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Scott Nations - A History of the United States in Five Crashes: Stock Market Meltdowns That Defined a Nation

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Scott Nations A History of the United States in Five Crashes: Stock Market Meltdowns That Defined a Nation
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A History of the United States in Five Crashes: Stock Market Meltdowns That Defined a Nation: summary, description and annotation

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In this absorbing, smart, and accessible blend of economic and cultural history, Scott Nations, a longtime trader, financial engineer, and CNBC contributor, takes us on a journey through the five significant stock market crashes in the past century to reveal how they defined the United States today

The Panic of 1907: When the Knickerbocker Trust Company failed, after a brazen attempt to manipulate the stock market led to a disastrous run on the banks, the Dow lost nearly half its value in weeks. Only billionaire J.P. Morgan was able to save the stock market.

Black Tuesday (1929): As the newly created Federal Reserve System repeatedly adjusted interest rates in all the wrong ways, investment trusts, the darlings of that decade, became the catalyst that caused the bubble to burst, and the Dow fell dramatically, leading swiftly to the Great Depression.

Black Monday (1987): When portfolio insurance, a new tool meant to protect investments, instead led to increased losses, and corporate raiders drove stock prices above their real values, the Dow dropped an astonishing 22.6 percent in one day.

The Great Recession (2008): As homeowners began defaulting on mortgages, investment portfolios that contained them collapsed, bringing the nations largest banks, much of the economy, and the stock market down with them.

The Flash Crash (2010): When one investment manager, using a runaway computer algorithm that was dangerously unstable and poorly understood, reacted to the economic turmoil in Greece, the stock market took an unprecedentedly sudden plunge, with the Dow shedding 998.5 points (roughly a trillion dollars in valuation) in just minutes.

The stories behind the great crashes are filled with drama, human foibles, and heroic rescues. Taken together they tell the larger story of a nation reaching enormous heights of financial power while experiencing precipitous dips that alter and reset a market where millions of Americans invest their savings, and on which they depend for their futures. Scott Nations vividly shows how each of these major crashes played a role in Americas political and cultural fabric, each providing painful lessons that have strengthened us and helped us to build the nation we know today.

A History of the United States in Five Crashes clearly and compellingly illustrates the connections between these major financial collapses and examines the solid, clear-cut lessons they offer for preventing the next one.

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W hile the image of a solitary author working away is a popular one, I had a tremendous amount of help in completing this book. That said, any errors are mine.

Without David Fugate at Launch Books, this work simply would not exist. David knew exactly who the publishing-world audience should be and precisely how to reach them. He helped fine-tune the concept and the voice. Hes been a great partner.

Without Henry Ferris at William Morrow this book would be much less than it isless interesting and less readable. Having someone edit your work can be as uncomfortable an experience as having someone tell you your baby is ugly. But Henry was almost always right and I caught myself realizing it as I read his suggestions. Hes been a great partner.

Emma LeGault was a tremendous help with research. She managed to find all of the old, esoteric information and articles I was searching for and always amazed me at how quickly she could turn around a random list into a pile of items to be read and digested.

Thank you to the Theodore Roosevelt Center at Dickinson State University, which has a wonderfully rich archive of Roosevelts speeches and letters and was a tremendous help in piecing together the private papers relevant to Roosevelts public speeches about finance and the economy during his presidency.

I extend a special thanks to Leo Melamed, formerly chairman of the Chicago Mercantile Exchange. Leo was generous in sharing his time so that I could get extra insight into the events surrounding the crash of 1987. And Leo doesnt realize it, but hes responsible for my TV career, such as it is.

Thank you as well to Eric Scott Hunsader for his time and for his insight into the Flash Crash of 2010. No one knows more about the market microstructure of todays electronic markets, and he was gracious in sharing his knowledge with me.

Finally, thanks to Wendi for her help and encouragement.

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H ayne Leland couldnt sleep. Despite a masters degree from the London School of Economics and a Ph.D. in economics from Harvard, he was worried about financeshis own.

The United States had been floundering in a recession from 1973 to 1975, with unemployment climbing to 9 percent as oil prices quadrupled. Leland, a thirty-five-year-old junior academic at the University of California, Berkeley, knew his salary was at risk as he tossed in bed that night. He would later explain, Lifestyles were in danger, and it was time for invention. He had to figure out how to increase his income.

He had been forming the pearl of an idea for years, ever since a conversation hed had with his older brother John, an executive at a money management firm. Shortly after the U.S. stock market bottomed out in 1974a loss for the Dow Jones Industrial Average of 39.6 percent in 1973 and 1974, still the worst two-year performance since the Great DepressionJohn lamented at a family gathering that so many institutional investors had pulled their money out of the stock market with no intention of returning. Its too bad there is no way you could buy insurance on your portfolio. Then people wouldnt have to sell out at the worst time and have no way to participate in the subsequent market rally. Hayne Leland was intrigued by his brothers complaint, but he also knew the issues involved were surprisingly complex, and other research topics were more pressing. He filed it away and planned to return to it at a later date. This sleepless night in September 1976 was that later date.

Leland eventually got out of bed, sat down at his desk, and started to think. He later remembered that it took something like two hours to reach a solution.

What Lelands brother needed was a put option on the stock market. A put option works just like insurance. For a small up-front paymentboth a put option and an insurance policy call this up-front payment a premiumone can buy protection against a stocks price dropping by purchasing an option to sell it at a predetermined price.

But these exchange-traded put options didnt exist. The Chicago Board Options Exchange had been launched three years earlier, but they traded only call options, the right to buy stock at a predetermined price. In 1976, put options, the right to sell stock at a predetermined price, were not available because they were considered dangerous and un-American.

Sitting in his darkened room, Leland remembered a paper published in 1973 that was gaining notice in academic finance. The Pricing of Options and Corporate Liabilities was the work of Fischer Black, a professor at the University of Chicago, and Myron Scholes, of MIT, and though the title promised solutions to a range of problems, the papers important nugget focused on figuring out how to calculate the value of an option, and not just its price. Leland realized that inherent in Black and Scholess work was the revolutionary concept that it was possible to replicate the investment results of a put option even if put options werent traded. Black and Scholess paper demonstrated that the investment results for a put option could be constructed using a portfolio that included just cash and a continuously adjusted position in the underlying stock or portfolio. Leland recognized it was possible to synthesize the option his brother had pleaded for by trading tiny slivers of stock in a careful, regimented fashion such that as the market fell, and the insurance value of the hypothetical put option increased, he would have sold many slivers of stock, but if the stock price increased, making the insurance value of the put option less valuable, he would have sold no slivers of stock.

The morning after Lelands middle-of-the-night insight, he realized that the mathematical complexity that had caused him to initially put the problem aside intruded again in the light of day. Even though Black and Scholes had described theoretically how to do what Leland wanted to do, he was not able to perform the actual calculations required to create a protective option out of thin air. Leland decided to approach Mark Rubinstein, a colleague at Berkeley, with his idea for insuring a stock, or a portfolio of stocks, and Rubinstein responded by saying, Im surprised I never thought of that myself! As the two settled into a discussion, they sketched a rough outline based on Black and Scholes. It would begin with a portfolio of stocks and would require continuously adjusting the amount of stock held, selling small slivers of stock if prices dropped, then buying them back if the stock rallied, and repeating the process endlessly. If the stock continued lower, they would sell more slivers as the price fellall in the mathematically rigorous and unthinking manner dictated by Black and Scholes, which would define exactly how many shares to sell at exactly what priceuntil eventually the synthetic option had expired. When the synthetic option expired, the profit or loss in the original position, combined with all the subsequent trading, would match that of a hypothetical portfolio with a protective option position. The concept wasnt really insurance; it simply offered a payoff that was supposed to mimic that of an insured portfolio.

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