The Bubble That Broke Kuwait : The Indicator from Planet Money How a simple financial innovation turned a parking garage in Kuwait into one of the most important markets in the world... and how it all came crashing down.

The Bubble That Broke Kuwait

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CARDIFF GARCIA, HOST:

Hey, everyone. This is THE INDICATOR FROM PLANET MONEY. I'm Cardiff Garcia. And today, we are continuing our series on history's financial bubbles, and we've got a doozy for you today. I'm joined by Darius Rafieyan. Darius?

DARIUS RAFIEYAN, BYLINE: Hi, Cardiff. Yes. Today, I've got a story for you about one of the greatest stock bubbles of all time, which occurred in, of all places, Kuwait.

GARCIA: Kuwait.

RAFIEYAN: Yes. And this story begins in the late 1970s, during what is known as Kuwait's golden era. So, you know, Kuwait had been this kind of sleepy desert outpost, and then due to the massive influx of oil money, it became this, like, bustling metropolis. And I actually talked to a man named Sabah al-Rayes (ph), who was a prominent businessman in Kuwait around this time, and he talks about what Kuwait looked like when he was a kid growing up.

SABAH AL-RAYES: Hardly had any electricity. We did not have running water. We did not have any infrastructure. There were no air conditioning, for example. There were no elevators.

RAFIEYAN: And by the late 1970s, Kuwait had become this modern metropolis. And it had also become the financial center of the Middle East because the region was rocked by turmoil at this point, and Kuwait, with its really well-regulated financial sector and its relatively stable political climate, became this magnet for all of this money that was fleeing turmoil elsewhere in the region.

GARCIA: Yeah, it sounds like a pretty classic emerging market story. It starts doing some things right, and then all this money starts coming in from other places.

RAFIEYAN: And obviously, that drove up prices in Kuwait's official stock market. But it was very, very tightly regulated. You know, there were lots of regulations about what kinds of companies could be listed there, who was allowed to invest, how are they allowed to invest. And that made it very stable, but it also made it kind of a boring place to invest, you know.

GARCIA: And meanwhile, there's all this money that wants to invest in Kuwaiti companies. And if it can't do it there, maybe it'll find some other way to invest in them.

RAFIEYAN: Well...

GARCIA: (Laughter).

RAFIEYAN: ...It did find another way. Basically, right across the street from the official Kuwaiti stock market, a sort of informal, unofficial stock market developed. It was known as the Souk al-Manakh, and it was literally in a air-conditioned parking garage on the site of the old camel market. And Souk al-Manakh literally translates to the market at the place where the camels rest. Traders started gathering there and trading stocks amongst each other.

And I spoke to Ben Craig, who is a economic and policy adviser for the Federal Reserve Bank of Cleveland, and he's written a lot about the Souk al-Manakh. And I have to clarify here that everything he said in our interview only represents his personal views; he doesn't represent the views of the Federal Reserve. But I talked to him about this sort of informal market that developed.

BEN CRAIG: It was seen as an area where you could have fun, but what plays in the souk stays in the souk.

GARCIA: I don't think I've heard that one before.

RAFIEYAN: (Laughter) Well, basically, the government said, hey, we like having this innovative, kind of risky market with big returns, but we don't want the risk to infect the rest of the economy. So they put all these rules in place that said banks are not allowed to touch the souk. They can't lend money to people who are investing there. It's got to be completely cut off from the financial sector.

But, you know, of course, traders don't like this because they don't want to just trade with the money they have in their pocket; they want to borrow money and, you know, potentially get even higher returns. And so this system developed between the traders and the souk that I think was a little bit ingenious. They couldn't borrow money from the bank, so what they did is they had this system of writing postdated checks.

So basically, Cardiff, I want to buy a stock from you. It's worth $100 now, and I think it's going to go up in the future. So I'll write you a check for, say, $110, and I'll date it for a year from now. You know, like, if your rent is due on the first, but you don't get paid till the third...

GARCIA: Yeah.

RAFIEYAN: ...So you date your check on the third?

GARCIA: Right.

RAFIEYAN: That's what they were doing, but they would do it for a year. And in that situation, it's like you just lent me money for a year. But then this sort of interesting thing happened.

CRAIG: The check itself became a little bit like cash. So suppose that maybe I want to buy some of that stock. I don't have any cash, but I have that postdated check, and so I just pass that postdated check on to another trader.

RAFIEYAN: It was essentially a way for these traders to print their own money. And, you know, Ben Craig cautions against drawing any comparisons to other markets. But in my opinion, it's not all that different from what happened in the run up to the financial crisis, where mortgage-backed securities became much bigger than mortgages. In this case, the checks that were backed by stocks became much bigger than the stocks themselves.

And thanks to this system of kind of endless, unregulated credit, the Kuwaiti stock market skyrocketed. It became the third largest stock market in the world, bigger even than London. And Sabah al-Rayes says that this was turning people into instant millionaires. He recounted this story to me of going to his friend's apartment.

AL-RAYES: And I saw this huge, big plate full with beluga caviar. You know, (laughter) they serve it by the ounce, and there, there were 10 kilos, maybe $100,000 worth of caviar on the table. I couldn't believe it.

RAFIEYAN: And this market, it started to draw in teachers and students, and he talks about how, you know, doctors were quitting their jobs to run down to the Souk al-Manakh and start trading stocks. It just became this national obsession.

GARCIA: Classic mania - everybody sees it going up; they think it will continue going up. And we'll tell you how they started going down after the break.

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GARCIA: OK, Darius, everything's looking good right now. Stocks are going up. People are quitting their jobs as doctors or engineers or whatever to go trade on the stock market. Obviously, this could not last.

RAFIEYAN: Well, as you'll recall, people were using the system of postdated checks to create this huge market. But then as the stock started to go down, people started trying to call in those checks. They went down to the bank and said, I want to cash this check because I'm not sure that this is going to be worth anything soon. And it quickly became clear that there was not enough cash to cover all of these checks. And so the government stepped in. They put together this committee and said, we're going to look at this, and everyone said, great; the government's got it under control. And they met over a weekend.

CRAIG: And on Monday, they made an announcement - there would be no bailout. And at that point, all trading stopped. There was just a stunned reaction (laughter) - paralysis.

RAFIEYAN: Imagine this - the third largest stock market in the world, in an instant, grinds to a halt, suddenly worthless. Nobody knows who owes what to who, who is bankrupt, who is solvent. It's just this mess.

CRAIG: They put all of the dealers under house arrest, and everyone was told no capital is allowed to leave Kuwait until it's all sorted out.

RAFIEYAN: So the government was scrambling, and the collapse of the Souk al-Manakh, it destroyed the Kuwaiti economy. I mean, it plunged the country into a recession that lasted almost 10 years. All but one of the country's banks were insolvent. In the end, all of the losses, adjusted for inflation, totaled nearly $250 billion, which for reference, was five times the size of the Kuwaiti economy at the time.

GARCIA: So this would be the equivalent of losing $100 trillion if it had happened in the U.S.

RAFIEYAN: Sabah al-Rayes, who was a prominent businessman, like I said, he says when it crashed, it just affected everyone.

AL-RAYES: That was the biggest thing that ever happened in Kuwait. Everything went down, whether it's a stock or whether it's property - everything went down.

RAFIEYAN: I think there's an interesting lesson in all this, and I think it demonstrates the two forces that are kind of battling each other at the center of capitalism, which is, you know, the forces of financial innovation and sort of human ingenuity that can't be stopped and the forces of financial regulation and trying to bend that ingenuity so that it fits into some kind of master plan.

And I don't think Kuwait's mistake was seeing the value in financial innovation; I think the mistake was thinking that they could somehow separate that from the rest of the economy. You're never going to be able to contain human ingenuity. I think that the most you can hope for is to try to find some balance between control and chaos.

GARCIA: Very nicely said, Darius. How the Souk al-Manakh explains the world.

(LAUGHTER)

GARCIA: Or at least financial history. Thanks, man.

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GARCIA: This podcast was produced by Darius Rafieyan, edited by Paddy Hirsch. THE INDICATOR is a production of NPR.

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