Financial Bubbles

The Dot Com Bubble

How it started

Between 1995 and 2001, the Internet (specifically the release of Mosaic and later web browsers that gave computer users access to the World Wide Web) created a euphoric attitude toward business and that inspired hopes for the future of online commerce. For this reason, many Internet companies (known as “dot-com” which motto was “get big fast” referring about the business model) were launched and led investors to assume that were going to be worth millions in the future. Nonetheless, many companies were overvalued and not that successful, causing investors to lose important amounts of money because of their eager dreams to become millionaires, ignoring the basics of fundamental analysis.

Economic prosperity among the participants and the crash

The bubble was enhanced by investment banks, which profited significantly from initial public offerings (IPO), rising levels of speculation and they encouraged investment in technology. There were highly reported cases of people quitting their jobs to invest all their savings to dot-com enterprises being motivated by the agile publicity made by the media, such as articles on The Wall Street Journal and CNBC. As a result, the venture capital reached historic levels and the Nasdaq Composite stock market index rose from 751.49 to 5135.52 between 1995 and 2000, meaning an increase of 400% in only 5 years, establishing P/E ratio levels of 200, surpassing the results of the Japanese Asset bubble in 1991. Several companies likewise Qualcomm, rose their value about 2000%. The picture below presents the bubble inside Nasdaq index, putting special attention in the downfall of 77.9% from its maximum value on March 2000 to its lowest point in October 2002.

Source: Global Entrepreneurship Institute

In addition to the crash, the terrorist attack of September 11th, 2001, created an important macroeconomic shock that affected the market, as the New York Stock Exchange dropped 14% on the day after the attack.

Monetary policy and financial regulation

Consequently, the FED´s president, Alan Greenspan, decided to burst the bubble due the fact that he realized an overheating in the economy. The way that he popped it was through the increasement of the interest rate to the point of being the same as 1995, named the “Tequila Effect”. After that, he adopted a contracyclical monetary policy (decreasing interest rate), making the interest rate almost 0%, encouraging people to take adjustable-rate mortgage loans rather than traditional fixed-rate mortgage rates, allowing the birth of another world known financial bubble.

Interest Rate from the FED through years
Source: Extracted from

Aftermath of the crash

Once the bubble burst, there was insolvency (bankruptcy) from a lot of dot-com companies and many of them were accused of fraud for misusing shareholders ‘money. Additionally, the U.S. Securities and Exchange Commission levied fines against investment firms for misleading investors. Nevertheless, there were some enterprises that got few troubles and continue running till nowadays like E-Bay and Amazon, consolidating their position in the technology sector (their OPI were in 1997 & 1998, years before shock).

Finally, though the adverse consequences, there were positive aspects to take into consideration likewise the optical fibber infrastructure development which lasted less than 5 years (it was expected for (at least) 15 years), the later creation of new web firms like Google and YouTube, and the Silicon Valley existence, promoting technological business models.

The Roaring 20s

The 1920s gave us jazz, movies, radio, making out in cars, illegal liquor, prosperity, and a consumer culture based on credit, which eventually led to the worst economic crisis the US has ever seen. There is a stereotypical view of the 1920s as “The Roaring 20s” a decade of exciting change and new lifestyle, as well as increased personal freedom. The 1920s was a period of rapid change and economic prosperity in the USA.

It was a time of increased wealth for some people. During the 1920s, the government helped the business grow, by not regulating it much at all. This is known as “laissez-faire”

Productivity rose dramatically largely because older industries adopted Henry Ford’s assembly line techniques and newer industries grew up to provide Americans with new products and new jobs. The economy also grew because American corporations were extending their reach overseas, and American foreign investment was greater than that of any other country. The dollar replaced the pound as the most important currency for trade by the end of the decade.

The widespread use of credit and layaway buying plans meant that it was acceptable to go into debt to support what came to be the American standard of living and this was a huge change in attitude. The fact that so many Americans were going into debt to pursue the American lifestyle meant that if the economy faltered, and it did, there was going to be lots of trouble.

Prosperity in the 1920s was not equally distributed through the population. In the mid-1920s, around 3 million Americans owned stocks, and Wall Street captivated the imagination of the audience with stories of fortunes won the idea overnight of a big bull market in which it seemed that stocks could only climb, seized everyone. People had so much faith in the bull markets that started borrowing money in enormous amounts to speculate on rising prices of stocks.

During the 1920s the number of manufacturing workers declined by 5%, the first time this class of workers had seen its numbers drop. New England was beginning to see unemployment in deindustrialization as textile companies moved their operations to the south where labour was cheaper.

The 1920s also saw increased tension between science education in the United States and religious beliefs. Immigrants were necessary for the economic boom of the 1920s, but at the same time, their numbers were restricted, as they were a threat to traditional American values.

The roaring 20s was a decade of excesses, and an obvious one was the stock market. By the fall of 1929, US stock prices had reached levels that could not be justified by reasonable anticipations of future earnings. A result of a variety of minor events led to gradual price declines in October 1929, leading to investors lose confidence and the stock market bubble burst.

At that time, the President of the United States was a Republican, Herbert Hoover. He believed that if you were in trouble you should help yourself and not expect others to help you. This is called “rugged individualism”. Therefore, he did not do a great deal to help those affected by the crash.

Hoover did not believe that the depression would last – “Prosperity is just around the corner” is what he said to a businessman in 1932 when things were at their worst.

However, Hoover did do some good. Money was used to create jobs to build things such as the Hoover Dam. In 1932 he gave $300 million to the states to help the unemployed (Emergency Relief and Reconstruction Act) but it had minor impact as states run by the Republicans believed in “rugged individualism” more

than Hoover did and they used only $30 million of the money offered to them. Many saw Hoover’s attempts as being “too little too late”.

During the 1920s, the U.S stock market underwent rapid expansion, reaching its peak in August 1929 after a period of wild speculation during the roaring twenties. By then, production had already declined, and unemployment had risen, leaving stocks in great excess of their value.

Among the other causes of the stock market of 1929 were low wages, the proliferation of debt, a struggling agricultural sector, and an excess of large bank loans that could not be liquidated.

Stock prices fell 33% between September and early October 1929, and on October 18 the fall began. Panic set in, and on October 24, Black Thursday, a record 12,894,650 shares were traded. Investment companies and leading bankers tried to stabilize the market by buying up great blocks of stocks, producing a moderate rally on Friday. On Monday, however, the market went into free fall. Black Monday was followed by Black Tuesday, in which stock prices collapsed completely and 16,410,030 shares were traded on the NYSE in a single day. Billions of dollars were lost, wiping out thousands of investors, and stock tickers ran hours behind because the machinery could not handle the tremendous volume of trading.

After October 29, 1929, stock prices had nowhere to go up, so there was considerable recovery during succeeding weeks. Overall, however, prices continued to drop as the United States slumped into the Great Depression, and by 1932 stocks were worth only about 20 percent of their value in the summer of 1929. Most people could not afford any loss of money. This had a particularly important economic impact as these people could no longer afford to spend money and therefore did not buy consumer products. Because there was no buying, shops went bankrupt and the investment downturn led factories to slow down production and begin firing workers, due to have no reason to employ people who were making products that were not being sold.

As a result, 12 million people lost their job, and for those lucky people who remain employed, wages fell, and buying power decreased. 20,000 companies had gone bankrupt, 1616 banks had gone bankrupt, and 23,000 people committed suicide in one year. Both, the 1929 stock market crash, and the Great Depression formed the largest financial crisis of the 20th century.

After the crash, in 1932, the U.S Senate established the Pecora Commission to study the causes of this event. The following year, the U.S Congress passed the Glass Steagall Act mandating a separation between commercial banks and investment banks. To prevent future events like this one, the stock markets around the world instituted measures to suspend trading in case of rapid declines, claiming that the measures would prevent such panic sales.

Tulip Mania


The Tulip Mania is considered by many as the first recorded story of a financial bubble, which reportedly occurred in the 1600s.   Tulips were introduced into Europe imported from the Ottoman Empire shortly after 1550, becoming a popular, exotic and costly item. Ten or eleven years after this period, tulips were much sought after by the wealthy, especially in Holland and Germany. Rich people at Amsterdam sent for the bulbs direct to Constantinople and paid the most extravagant prices for them. Until the year 1634 the tulip annually increased in reputation, until it was deemed a proof of bad taste in any man of fortune to be without a collection of them. Many learned men, including Pompeius de Angelis and the celebrated Lipsius of Leyden, the author of the treatise “De Constantia,” were passionately fond of tulips.


The demand for tulips of a rare species increased so much in the year 1636, that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns. Symptoms of gambling now became, for the first time, apparent. The traders, ever on the alert for a new speculation, dealt largely in tulips, making use of all the means they so well knew how to employ, to cause fluctuations in prices. At first, as in all these gambling mania, confidence was at its height, and everybody gained. The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich.

Graph of the price of the tulip bulb.

The example of the Dutch was imitated to some extent in England. In the year 1636 tulips were publicly sold in the Exchange of London, and the traders exerted themselves to the utmost to raise them to the fictitious value they had acquired in Amsterdam. This also happened in Paris, and in both cities they only partially succeeded. However, the force of example brought the flowers into great favour, and amongst a certain class of people tulips have ever since been prized more highly than any other flowers of the field. The Dutch are still notorious for their affection to them and continue to pay higher prices for them than any other people. As the rich Englishman boasts of his fine race-horses or his old pictures, so does the wealthy Dutchman boast him of his tulips.


By the end of 1637, the bubble had burst. Buyers announced they could not pay the high price previously agreed upon for bulbs and the market fell apart. While it was not a devastating occurrence for the nation’s economy, it did weaken social expectations. The event destroyed relationships built on trust and people’s willingness and ability to pay.  

The Tulip Mania is considered by many as a prime example of a bursting bubble. While savvy people started to get out early, the late ones were panic selling after the free fall started, causing many investors and service providers to lose a lot of money.

Did the Dutch Tulip Mania really exist?

Recent scholarship has doubted the magnitude of the tulip mania, suggesting it may have been exaggerated as a parable of greed and excess.  

In 2007, Anne Goldgar published a book entitled “Tulip mania: Money, Honor, and Knowledge in the Dutch Golden Age,” where she presents lots of evidence that the popular Tulip mania story is actually full of myths. Based on extensive archival research, Goldgar’s arguments indicate that both the rise and the burst of the tulip bubble was much smaller than most of us tend to believe. She states that the economic repercussions were pretty minor, and the number of people involved in the tulip market was quite insignificant.

Today, the tulip mania serves as a moral tale for the consequences that excessive greed and speculation can lead to.

The United States Housing Bubble


The Housing Bubble started in the mid-90’s alongside the economy and stock market boom. People who had increased their wealth with the run-up in stock prices were spending their money accordingly with their gains. This consumption increase caused the savings rate out of disposable income to drop from 5 percent in the middle of the decade to 2 percent by the year 2000. Of course this consumption increase led to a rise in home demand, and subsequently an increase in home prices. The expectations of prices continuing to rise grew, and led homebuyers to pay more for their homes than they would of otherwise, accelerating the prices higher. From 1995 to 2002, house prices grew 30 percent after adjusting for inflation.

The collapse of the stock market bubble in 2000 actually fuelled the housing bubble. The loss in faith in the stock market led previous market participants to turn their investments into the housing market, as it was deemed a safer alternative. Furthermore, the slow recovery of the 2001 recession led the Federal Reserve to continue to cut interest rates to stimulate consumption, with the federal funds rate reaching a 50-year low at 1 percent. Mortgage rates followed suit, with the average 30-year fixed rate reaching 5.25 percent, also a 50-year low.

Thousands of mortgage brokers competed with one another to sell mortgages to anyone they could find, including lower-income americans, which relied on adjustable rate mortgages (ARMs). Buyers would pay low interest rates for the first two years and after rates would rise substantially. This would leave ARM owners unable to make payments, but since house prices kept rising, the homeowners could refinance with another ARM, or pay down a part of the mortgage to reduce monthly payments. Middle-class americans also made use of ARMs to buy houses that otherwise would be out of their reach. Alan Greenspan, the Chairman of the Federal Reserve at the time, was warned by his associates about sub-prime mortgages (type of mortgage sold to individuals who have poor credit scores that offers a higher interest rate) and ARMs, but in 2004, Greenspan remarkably said: “Many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade”.

Economic Prosperity amongst the participants

In the years leading up to the crisis, lenders’ behavior changed dramatically. Lenders increasingly offered loans to riskier borrowers, including undocumented immigrants. Lending standards deteriorated especially between 2004 and 2007, as the mortgage market share of government-sponsored enterprises (GSEs) declined and the share of securitizers increased, reaching more than half of mortgage securitizations.

Historically, less than 2% of homebuyers lost their homes to foreclosure. But in 2009 more than 40% of subprime adjustable rate mortgages were past due. Subprime mortgages increased from 5% of total originations ($35 billion) in 1994, to 20% ($600 billion) in 2006. Another indicator of a “classic” boom: The credit bust cycle saw a closing in the gap between subprime and prime interest rates (the “subprime spread”) between 2001 and 2007. In addition to considering riskier borrowers, lenders had offered increasingly riskier loan options and borrowing incentives. In 2005, the median down payment for first-time homebuyers was 2%, and 43% of those buyers made no down payment.

The Downfall

The housing market peaked and began to turn down in the middle of 2006 as interest rates rose throughout the year. This led to rapid default rates, especially in the subprime market, since home-owners no longer had equity in their home to borrow against and lacked savings and retirement accounts, making them unable to meet mortgage payments. The spread of defaults in the subprime market led to a reduction of the valuation of Mortgage Backed Securities (MBS) that contained large quantities of subprime mortgages in them, aswell as other derivative instruments that were based on MBS with subprime components. Many of these financial instruments were passed on to various institutions and individual investors, and when the value of these securities took a turn for the worse, financial institutions were heavily exposed to large amounts of Credit Default Swaps (CDS) that essencially gain from the disorder of the underlying security when it defaults on its payments or loses its value.

The attempts of monetary policy and financial regulators to ease the downfall

Since the end of August 2005, the U.S. government has announced several measures to prevent household defaults. A first rescue plan for banks was officially presented in early December 2007, with a dual objective: firstly to protect the most fragile households, but also to manage the crisis. The main measure aimed at limiting mortgage defaults is to freeze, under certain conditions, interest rates on high-risk variable-rate loans. Seeking a long-term solution, the U.S. government provided a $700 billion bailout to buy up bad Wall Street debt in exchange for a stake in the banks. The government wanted to borrow on world financial markets, and hoped it could sell the bad bonds as soon as the housing market had stabilized.3 The UK government launched its own bailout, making £400 billion available to eight of the UK’s largest banks and housing companies in exchange for equity stakes in them.

Since the outbreak of the crisis in August 2007, central banks have been highly responsive and have acted both to prevent a systemic banking crisis and to limit the impact on growth, and the US Federal Reserve has also loosened monetary policy by injecting liquidity and eventually acted on interest rates. Banks traditionally finance themselves by borrowing short-term on the interbank market. But the financial crisis that began in 2007 has been characterized by high mutual distrust among banks, which led to an increase in interbank rates. Interbank rates far exceeded the central bank’s guideline rate. Central banks have also intervened massively to inject liquidity, hoping to reduce money market tensions and restore confidence. Monetary policy has also been characterized by an extension of the duration of loans, an extension of collateral and the possibility of obtaining refinancing.

The crash and how it was provoked

As 2007 began, subprime lenders filed for bankrupcy one after another and the value of most MBS had fallen immensely, even AAA rated MBS. During the summer, these problems were well beyond the United States borders; The interbank offer rate froze completely due to fears of the unknown. The english bank Northern Rock had to approach the Bank of England for emergency funding due to lack of liquidity, and in October, UBS became the first major investment bank to announce losses of subprime related investments at around $3.4 Billion. From the highs of October 2007 to the lows of March 2008 the S&P500 had fallen 48.0%, Bear Sterns had now tumbled and was acquired by JP Morgan by pennies on the dollar. By the summer of 2008 more financial institutions began to fail as the United States’ biggest home lenders Fannie Mae and Freddy Mac had been seized by the U.S Government. In September of 2008, Lehman Brothers declared bankruptcy and remains to this day the largest bankruptcy filing in the U.S history, involving more than $600 Billion in assets.

While the S&P500 bottomed in March of 2009, the Housing market had its low in 2012 as the shockwaves from the recession were too much to handle for homeowners and mortgage buyers.

The aftermath of the crash

Given the magnitude of the real estate market and the enormous size of the shadow banking system, the real estate and financial crisis had an enormous impact on the US economy as a whole and, therefore, on the international economy, filling the world’s corporate balance sheets with uncollectible assets or assets of completely uncertain quality. From the bursting of the mortgage bubble at the beginning of 2007 (subprime homebuyers’ suspension of payments due to the collapse in the price of their homes and the rise in interest rates), the entire mortgage market collapsed, almost immediately followed by the banking and stock exchange markets, and then by the interbank and commercial credit that feeds the day-to-day functioning of the economy in the short term.

This process of mortgage, financial and productive crisis was aggravated by the consequences of the additional large-scale shift of international speculative capital from mortgage markets to commodity markets in general and oil in particular, especially from 2005-2006 onwards. This drove crude oil prices from $70-80 per barrel in the second half of 2007 to around $160 in mid-2008, before leading to the subsequent collapse (bursting of the new bubble) to minus $50 in November of that year. This phenomenon, which affected the different countries negatively or positively depending on their position in the commodity markets, hit the US economy particularly hard at the time of the outbreak of its crisis. According to data from the Federal Reserve, in the United States alone there was a 6.2% contraction in GDP in the fourth quarter of 2008; industrial production in the United States was down 10% on a year-over-year basis. The unemployment rate reached 8.5% in March 2009, which meant that the number of unemployed increased by almost 5.3 million with respect to 2008.

The United States and the world entered another great crisis, which affected the US above all, both in the short term (due to its great consequences on employment and corporate bankruptcy), and in the long term, due to the enormous public and private indebtedness that the country took on.  This crisis was terminal for the securitized-speculative credit system, and the world economy was reoriented towards a much more regulated one.

This article is in our January Newsletter

Gabriel Gonçalves, BSc in Economics

Pedro Mendes, BSc in Economics

Lourenço Cardoso, BSc in Finance

Andrés Damián Cerda, BSc in Economics


The Dot Com Bubble

The Roaring 20s

The Tulip Mania

MacKay, Charles (2003) – Extraordinary Popular Delusions and the Madness of Crowds. Harriman House.

The United States Housing Bubble

Published by lisboninvestmentsociety


Leave a Reply