The Bear Stearns bailout, the government takeover of Fannie Mae and Freddie Mac, the Lehman Brothers bankruptcy, the sale of Merrill Lynch & Company, and
now a drop of more than 62% in AIG's share price, have combined to create a financial atmosphere verging on panic. Politicos and financial analysts are weighing in on what can be done to shore up failing insurance giant, AIG and by extension the U.S. economy.
The fear of massive sell-offs are keeping Wall Street on edge and further hinder AIG's abilities to raise much needed cash. The debacle of the hyper-buoyant housing market and the freewheeling attitude of the subprime mortgage industry, most recently illustrated by the Lehman Brothers collapse, have resulted in a take down of giant financial institutions that had successfully weathered the stock market crash of 1929.
In comments made Monday by presidential candidate Sen. John McCain, it appeared as if he were correct in his self-assessment that his understanding of economics is not as fully formed as it should be. At a fundraiser in Florida on Monday, Senator McCain stated that the 'fundamentals of the economy are strong'. Senior partner of J.P. Morgan, Thomas Lamont expressed similar sentiments after Black Tuesday in October 1929. He told reporters, "There has been a little distress selling on the Stock Exchange..."
Conversely, Democratic presidential nominee, Barack Obama had a difference take on the collapse. In a speech given in Colorado yesterday, Senator Obama referred to the failure of Lehman Brothers and the Merrill Lynch sale as "the most serious financial crisis since the Great Depression."
But, is it? What economic failures actually triggered the Great Depression?
Although the stock market crash of 1929, Black Tuesday, is widely credited for causing the Great Depression, it was in actuality the failure of thousands of banks in 1932-1933
that created the conditions. These banks had provided loans for stock market speculation and invested themselves with depositors' cash during the artificially enhanced Bull Market of the Roaring 20's. As stock prices plummeted, investors began a massive sell-off of their holding and values slid to pennies on the dollar. The majority of market speculators bought on margin and had only been required to put up 10% of their stock purchases. Brokers, needing an influx of cash as the stock market plunged, sent out margin calls by the thousands. When the margin calls came, the stock speculators defaulted in record numbers.
The market continued to drop over the next four years, bottoming out in 1933. Depositors, spurred on by the rumors of failing banks and terrified of losing their savings, descended on banks throughout the country to pull out their cash. The banks did not have the cash on hand and government deposit insurance did not yet exist. Only the lucky few were able to withdraw their savings, leaving the rest of the depositors with nothing. The banks, unable to withstand the "run" suspended operation, and in many cases closed their doors for good. In a scene made famous by Jimmy Stewart in the film, "It's a Wonderful Life", Stewart's character George Bailey tells his Savings and Loan clients to only withdraw what money they had to have right then because if they closed their doors, they'd never reopen. Unfortunately, for the banking industry of the 1930's, there was no one like Bailey to persuade the depositors.
As the banks failed, the credit crunch got deeper and lending dried up. Businesses across the country, unable to secure credit failed as well, compounding unemployment. The cascade of financial collapse peaked in 1933 with an estimated 24% unemployment. It would be six more years before the United States was able to begin to claw its way back. The stock market did not fully recover until the 1950's.
Legislation enacted during the 1930's, particularly the Glass-Steagall Act of 1933, changed the way banks did business. Until the law's repeal in 1999, Investment banks were separate from commercial banks and prohibited from taking deposits. Some economists believe the repeal is partially responsible for the subprime mortgage crisis by allowing mega-banking to develop without adequate regulation.
How far the market will drop and how many giants of the financial world will fail in the next few months is anyone's guess. Had you asked the financial watchers on Wall Street last week
if AIG would be scrambling to gather millions in cash, the answer would most probably have been a resounding "no." The lessons of the past teach us that caution and calm is key when facing an economic crisis such as what we are presently experiencing. The credit crunch and instability of our major investment banks will likely go on for sometime but the market will correct eventually. Answers will be forthcoming; at least that's what they tell us.
Sources:
http://www.dailymail.co.uk/news/worldnews/article-1056475/McCain-calls-U-S-economy-fundamentally-sound-day-Lehman-Brothers-declared-bankrupt.html?ITO=1490
http://www.boston.com/news/politics/politicalintelligence/2007/12/mccain_its_abou.html
http://elections.foxnews.com/2008/09/15/obama-blames-gop-for-great-depression-style-crisis-on-wall-street/
http://www.americanheritage.com/articles/magazine/ah/1965/5/1965_5_88.shtml
http://www.investopedia.com/articles/03/071603.asp
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