ARCHIVES :: NOVEMBER 2002 :: COVER STORY

Seeds of the 1929 Crash

Buying on Credit Helped
To Fuel an Economic Boom--
Until It Got Out of Control

By KAREN BLUMENTHAL
Staff Reporters of The Wall Street Journal

Americans’ taste for consumer products is sustaining the economy through recession and weakness, and will be crucial to a recovery. But what would happen if consumers suddenly found themselves neck-deep in debt?

For some idea of the answer, turn back the clock to the early 20th century, when consumers got their first sense of the benefit of borrowing a little now for gain in the future—and saw firsthand how devastating too much debt could be.

Patriotic Duty

 The seeds of America’s love affair with loans were planted during World War I, when the nation needed money to finance its missions overseas. Politicians and top businessmen encouraged ordinary people to buy Liberty Bonds to help their country. The bonds were essentially a loan to the U.S. government, which paid 4% a year in interest until the debt was paid back.

Respected leaders urged patriotic citizens to stretch a little and borrow money so they could buy a larger bond.  All they had to do was go to the bank and take out a loan, then pay it back from their paychecks over six months. “You mustn’t be timid,” financier Thomas W. Lamont would tell potential investors at rallies to stir up interest in Liberty Bonds. “Think of the courage that our soldiers must show in the trenches, and then stop for a moment and consider whether you are showing anything like equal courage in the way you are proposing to handle this loan.”

People listened, and over two years, the Liberty Loan program raised $18.5 billion from bond sales. Americans got one of their first lessons in investing and borrowing. In fact, some say they learned the lesson too well.

By the 1920s, the war was over, but Americans’ comfort with loans endured. And there were many new things to buy. One of Henry Ford’s cars could be purchased on the “partial-payment plan,” to be paid off a little at a time. As people moved to the cities, they bought new homes, taking out loans to pay for them. Stores offered credit for all kinds of things, from the newest household appliances, like refrigerators and washing machines, to jewelry and clothes. An estimated 15% of retail sales were made on the “easy payment” or installment plan.

Investors had long borrowed money to buy stocks, but the amount they borrowed and the enthusiasm for borrowing grew rapidly in the late 1920s, as credit became plentiful and the stock market started to boom. Borrowing to buy a stock—an investment representing a share of a corporation—meant putting up “margin.” Margin was like a down payment on the stock purchase, sometimes as little as 10% of the purchase price. Investors didn’t have to pay anything more upfront, unless the stock price fell. The loan would be paid off by the rising value of the stock.

As stock prices climbed to record heights in 1927 and 1928, investors saw great riches within their reach, especially when they could borrow so easily. In 1927, brokers borrowed $4 billion, up 33% from the previous year, and they in turn would lend the money to stock buyers. By the end of 1928, brokers’ loans had exploded to $6.4 billion, a 56% increase in one year.

The stock market seemed to have no limit. Hot stocks like RCA—the biggest radio maker and the dot-com of its time—doubled, tripled, and then quadrupled in value. Eager to get in on the gains, investors sought to borrow more for stock purchases, and banks were happy to make more loans. In fact, in 1929, nearly $4 of every $10 banks lent was for stock purchases. Even corporations jumped in on the lending business. John D. Rockefeller’s Standard Oil of New Jersey, Chrysler and General Motors all made millions of dollars in stock loans.

Buying stocks on margin, and making margin loans, made plenty of sense when stocks were rising. But when stock prices started to fall in October 1929, many of the loans started to look risky. Brokers had to make “margin calls”—asking investors for more upfront cash to cover the loans. If customers couldn’t provide the cash, their stocks would have to be sold.

Comedian Groucho Marx of the famous Marx Brothers got his first margin call after prices tumbled on Oct. 24, 1929, a date known in history as “Black Thursday.” Groucho, who had invested all of his savings in the stock market, had to give his broker all the cash he had left to keep him from selling his stocks.

But stocks continued to fall, dropping 12.8% on the following Monday, Oct. 28, and nearly another 12% on Oct. 29, Black Tuesday, one of the worst days ever in the stock market. Over six days, the stock market lost nearly one-third of its value—$25 billion in savings disappeared.

As lenders called in loan after loan, more and more shares had to be sold, and the stock market fell further. Like many other investors, Groucho had to come up with still more cash for his broker, and turned to even more borrowing. He borrowed money from a bank. He borrowed against his life-insurance policy. He took a mortgage loan on his home.

‘All the Money I Had’

 But even that wouldn’t be enough. His broker sold all his stock, depleting all of Groucho’s savings. “Some of the people I know lost millions,” Groucho Marx wrote in his autobiography. “I was luckier. All I lost was two hundred and forty thousand dollars. I would have lost more, but that was all the money I had.”

The stock market crash was painful, wiping out the life savings of millions of people and leaving some deep in debt. After watching the devastation of such a borrowing binge, federal officials were determined to keep people from overindulging again. They took steps to keep interest rates high and discourage borrowing. So people didn’t borrow—and companies didn’t either. Consumers couldn’t buy houses. Companies didn’t have money to expand. Workers lost their jobs as the businesses shriveled. The result was a downward economic spiral.

From the book “Six Days in October: The Stock Market Crash of 1929,” by Karen Blumenthal. © Copyright 2002 Karen Blumenthal. Click here to order.