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If the sole purpose of a broker is simply to buy and sell for others, why would they go bankrupt? It's not like they have money invested in the cause, they just play with other people's money (or is it?). Thanks for your help!

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    First we'd have to establish whether brokers did go bankrupt. This might be a better question for Economics.SE. – Schwern Mar 20 '18 at 0:42
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    A business can go bankrupt if it has too few active customers. I bet the amount of orders went down significantly at the time. – Erno Mar 20 '18 at 11:24
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    Technically "stockbrokers" didn't go bankrupt, "people who could not make their margin calls" went bankrupt. Just so happens that stockbrokers were more likely to buy on margin. – Mark C. Wallace Mar 21 '18 at 12:19
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    2 words baby: Margin Call. It basically means 'Day of Reckoning' for risky traders. – Jalapeno Mar 23 '18 at 14:02
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    Brokers went bankrupt in droves and this is thought to have been a major factor in the early onset of the crash and depression. Note that today's regulation of stockbrokers' margins is more strict. I have no idea why the top-voted comments (not answers) are so wrong. This has a relevant discussion (not gated): pubs.aeaweb.org/doi/pdfplus/10.1257/jep.4.2.67 – PatrickT Mar 25 '18 at 11:58
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To expand on Schwern's answer somewhat, using leverage as a trader works more or less like this:

  • Scenario 1: you have $1k of play money and use it to buy stocks. The market goes up 10%. You sell. You now have $1.1k. Net gain: $100, minus some transaction fees.

  • Scenario 2: you use $1k as collateral for a loan to bring your play money to $10k. The stocks go up 10%. You sell. You now have $11k. Repay the loan. Net gain: $1k, minus some financial fees and some transaction fees.

Suppose now that, in the above two scenarios, the market goes down 10% instead. The first sets you back $100; the second wipes you out.

Suppose finally that the market goes down 20% instead. In the second scenario you're not only wiped out; you also owe whoever loaned you money an extra $1k. That whoever usually is your broker, and that is how they lost money.

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    I like this answer because it breaks down what I imagine can be a quite complex topic into an easy to understand example that gets the point across well enough to help answer the question. – RobbG Mar 20 '18 at 11:23
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    Thanks, though I'd like to stress that Schwern's answer is better than my own. Mine is a mere addendum to his, if anything. I stick to raising how leverage can go very wrong very quickly, @Schwern gives a clearcut picture of the whole process. In particular he mentions brokers needing to (fire)sell their own assets to cover their losses. – Denis de Bernardy Mar 20 '18 at 16:54
  • Did this actually happen like this back then? I mean, did brokers regularly loan as well? – AnoE Mar 21 '18 at 10:17
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    @AnoE: Finance was a bit of an unregulated wild west at the time, and was fairly sophisticated already. Regulations started to pour in after the 1929 crash. – Denis de Bernardy Mar 21 '18 at 11:01
  • This answer is logical, but it needs some citation about loans. – jpmc26 Mar 21 '18 at 17:59
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If they did, it would be because of the practice of buying on margin, a form of loan from your broker where you use the stocks themselves as collateral. This allows you to buy more stock than you have cash on hand. If the price goes up, you get even richer and sell some of the stock to pay off the loan. If the price of the stock falls, you'll find yourself suddenly owing a lot of money to your broker; a margin call.

This is still the norm today. The major difference is the Federal Reserve has stricter regulations on how much you can buy on margin. Now it's 50%. Then it could be up to 90%.

According to Wikipedia, brokerages were also lending a lot of money. More than could ever be repaid. The whole thing was a pyramid scheme that required the stock market value to continue to rise to support itself.

By August 1929, brokers were routinely lending small investors more than two-thirds of the face value of the stocks they were buying. Over $8.5 billion was out on loan, more than the entire amount of currency circulating in the U.S. at the time.

When the market started to fall and the brokers made margin calls people had to sell their stocks to their brokers. The more they sold the more the price dropped. With such high margins the value of the stock would quickly fall below what they owed. As stock prices fell, more margin calls would happen, prices would fall further. As the value of stocks continued to fall, less and less people would be able to repay their brokers. The brokers would have to sell their own assets to cover.

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    "The brokers would have to sell their own assets to cover." That part I don't understand. Wouldn't the lending money scheme not have lead to the brokers owning the majority of the stock market at the end? Looks like a nice way to get people to sell their property to the brokers really cheap. Anyway, I wonder who owned the shares at the end. – Trilarion Mar 20 '18 at 12:26
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    It is worth noting that this cascade margin call crisis happend again in 2015's China. – Mindwin Mar 20 '18 at 13:23
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    @Trilarion Debtors had to sell their stock back to the broker really cheap because no one else would buy it. Even if the stock broker winds up owning a huge amount of stock in the end, it's effectively worthless because no one wants to buy it. Stock is only worth what someone else will pay for it. The brokers wind up having lent money in dollars that they can't recoup, and assets in the form of stock that don't make up the difference. – Nuclear Wang Mar 20 '18 at 13:42
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    @Trilarion: Perhaps the money the brokers were lending was in part (or indeed, in whole) borrowed from other people? So when the people who've bought on margin can't repay the brokers, the brokers can't repay the people they've borrowed from. – jamesqf Mar 20 '18 at 18:36
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    Small correction: the amount of currency in circulation is less than the amount of all money in circulation (wiki "Money supply"), which is less than the value of all assets. So the fact brokers lent out more money than extant currency doesn't mean "it could never be repaid." – Aleksandr Dubinsky Mar 20 '18 at 19:33
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Brokers went bust due to an aspect of investing that isn't often covered by mainstream media: the margin call.

When you buy stocks on margin, meaning you're borrowing the money to buy a lot of the stocks, who puts up the rest of the money? The broker.

Buy $10k worth of stock at the 15% margin allowable in the 1920's, and you only paid $1500. So if it goes up in price, you get 100% of the increased price. Wow, isn't that great?

But, if it goes down below what you paid the 15% on, you eat 100% of the loss, and you're expected to pay the difference right now so the broker doesn't lose their equity. That's the margin call... in those days, it was literally a call from the broker you didn't want to get.

If your $10k of stock you only put up $1500 for drops to $8k, you now owe your stockbroker another $2k, and you get nothing for that $2k, just the stock you thought you owned. You do have that $2k, don't you? Or did you buy more stock on margin with that, figuring you'd cash in even more? Oops, looks like you'll have to sell off some of your other stock to make that margin call, only your other stock has just plunged in value, so you have margin calls on that, too.

This worked well as long as a lot of people were pouring money into the market and it kept going up. It doesn't work well if the stock prices drop. That tends to spook margin investors into selling everything just to limit their losses, especially if they only put up 15% to buy in but are on the hook for 100% if the price drops.

And if the market in general consists mostly of margin investors, as it did in the 1920's, even a small overall stock drop can spook a lot of people into selling, which accelerates the price drop because there aren't that many buyers...

If you wonder why some investors even today will sell stock that slips just a little, that's one reason why. They bought on a 50% margin, and want to limit their losses.

So that's what happened in 1928... prices started to drop, people started selling to cover their margin calls, no one was buying, the price really dropped, even more margin calls. You, who put up $1500 for $10k of stock that's only worth $1k now, don't have $9k, so you default on your broker.

And your broker... um... went broke because most of their clients couldn't make good on the margin calls. Add in the fact that the 1920's broker was getting their money that they loaned you by borrowing on their stocks (which were also highly inflated in value), and the whole thing became a house of cards that collapsed, because there wasn't nearly the hard currency backing the market up that everyone thought there was.

To a degree, this was mirrored in the 2007 real estate crash. Inflated prices, speculators borrowing beyond their means, and when real estate prices plummeted, the banks and investment houses that put up the mortgage expect you to pay the difference between what they loaned and what the house is now worth (it's in the mortgage agreement, in the fine print), and you don't have that money.

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    A related issue many people fail to recognize is that when a stock price crashes, it's impossible for everyone to sell fast enough to beat the crash. The best one can hope to do is sell before the other shareholders do, so they have to take the losses instead of you. – supercat Mar 22 '18 at 17:31
  • to sell fast enough - not just that but in order to sell you have to have a buyer. If the stock is crashing and there are no buy orders to fill you may not be able to sell at all. – pbhj Mar 25 '18 at 4:42
  • @supercat: Movie "Margin Call" (2011) is about exactly this. I recommend. :) – Sergio Tulentsev Mar 26 '18 at 8:06
  • @pbhj: That's true, but the key point is that there is almost always a short-term limit to the total amount of stock that may be sold at any given price; no matter how fast people try to sell, the only way they'll be able to sell more than that is by accepting a lower price. – supercat Mar 26 '18 at 16:18
  • @pbhj hence why you have to sell before everyone else starts selling. Obviously, by definition, most people can't do that. – user253751 Mar 26 '18 at 21:36
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Well the most basic answer is people were buying fewer shares for less and their commissions went down. So even if they didn't lose money there income falls and they now can't pay their debt, salaries or rent.

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