I’m currently reading a book about the life of Jesse Livermore.  Part of the book describes how Livermore made a fortune shorting stocks just before the panic of 1907 hit.  He had one key insight: the loans of lesser brokers were being funded by the large brokers, and the large brokers were losing confidence in the creditworthiness of the lesser brokers, and banks were now funding the borrowings by the lesser brokers.
Photo Credit: Vinoth Chandar || Do you control the elephant, or does the elephant control you?
What Livermore didn’t know was that the same set of affairs existed with the banks toward trust companies and smaller banks. Most financial players were playing with tight balance sheets that did not have a lot of incremental borrowing power, even considering the lax lending standards of the day, and the high level of the stock market. Remember, in those days, margin loans required only 10% initial equity, not the 50% required today. A modest move down in the stock market could create a self-reinforcing panic.
All the same, he was in the right place at the right time, and repeated the performance in 1929 (I’m not that far in the book yet).  In both cases you had a mix of:
- High leverage
- Short lending terms with long-term assets (stocks) as collateral.
- Chains of lending where party A lends to party B who lends to party C who lends to party D, etc., with each one trying to make some profit off the deal.
- Inflated asset values on the stock collateral.
- Inadequate loan underwriting standards at many trusts and banks
- Inadequate solvency standards for regulated financials.
- A culture of greed ruled the day.
Now, this is not much different than what happened to Japan in the late 1980s, the US in the mid-2000s, and China today. Â The assets vary, and so does the degree and nature of the lending chains, but the overleverage, inflated assets, etc. were similar.
In all of these cases, you had some institutions that were leaders in the nuttiness that went belly-up, or had significant problems in advance of the crisis, but they were dismissed as one-time events, or mere liquidity and not solvency problems — not something that was indicative of the system as a whole.
