. Even relatively minor disagreements with potentially helpful businessmen evoked in him the furor of battle. For Roosevelt, losing the battle or being killed was preferable to missing the action entirely. When asked about the possibility that the war would conclude before he got there, he said that would be “awful.” He professed the hope that all his officers would be “killed, wounded, or promoted”; coming upon a dying Rough Rider on the battlefield, Roosevelt stopped, shook his comrade’s hand, and said, “Well, old man, isn’t this splendid?”

Roosevelt wasn’t new to politics when he entered the 1898 race for governor of New York. He’d been elected to the New York Assembly in

1882 as a twenty-three-year-old, despite being warned off by friends that those of Roosevelt’s ilk, education, and wealth didn’t go into politics. Roosevelt simply replied, “That merely means that the people I know do not belong to the governing class, and I intend to be one of the governing class.”

As an assemblyman, Roosevelt was branded a troublemaker and reformer, a title that was anathema to the governing class. When he demanded to be heard on every issue, newspapers started calling him “the cyclone assemblyman,” and while still a freshman, Roosevelt managed to anger businessmen by exposing a financial relationship between financier Jay Gould and New York Supreme Court justice Theodoric Westbrook. As he would show in Cuba, Roosevelt made every issue a fight between right and wrong, good and evil; there was no middle ground or “go along to get along” in Roosevelt. And occasionally his indignation made him appear unnecessarily and dangerously belligerent.

Even with his war record, Roosevelt needed help getting elected governor of New York. One month after Roosevelt returned from Cuba, he was summoned to the Fifth Avenue Hotel by Thomas Collier Platt, known as the “Easy Boss” of New York. Platt had served as a congressman for two terms and was in the middle of his second term as senator, but when he called for Roosevelt he had distinguished himself only as the political boss of Republicans in New York State. The New York Times would eulogize Platt in 1910 by saying that “no man ever exercised less influence in the Senate or the House of Representatives than he.” However, the Times went on to explain: “But no man ever exercised more power as a political leader.”

Platt offered to put that power to work for Roosevelt; he boldly offered Roosevelt the Republican nomination for governor as long as Roosevelt promised he wouldn’t get carried away with his reform agenda.

The two men struck a purely political bargain; Roosevelt agreed to consult with Platt’s people when it came to patronage. The election was close. Roosevelt won with 49 percent of the vote in a five-man race. But his victory would be a resounding defeat for “Easy Boss” Platt; Roosevelt simply refused to do as Platt wished, failing to support suggested nominees and, in an important harbinger, moving to regulate business. Platt quickly had

enough: “I want to get rid of the bastard. I don’t want him raising hell in my state any longer. I want to bury him.” Platt realized the only way to “bury” Governor Roosevelt was to slide him into the job that John Adams, the first to hold the position, had called “the most insignificant office that ever the invention of man contrived or his imagination conceived.” Platt would get Teddy Roosevelt out of New York by making him vice president of the United States.

Roosevelt hated the idea of the vice presidency and threatened to decline the nomination, but Platt used Teddy’s fame against him and Roosevelt won every vote the 1900 Republican convention had to offer, with the lone exception of his own. Roosevelt was crushed: “I would rather be anything, say, a professor of history.” Others were unhappy, too. Mark Twain, who had met Roosevelt more than once, said after he’d been inaugurated, “I think the president is clearly insane.” Mark Hanna, senator from Ohio and a power in the Republican Party, asked simply of the men responsible, “Don’t any of you realize there’s only one life between that madman and the presidency?”

On September 14, 1901, that one life winked out, and Hanna’s “madman” was in charge.

On Saturday, September 7, 1901, the first day the stock market could fully respond to McKinley’s shooting (until 1952, the New York Stock Exchange was open on Saturdays for an abbreviated trading session), the Dow Jones Industrial Average lost 4.4 percent, to close at 69.03, but as hopeful news of McKinley’s recovery was reported, it regained most of that loss. Only when it appeared that McKinley would not survive did stock prices break again, losing nearly 6 percent in the three days before McKinley’s death, at the prospect of an antibusiness progressive “reformer” in the White House. But just when Americans were desperate to be reassured, Roosevelt’s first act as president was to promise that he would “continue absolutely unbroken the policy of President McKinley for the peace and prosperity and the honor of our beloved country.”

Though the prosperity Roosevelt aimed to continue had surely bypassed

some, it was true that much of the country was wealthier than ever. The superintendent of the U.S. Census Bureau had said in 1890 that the western part of the country was so settled that the “frontier” had ceased to exist. Those who remained in the cities were enjoying a second industrial revolution.

The American economy had expanded rapidly from the end of 1896 to the end of 1900, when annual economic growth averaged 6 percent and the optimism was being expressed in the stock market. The Dow Jones Industrial Average rallied from 40.45 to 70.71, an increase of 74.8 percent, including gains of 22.2 percent in 1897 and 22.5 percent in 1898. Referring to 1899, when the Dow gained 9.2 percent, the Boston Herald reported, “If one could not have made money this past year, his case is hopeless.” The American Century had just dawned when Senator Chauncey Depew remarked, “There is not a man here who does not feel 400 percent bigger in 1900 than he did in 1896, bigger intellectually, bigger hopefully, bigger patriotically.”

As the frontier was disappearing and the stock market was booming, American businesses were growing in size and complexity. In 1882 John D. Rockefeller’s counsel at Standard Oil had devised the “corporate trust,” a novel piece of financial engineering that allowed Rockefeller and his managers to control the labyrinth of partnerships and corporations that Standard Oil had become. From that single oil trust in 1882, which controlled more than 90 percent of the nation’s oil refining capacity, about eighty different trusts, covering an immense range of industries, existed in 1897. In 1898 a new corporate form was wedded to the corporate trust when New Jersey began allowing one corporation to own stock in another. Delaware followed the next year with even more liberal rules, and the holding company was born. By 1904, 318 corporate trusts were dominating the business world, from steel and copper, crude oil and kerosene, to lead and linseed oil.

On December 3, 1901, President Roosevelt delivered his first message to Congress. He began by eulogizing McKinley, then turned to the country’s other business, particularly business itself, noting that the growing complexity of industrial development brought with it serious social problems, including pollution, overcrowding in the cities, and an enormous income

disparity between the average workingman and the industrialists. But Roosevelt then cautioned against dealing with corporations in ways that might jeopardize the resurgence American business was enjoying. “The mechanism of modern business is so delicate that extreme care must be taken not to interfere with it in a spirit of rashness or ignorance,” he said. “Many of those who have made it their vocation to denounce the great industrial combinations . . . appeal especially to hatred and fear.”

As he continued, Roosevelt shifted from killing businessmen with kindness to turning on them by calling for federal regulation of the “corporate form,” the legal fiction that allows a group to limit its liability and be treated as an immortal individual through the process of incorporation. Roosevelt argued that since the form, essentially all corporations, had these decided advantages that were conferred by the government, it should be regulated. He also called for the government to inspect and examine the “workings of the great corporations engaged in interstate business.” He said that “artificial bodies, such as corporations and joint stock or other associations, depending upon any statutory law for their existence or privileges, should be subject to proper government supervision, and full and accurate information as to the operations should be made public regularly at reasonable intervals.” And how might he regulate? Roosevelt gave a clue when he said, “Since the industrial changes which have so enormously increased the productive power of mankind, [the old laws and the old customs] are no longer sufficient.”

When Roosevelt was assistant secretary of the navy, he had professed that only those “who dared greatly in war, or the work which is akin to war” were worthy. Now he seemed to have found his work akin to war and his next opponent. If businessmen were surprised by the new president’s path going forward, then they simply hadn’t been listening.

James J. Hill and E. H. Harriman didn’t like each other, even though both had come up hard and built incredible fortunes as they established railroad empires. Hill originally wanted to be a trapper and fur trader but began his career as a clerk and freight hauler. Eventually he came to own the Great

Northern Railway and much of the stock of the Northern Pacific. This meant he controlled most of the railroad business in the Northwest. Hill was largely self-educated, with only a brief period as a scholarship student at Rockwood Academy. Despite his lack of advantages, Hill’s railroad empire had been built in part through his alliances in business with J. P. Morgan and the Vanderbilt family.

In 1901, Hill’s roads from the Northwest extended only as far east as Minnesota, and he was anxious to expand his network to Chicago, the belching, stinking center of the industrial Midwest and the crossroads of transportation that fed it. To do so, Hill would buy the Chicago, Burlington & Quincy Railroad, known as the Burlington, for its sprawl of track from Minnesota to Chicago and back west across Iowa, Missouri, Nebraska, and Kansas. With J. P. Morgan providing the financing, the Northern Pacific, which Hill had a large stake in but did not yet fully control, reached an agreement to buy the Burlington and its eight thousand miles of track, much of which paralleled that of E. H. Harriman’s Union Pacific.

Edward Henry Harriman had quit school at the age of fourteen—Hill’s age when he was forced to leave Rockwood Academy—to take a job as a messenger on Wall Street. Eight years later, Harriman was a member of the New York Stock Exchange. Harriman entered the railroad business when he was forty-nine. Initially he’d been a mere investor, but by the turn of the century he controlled the Southern Pacific and Union Pacific railroads, and as such, much of the railroad business in the West and Southwest. Harriman did so by aligning himself with the Rockefeller and Gould families.

On hearing of Hill’s plans, Harriman requested that they buy the Burlington together. After all, Harriman already owned a sizable chunk of Burlington stock, and the Burlington routes served as feeders to much of Harriman’s Union Pacific. But Hill rejected Harriman’s proposal, leaving Harriman’s railroads in a supremely precarious situation. Not only might Hill use the Burlington routes to freeze Harriman out of Chicago, but the Burlington routes west of Chicago could compete directly with Harriman’s Union Pacific routes once they were strengthened via the combination Hill imagined.

This prompted Harriman to make an audacious decision: If he couldn’t acquire enough of the Burlington to guarantee access to Chicago and prevent competition elsewhere, then he would acquire the acquirer of the Burlington. After confirming that Hill and Morgan controlled the board of the Northern Pacific, but owned less than a controlling percentage of the outstanding stock, Harriman began buying Northern Pacific shares quietly. On April 22, 1901, with the Dow at 74.56, Northern Pacific was trading at $101 a share. By April 30, it was $117. On Monday, May 6, it was at $133. At this point Harriman quit being quiet, as he realized Morgan had figured out what he was up to. Both camps began buying madly; the next day Northern Pacific, a company that had just emerged from bankruptcy, reached $149, while the Dow, at 75.02, was little changed since the buying in Northern Pacific commenced. By Thursday, May 9, Northern Pacific briefly reached $1,000 a share as the Hill-Morgan team finally secured a controlling interest.

May 9, 1901, the day Northern Pacific reached its peak, became known as “Blue Thursday” because this action in Northern Pacific sucked all the air out of every other stock and caused the rest of the market to plunge; on May 8 and 9, as Northern Pacific was cresting, the broad stock market lost 10.2 percent of its value, with the Dow closing at 67.38. The headline of the May 10 edition of the New York Times described it as “Disaster and Ruin in Falling Market.” A handful of robber barons, icons of the Gilded Age, in fighting for a relatively small railroad, the Burlington, had nearly crashed the stock market.

Eventually the protagonists realized they could go on fighting each other or they could join forces in the sort of industrial trust that Standard Oil had perfected and that was becoming so popular with Wall Street. The players came together, the chaos they had caused propelling even normally impatient businessmen to reach an agreement quickly, just twenty-two days after the panic. On June 1, 1901, an agreement was announced and “harmony” was declared; the principals would merge all their holdings into a single entity. The vessel of this harmony was the Northern Securities Company, with Morgan in charge and Hill leading the board of directors, which Harriman and several fellow raiders joined. Having regained all the ground lost in the

“Blue Thursday” panic, the Dow closed that day at its highest level of 1901 to date, 76.59, up 8.3 percent for the year.