FINANCIAL MARKETS

THROUGH TIME
FM 563 : Banking and Financial Institutions

Brandl, Money, Banking, Financial Markets & Institutions, 2nd Edition. © 2021 Cengage. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Early Twentieth Century
• Part of the change in financial markets came about as the structure of American
business evolved during the first decade of the 20th century.
• The U.S. business sector was dominated by the expansions of trusts.
• Trusts are horizontally integrated ownership structures that dominated key
industries such as railroads, oil, steel and banking.
• The first decade of the 20th century saw American businesses being transformed as
corporations moved away from trust dominated markets.
• Frederick Taylor introduced the scientific management theory or the “Taylorism”.
• Result of Taylorism - output increased significantly, causing the number of workers
increased.
The Panic of 1907
• National Banking Era (1863-1913)
• The U.S. did not have a central bank.
• Almost all commercial banks were “local” and regulated on a state level
• The Panic of 1907
• Triggered by wild speculation in the stock market; loose lending by banks (A lack of
effective oversight of financial markets)
• John Pierpont Morgan ended the panic of 1907
• JP Morgan assembled a committee which will determine whether affected financial
institutions should be saved or not.
• He was able to convince the US Government to save some of banks in New York City
(NYC).
• JP Morgan supported the issuance of NYC bonds bringing the crisis to an end.
Early Structure of the Federal Reserve
• Congress envisioned a “lender of last resort” to the banking system.
• Be there for the benefit of banks; Congress created a quasi-government agency ---
something created by the federal government but not part of the government.
• Commercial banks were required to buy shares to raise capital to begin
operations.
• President Wilson - 12 regional banks, whose policies are coordinated by the Fed’s
Board of Governors
Early Structure of the Federal Reserve (Cont.)
• The Federal Reserve - No clear division of power.
• District banks setting their own interest rates and lending policies.
• 1914: Benjamin Strong, Jr. was appointed as the first president of the Federal
Reserve Bank of New York.
• 1923: Open Market Investment Committee was created to centralize the making
of monetary policy.
• Strong’s vision; a central bank headquartered in the center of the nation’s
financial market: New York.
Financial Markets During the Great Depression
• September 3, 1929 – stock market hits an all-time high
• Roger Babson, writes “Sooner or later a crash is coming, and it may be terrific”-
Stock speculators receive margin calls.
• Stock bought on credit was falling, cash would be needed or face the loss of the
stocks held. Margin calls were not being met and thus forcing to sell their shares.
• Markets react to lower prices causing markets selling in a near panic. Panic
selling had set in.
Preparing for War
• 1940 - Walter Reuther, President (UAW) utilizes unused production capacity to
produce 500 airplanes a day for US military.
• 1941 - Roosevelt signs the Lend-Lease Act, provide military and economic
assistance to countries viewed as” vital to US defense.
• US exports amount to $250 million in August 1939. This has increased to $450
million worth of goods and services in August 1941 due to the Lend-Lease Act.
• US ramps up military output. Government takes control of both labor market, as
well as wage and price control and capital markets to finance the war.
Funding the War Effort
• John Maynard Keynes is the author of “How to Pay for the War”.
• Government ran budget deficits by borrowing from the public and financial
system.
• To avoid inflation from spiking up, the government argued on rationing of
necessities and impose high progressive income taxes.
• US spending were increased by sixfold from 1940 to 1946 of which 75% were
used for military expenditures.
• Debt covering; Government sells government bonds.
Controlling Inflation During the War
• War bonds: used to fund government’s purchases. Key in keeping down inflation.
Consumer goods become scarce; diverted for the war effort. Many fear prices
would increase dramatically.
• Compounding this fear, employment increase needed for war. The US military
increases dramatically. American men and women were needed in factories to
produce military equipment. Cost of living up 62% due to increased earning power.
• Government rationing – helps restrict consumption and thus inflation. Rationing
coupon – issued by government, helped retard household spending.
• Wage and price controls: Also called incomes policy, an economic policy where
governments place legal limits on the amount of wage and price increases.
Financial Markets Help Fund the
“American Dream”
• Many GIs were returning home from overseas and wanted to settle into the American
Dream of a well-paying job and a house with a white picket fence.

• To make this dream come true, the US financial markets greatly expanded their lending
to families to buy homes.

• Savings & Loan: A depository institution that focuses on taking deposits of households
and individuals. Most loans are consumer loans including home mortgages.

• Federal Government created Fannie Mae to assist in home buying.

• Fannie Mae (formerly the Federal National Mortgage Association) buys mortgages
from S&Ls insured by the Federal Housing Administration.
Push for European Economic and Financial
Integration
• Leaders of Western Europe desire to create a “United States of Europe” -- a
United Europe; a good idea.
• Europe was divided in half; Western Europe – democracies leaning towards
market-based economies. Eastern Europe, Soviet influence focused on a centrally
planned economy.
• The Treaty of Versailles ended WWI. Germany faces very high rates of inflation
during the 1920s -- some lessons learned
• Western nations realize, rebuild and trade leading the way, Germany and Italy are
welcomed into United Europe. Trade Barriers between member nations are lifted.
The Rise of Stagflation
• Stagflation: A time when the economy suffers from high rates of inflation and
economic stagnation, often a high and/or increasing unemployment rate.
• Growing unemployment, increasing rates of inflation caused the economy to
stagnate.
• As the economy expanded, increased competition led to higher wages. Higher
labor costs get passed on to consumers, causing higher market prices.
• Stagflation: economy was experiencing growing inflation and unemployment at
THE SAME TIME.
Paul Volcker
• 1979 - Jimmy Carter announced the appointment of new Federal Reserve
Chairman: Paul Volcker.
• Volcker had been serving as president of the Federal Reserve Bank of New
York and had a long history of public service
• Federal Reserve should concentrate on growth rate of the money supply.
Volcker contended – to get inflation under control we needed to reduce the
growth rate of the money supply.
• Volcker took over as the Federal Reserve chair on August 6, 1979
Reagan and Thatcher
• Their economic policies focused on long-term issues: Growing the economy,
controlling inflation, and creating economic opportunities.
• 1981-82: the worst recession since the Great Depression.
• Tight money policy helped the economy rid inflation.
• Easing the monetary policy helped the economy start to grow and expand
without inflation.
The Savings & Loan Crisis
• Savings & Loans: Major player in the housing boom; post-WWII era.
• Inflation began to rise, causing interest rates to follow. S&L began losing
deposits to Money Market Mutual Funds.
• Regulation Q law: Capped interest rates that S&L could pay.
• DIDMCA (Depository Institution Deregulation and Monetary Control Act):
Allowed S&L to pay market interest rates on deposits.
• Garn-St. Germain Act of 1982 – Reduced the amount of regulation over the
Savings & Loan or thrift industry.
Leverage Buyouts & Junk Bonds
• Leveraged buyout: The acquisition of a public or private company where the
buyout is financed mostly by debt (leverage).
• A push for deregulation of markets; (LBO) craze followed.
• Assets are used as collateral for the debt that is issued to buy the acquired
company’s outstanding stock.
• 1980s saw LBOs increase due to the deregulation of financial markets and the
relaxation of anti trust and securities laws.
• Rise of the Junk Bond Market
The Tech Bubble and Burst
• The decade of the 1990s saw financial markets funding the technology
focused “new economy.”
• In the “new economy” things were” different.” No longer did firms need to be
managed by seasoned professionals to insure financial stability.
• Venture capitalists looking to get in on “the ground floor” of the next big
industry would provide seed stage capital to firms that were starting out.
• A few months later they would sell the shares they owned to the public in an
Initial Public Offering or an IPO. Everyone wanted in and a boom was
underway.
• Then these stocks crashed.
Subprime Crisis
• In less than a decade after the Tech Bubble burst, came the mortgage bubble and
resulting subprime crisis that would spread across the globe and trigger the worst
economic slowdown since the Great Depression.
• The subprime crisis was similar to all the other financial crises.
• It starts with mispricing or misunderstanding of risk, leads to speculative behavior,
the suspension of reality as many believe “this time is different.”
• Asset prices increase quickly and irrationally. More people are drawn in and the
asset bubble grows…and then bursts.
• It was truly a catastrophic event. Hopefully by understanding what happened, and
putting into a historical context, we can all be part of the process to make sure it
will never happen again.