Margin lending refers to the process of using borrowed money for investing. For example, a traditional investor may purchase 100 shares of a business for $10, spending $1,000. However, using margin, that same person may purchase 150 shares, spending the same $1,000 and borrowing another $500. If the stock price goes up, they pay the loan costs and keep the gains. However, if the price declines, they are forced to sell the stock to pay off the loan. Margin lending is an example of the use of blue ocean strategy in finance.
Building early railroads was an expensive undertaking and Americans were short liquid capital in the mid-1800s. To finance businesses in the early 1800s, people typically turned to broker Nicholas Biddle of Philadelphia who marketed sterling bonds from the UK. This funding mechanism dried-up with the failure of the Bank of the United States of Pennsylvania in 1841. State Street, in Boston, took over and became the primary financier for railroads. In 1847, a severe recession caused a liquidity crunch that left the bank standing but unable to finance large projects.
Subsequently, lenders turned to New York-based merchants, bankers, and brokers who typically had more capital to make loans. Funds flowed from Wall Street to build railroads in the Southern and Western states.
Brokers considered early railroad bonds low-risk, and they competed to sell bonds. Therefore, they offered to partially finance bond purchases. A person who wished to purchase, say, $500 of railroad bonds could use $250 cash and borrow another $250 with the bond as collateral. This type of funding mechanism, encouraged by the government because it helped build infrastructure, was referred to as a “call loan.”
Over time the US flourished. Eventually, the stock market became more popular. Brokers and eventually ordinary people used a similar type of call loan. Brokerage houses lent funds to buy stock secured by the stocks as collateral. For example, a person who wished to buy $1,000 of stock might pay for $500 of stock and finance another $500, with the loan secured by the initial $500 block of stock.
Margin loans worked great when stocks went up in value. Using the example above, if the stock price increased by 25% then the stock would be worth $1,250. The person could then sell the stock, use the proceeds to pay off the $500 loan, and realize $250 profit. Without the margin loan, our hypothetical stock buyer could have only purchased $500 of stock that would have increased in value by $125. Margin lending doubled their profits.
By 1929 the US stock market was booming, and everybody was buying stocks. Margin lending requirements were extremely weak; everybody was buying stocks on margin and making lots of money. In the winter of 1928, financier Joseph Kennedy, father of the late President, famously quipped “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over.”
By this time some brokers were leveraged 10:1. That is, they’d pay $100 and borrow $900 for $1,000 of stock.
When stocks began to drop in price, the underlying collateral securing the margin loans was no longer enough. Subsequently, brokerages made “margin calls.” They demanded margin borrowers sell the underlying stocks to pay down or pay off the loans. This forced selling caused the price of the stock to drop further, setting off further margin calls.
As the overall market dropped, cascading margin calls and the forced selling caused the market to drop even further. By late October 1929, the stock market all but collapsed with forced and panic selling. A four-day run was the worst percentage decline in US history before or since. WWI cost less than those four days.
Both banks and their customers heavily invested in stocks. Banks also received margin calls. They then used reserve funds (customer deposits) to cover the margin calls. Eventually, the banks ran out of money.
During this era, deposits were uninsured. When a bank went bankrupt depositors lost their money. Therefore, when people heard their bank was in trouble they’d line up to take their funds out before the bank ran out of money, a bank run. As banks paid deposits in cash they’d have fewer reserves necessitating more margin calls, shuttering countless banks.
It wasn’t until June 1933, the US government intervened by creating the Federal Deposit Insurance Corporation to guarantee certain bank funds would be available even in the case a bank failed.
Stock losses, margin calls, and bank runs caused people to withdraw their money and save it. Americans stopped spending for anything besides the most vital goods. This caused retailers to fail, leaving their workforce unemployed and their creditors with unrecoverable debt.
With the economy in dire shape, the US decided to sharply restrict world trade, putting up protectionist barriers. Europe retaliated with their own trade barriers and export markets for US products froze, causing crop prices to drop. Farmers could not repay loans and lost their properties to widespread foreclosures.
Additionally, in an attempt to grow more crops farmers over-farmed their land resulting in widespread erosion and dust storms that destroyed vast amounts of farmland.
The margin lending, bank runs, lack of spending, trade war, and environmental mess led to the Great Depression.