Why we'll have another financial crisis: Tulips, Stocks, and Houses

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Why we'll have another financial crisis: Tulips, Stocks, and Houses
September 14, 2022

Tough times are, unfortunately, back. Is a recession on the horizon? It’s gotten so bad that it has even taken a toll on something that New Yorks love a lot - pizza - and it’s a big deal. In NYC, for decades, there was the pizza principle: where a slice of pizza was the same price as a subway ticket. But not anymore. The decade-long balance is now gone. The bad thing is that it’s much more than just pizza. Global chaos, rampant inflation, and a looming financial crisis. Crypto rose, it promised millions and then collapsed, taking people’s fortunes with it. Startups are closing down, and thousands are losing their jobs. Expensive pizza is the least of our problems. A bigger question lingers: how do we end up in this shit in the first place? And, most importantly, who’s responsible? 

Let’s talk about financial crises. 

The Power of Tulips

In 2021, Slidebean decided to rent a house in Brooklyn, NY, so that when different team members from our overseas offices went to New York they would have somewhere to stay. This year the rent went up $800, and we aren’t the only tenants that have had our rent increased across the city. But all you needed to own a house in 1700 Netherlands was one thing: tulips. 

The Dutch were powerful in the 1700s. There was a company that essentially ruled the seas and had a private army for themselves (we made a whole video about it). 

Now, there’s one crucial cultural context that you need to understand about them - most of the population back then were Calvinists, one of the strictest forms of the Protestant religion. Calvinism forbids them from parading around, showing luxury, or even wearing fancy clothes. 

So get this, you are Dutch in the 1700s: you’re making good money selling and trading spices; you live comfortably; you eat poffertjes and visit the occasional coffee shop, but you can’t brag about your newfound social status in a religion-approved way?

Tulips. 

I mean, they’re pretty, but in 18th century Holland, this was a symbol of luxury that didn’t break the rules. They put them in hats and dresses or just carried them around. Tulips got so expensive that owning one meant you were rich, and owning many implied you were filthy rich. 

People even started valuing ‘special’ tulips like the ones with color strips (which were caused by a virus). Tulip prices went up and up and up. But, so far, things were normal. The thing with tulips is that they only bloom for a short season. Everybody was getting better at growing tulips, but you could still only get them in the spring. 

That's when stock brokers stepped in. They did come up with a sort of contract that you could buy anytime in the year, but it would guarantee that you could get your tulips during the season at a pre-set price. 

This is great, because not only are you guaranteed your looks for the summer, you have this paper that guarantees you can get tulips at your fixed price. 

This means that if people start getting really excited about tulips, you can sell your tulips at a more expensive price. Better yet, you could sell your contract for a better price! You didn’t even have to wait for the tulips.  

This contract that we are talking about is called a future - and yes, we still use futures to this day. And at some point, tulip futures were more expensive than a house. Some reached 5,000 guilders when a yearly salary was 250.

What many people don’t get is that this boom wasn’t created by flowers - it was created by speculators. I don’t expect anybody ever traded a house for a flower, the madness happened over the contracts; over the speculation. But what people really wanted was flowers, not papers, not speculation. So in no time, those with contracts had no buyers. 

In a matter of weeks, days even, prices plummeted. Chaos, suicides, lawsuits… 

Actually no. That's what a lot of people get wrong. As historians researched more and more, they found no evidence to suggest that the tulip bubble rattled the nation. There's not even a single record of individuals filing for bankruptcies. Some people lost a lot of money, but the country didn't enter a default. I mean, the Dutch didn’t do too well after that, but not because of the tulips.

The urban legend of sorts happens because we love saying I told you so, we love to be the smartest person in the room, bragging about that insight that nobody else has. But who was to blame here? The Bro that invented the future? The people who wanted some quick cash? The religion that banned other luxury items? 

Hold that thought. Let’s go to the next one. 

The 1929 Stock Market Crash

Let's talk about the 1929 stock market crash. This one actually might have some more familiar terminology - and a character who makes a comeback here. 

The 1920s were crazy times. The Great War is over. The US comes out victorious, and post-war economic booms are not rare. If you are a farmer, you are suddenly maximizing production to feed those soldiers coming home. Henry Ford had mechanized the Model T, and people wanted cars, houses, and the latest technology. That means the demand for wood, rubber, and steel grew. It's estimated that the US economy doubled in size from 1920 to 1929. 

That's great, but with a catch. 

Fast growth usually means borrowing money. Now that’s not necessarily bad. Farmers took out mortgages to pay for equipment and land. Factories expanded and hired people to ramp production. Even regular folks used credit to buy new technology like vacuum cleaners, radios, and washing machines. So, the entire US economy had doubled, but it had done so using credit, and the US was printing money like crazy to keep up with all this activity. 

With so much money, regular people invested everything they had into the stock market, which was growing too. It had reached historical highs, and people were confident it would never drop. Millionaires, cooks, and janitors all ran to put their life savings in the stock market. 

It’s hard to resist. The prospect of making more money from this passive income is very tempting, and many people don’t do it responsibly. There was no Robinhood in ‘29. Only about 10% of the population had actually invested in stocks - so how was this crash so bad?  

Well… banks. Banks saw an opportunity to profit from this thriving stock market too. They would loan money to people so that they would invest in the stock market, and when the money ran out, banks borrowed more money from other institutions. Loans on the top of loans, to bet on the stock market. This new little creative instrument, when you borrow money to invest in something, is called margin trading. 

Let’s say that you want to buy Tesla stock and you’ve got $10,000 you’d like to invest. At the end of 2021 that would be about 9 Tesla shares. That’s cool but it’s not that many shares. If shares gain $100 per share, you make $900, but the guy next door is making much more because he has more. 

So, you obviously want much more, and stock brokers could help you fund that with margin trading. All you needed was 10% collateral. So if you show you have $10,000 in your trading account, they will lend you the other $90,000 so you can invest a total of $100,000 in stocks. 

Mind you, you won’t own $10,000 of Tesla Stock, you will own $100,000 of Tesla stock thanks to that little loan. Now you have 90 Tesla shares, and you can brag to your friends who are also trading. This is called a leveraged trade, or a leveraged position. 

Fast forward a few months, Tesla stock drops (as it actually did) and it’s now worth $639. your 90 shares are now worth $57,000: you’ve lost $43,000. But remember, you only had $10,000, to begin with. You now owe your Broker bros $33,000, and they don’t really care about the stock price anymore, they care about this loan they gave you. This is called a MARGIN CALL (and it will be really important in a second). 

Leveraged or margin trading is very dangerous: today it’s accessible to everyone but even back in 1929 it was pretty easy to do margin trading, and nobody likes to think about those bad scenarios.

From 1922 to 1929, the Dow Jones increased by 220%, and at its peak, it reached 381 points. People would invest in companies, and more people decided to bet on companies with money they didn’t have. Some would say it’s almost obvious that this makes no sense, but nobody likes to think about that. 

What happens when people don’t meet their sales expectations? People panic. They sell, in mass. 

Company values began tanking. The stock market freaked out and the world was moments away from chaos, but that’s not all.

The History of the Fed

There’s another element to this perfect storm.I don’t want to dig that deep into this part but you need to understand some basics. 

The Fed, which is the Central Bank in the US, defines the base interest rate from which all banks and lenders operate. In the 1920s, The Fed wasn’t happy with all this margin investment, so in order to control spending, they spiked those interest rates. That means borrowing money is now more expensive. It might mean the loan you already took now pays more interest. It also means that if you put your money in the bank, they’ll pay you more interest for it- so people are now encouraged to go with a safe Certificate of Deposit rather than the stock market. Other countries also raised their rates to keep up with the US. So, overall people borrowed less, and spent less. What about all of those companies that ramped up production to keep up with demand? Now they have things they can’t sell, and so comes the perfect storm. 

The Perfect Storm

Companies fired people and cut wages to keep up with the losses. So, people didn't have the money to pay all those debts. One person defaulted, and another, and another. So, started the chaos. As soon as the bell rang on a new trading day, a collective panic sparked a sell off. As the crowds gathered round the stock market and watch as the value plummeted. 

So, brokers started calling for more money. Only problem: these were regular people with no more money. The brokers demanded such large sums that were impossible to pay. People tried desperately to sell whatever they had to pay off these margin calls, but selling a car, or even a house, was impossible to do in such a short time. 

What happened on Black Tuesday?

It’s October 29th: Black Tuesday the stock market doors opened with one word: sell. But no one was buying. Stocks were worthless. People rioted inside the stock exchange and outside, on the streets. Fortunes were disappearing. The stock market dropped 23% in two days, and nothing could stop it. On Black Tuesday alone, the Stock Exchange lost $14 billion, which is roughly $240 billion in today’s money. In total, it’s estimate that the crash caused $600 billion in losses in today’s money. Banks ran out of money, so they started defaulting and were unable to pay other banks. And so, money ran dry. People couldn’t even afford to eat. Farms all over the US saw their income drop by 50%. Nobody was buying cars, or houses, or anything, so factories closed down. 

The crash didn’t stop until 1932. By then, one out every four American was out of a job, and banks didn’t fair any better. Half of them went bankrupt. Half! 

So almost 100 years later, we know this story. We can blame the brokers, sure, but we can also blame the 10% of people who gambled with stocks. But before we point fingers - isn’t this story somewhat familiar? Could we have learned a thing or two from this? 

The Dot-Com Bubble 

That of course brings me to the year 2001 (and I’m not talking about The Dot Com bubble which we have already covered).  

The world was recovering from the 2001 crisis, and people wanted to invest their money in something other than risky, intangible, fugazi tech stocks. What tangible asset we’ve been sitting on? Houses. 

But who has the money to buy a house upfront? Of course not. You need to take out a margin - I mean a mortgage. How could I confuse them? Margin trading is risky. No background checks, a 10x leverage on your money. It’s nothing like a mortgage. I’m half kidding here. You’ll see why in a sec. 

Yes, a mortgage does require a good credit record. And if you don’t pay it, the lender could take possession of the house (a very real and tangible asset) and re-sell to collect the money. So, for those lending the money, this is an obvious win-win. It’s a safe bet. Who doesn’t pay their mortgage? 

Now, if everybody is buying houses - the lender needs liquidity, more cash to keep lending to new customers. So what they can do is package all of these mortgages into a thing called a Mortgage-Backed Security. You can take this pool of mortgages and sell it to investors. The lender collects cash up front and the investors get an asset that pays them interest, and that is backed by houses. 

The idea was so popular that the investment banks doing this became HUGE. Now we can go really deep around about this (and we did so using Monopoly), but what you need to understand here is that these investors could trade with these securities, like with stock. They could sell the right for these interests to other investors and with the extra money, they would have the cash to buy more securities, which motivated lenders to create more mortgages. The problem was that there weren't enough mortgages for everyone who wanted in. So requirements to get a mortgage got loose. Really loose. Other people wanted in on the action. For example, insurance companies began insuring the mortgages, meaning that they would have to pay up if the homeowner failed to pay. So, people loved the real estate market, from the real estate agent to the lender, to the bank, to the insurance company! And this was a bet that wouldn't happen because everything was going great and nobody was not going to not pay their mortgage. So you could bet a lot. And then others could invest in those bets, and profit as long as people paid their mortgages. With so much real estate money on the market, housing prices of course grew. So now you could refinance this house because it was worth more. Maybe get into a different mortgage for a vacation home. 

The real estate market went from $1 trillion in 2000 to $50 trillion market by mid-2008! 

A cycle of bets on bets, on margins in a way that nobody had seen before, and they were gambling on people’s dream to own a house. On the assumption that they would always pay. That might have been everyone’s intention but many of the loans that these homeowners were getting were a type of loan called sub-prime: that has a low-interest rate for a few years, and then it spikes up.  People either didn’t understand this or didn’t care but the rates were so high that it was enough to make people default. This started a domino effect that toppled all the financial institutions in the US because people weren’t paying. Nobody was getting new loans so houses became so worthless that banks couldn’t even sell them to cash in. A bunch of these investment banks went out of business,

The biggest bankruptcy in US history! It was their own fault for speculating and gambling, and being irresponsible, but that is obviously not the end of economic turmoil in the US.

Is a Recession Coming? 

I honestly didn’t really understand what had happened in these crises until very recently but now that I do shouldn’t we have seen it coming? If history does repeat itself, if we see cycles of a thriving economy followed by downturns and crashes, should we have smelled that something was coming after what we saw in 2020 and 2021? 

The problem is that it’s hard to resist. When Bitcoin doubles its prize in a few weeks, it’s hard to resist the urge to take that gamble, especially when we are bombarded by content from people who took the gamble and won. People have stopped trusting their governments, their banks, and they certainly have stopped trusting Wall Street. At least we learned that much, and we can all agree that they carry much of the blame. 

For so many people, what goes on in the twisted world of finance is just too far off, but we forget that we are just a privileged few. The few that can get a grip on futures, margin calls,  and leveraged trading; a select few who engage with our content on our blog and on our YouTube channel. 

Why we'll have another financial crisis: Tulips, Stocks, and Houses
Caya
CEO at Slidebean/FounderHub. TEDx Speaker. 500 Startups Alum. 40-under-40.
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