- Published: Sunday, 24 August 2014 17:05
- Written by Lucian Dronca
October 19, 1987 was a stomach-twisting day for Wall Street and the American nation. In a single trading session the Dow Jones industrials dropped 508 points, and $480 billion in market value was expunged. The euphoria of a previous five-year bull market was shattered.
The Reagan-era expansion was well into its fourth year, and while the economy was thriving, it was also showing clear signs of instability. Since the beginning of 1987, when the Dow Jones Industrial Average had risen through 2,000 for the first time, the stock market had run up more than 40 percent- in the first semester of 1987 it stood at more than 2,700 and Wall Street was in a speculative froth. Something similar was happening in commercial real estate.
The economic indicators, meanwhile, were far from encouraging. Huge government deficits under Reagan had caused the national debt to the public to almost triple, from just over $700 billion at the start of his presidency to more than $2 trillion at the end of fiscal year 1988. The dollar was falling, and people were worried about America losing its competitive edge--the media were full of alarmist talk about the growing "Japanese threat." Consumer places, which had gone up just 1.9 percent in 1986, were rising at nearly double that rate. Though 3.6 percent inflation was far milder than the double-digit nightmare people remembered from the 1970s, once inflation begins, it usually grows.
These were vast economic issues, far beyond the power of the Fed alone to resolve. A rate increase would have been prudent, but the Fed hadn't raised interest rates in three years. Hiking them now would have been a big deal. Any time when Fed changed direction, it could rattle the markets. The risk in clamping down during a stock-market surge was especially acute - it could pop the bubble of investor confidence, and if that scared people enough, could trigger a severe economic contraction.
On September 4, at a meeting of the Board of Governors, a rate increase, from 5.5 percent to 6 percent, was approved by the governors unanimously.
Thus, to subdue inflationary pressures, Fed were trying to slow the economy by making money more expensive to borrow. There was no way to predict how severely the markets would respond to such a move, especially when investors were gripped with speculative fervour. The Fed's hope was that the key markets - stocks, futures, currency, bonds - would take the change in stride, maybe with stocks cooling off slightly and the dollar strengthening.
Banks upped their prime lending rates in line with Fed’s move, and the financial world noted that the Fed had begun acting to quell inflation.
But signs of trouble in the economy continued to mount. Slowing growth and a further weakening of the dollar put Wall Street on edge, as investors and institutions began confronting the likelihood that billions of dollars in speculative bets would never pay off. In early October, that fear turned to near panic. The stock market skidded, by 6 percent the first week, then another 12 percent the second week. The worst loss was on Friday, October 16, when the Dow Jones average dropped by 108 points. Since the end of September nearly half a trillion dollars of paper wealth had evaporated in the stock market alone - not to mention the losses in currency and other markets. The decline was so stunning that Time magazine devoted two full pages to the stock market that week under the headline "Wall Street's October Massacre."
The October 1987 stock market crash was an international phenomenon. At the time some saw it as a catastrophe. Parallels were drawn with the stock market crash of October 1929 and many feared that the 1987 crash would inexorably lead to a world-wide economic slump which would be as profound and as devastating as that of the 1930s.
It began in New York on Monday, 19 October 1987 — a date that has since been dubbed 'Black Monday'. On that date, the New York stock market went into what has been described as a 'free fall', with the Dow Jones Industrial Average plunging by 508 points - or, in other words, it collapsed 22.6 per cent in a single day, the biggest one-day loss in history, bigger even than the one on the day that started the Great Depression in 1929. The paralysis created by the avalanche of orders on Black Monday and the days that followed caused some of the scariest moments.
On October 20, tens of thousands of investors who had placed sell orders the previous day "had no idea what they owned," recalls Richard Ketchum, then director of the division of market regulation at the Securities and Exchange Commission. The uncertainty made some of them even more desperate to get out of the market. Most perversely, the congestion also slowed investors who wanted to buy stocks (thus slowing the fall).
The London Stock Exchange suffered over two days - Monday, 19 October and Tuesday, 20 October. The furious, record selling of shares extended across the globe, “chasing the sun from one stock market to the next”. Tokyo's Nikkei index dropped 15 per cent, Singapore's by 21 per cent and Australia's by 25 per cent. The Hong Kong and New Zealand stock markets were closed to prevent similar losses. No major stock exchange escaped unscathed. No one knew when the frenzy of selling would end and in what condition the world's financial markets would be left in the aftermath. On Tuesday, 20 October, Alan Greenspan of the US Federal Reserve Bank said that he would make “liquidity” available to the system. The next day, Wednesday 21 October 1987, the world's stock markets began to recover. New York rose by 10.1 per cent; London by 7.9 per cent. This was followed by recovery of the Tokyo stock exchange and soon there was a general calming of the stock exchanges around the globe. However, the October 19, 1987 crash brought to an end the bullish international markets that had been strongly in evidence since 1982.
What were the antecedents? The apparently ever-increasing share prices in the United States had meant a flood of foreign investment capital into Wall Street. However, from 1985 onwards there was intense pressure on the dollar as America's trade and budget deficits continued to burgeon without any sign of diminution. The US trade deficit was substantially with two countries - Japan and West Germany. These two countries feared that a sliding dollar would make their industrial goods less attractive to Americans, and contracting US demand would push their domestic economies into recession.
At the same time, the falling value of the dollar was of concern to both the US Federal Reserve and the British Treasury. Each was concerned that inflationary pressures could be building up in their respective countries. In fact the situation was a cause for anxiety in all the countries which comprised the Group of Seven (G7) industrialised nations - Canada, France, Italy, Japan, the United Kingdom and the United States of America. In an attempt to resolve this situation a meeting of six of the G7 ministers at the Louvre in Paris (February 22, 1987) agreed that the value of the dollar should be stabilised and be held at levels then current. However, the Louvre accord was not greeted with enthusiasm by the world's financial markets and, after a period of rallying, the dollar continued to face downward pressure. This was because the accord had done little to assuage the concern of international investors that the only way to finance the continuing US budget deficit would be through higher American interest rates. Increased interest rates would have curbed domestic demand in the US, thus dampened economic activity, which would then have led to falling profits and dividend payments. This would have made investment in US stocks and shares less worthwhile. Therefore, it was feared that the outcome could only be a recession. This meant a continued pressure on the dollar, which was relieved by massive intervention by the central banks of the G7 nations. In an attempt to give confidence to financial markets, the G7 ministers reaffirmed the Louvre accord in Venice in June 1987.
Realising the inherent instability of the situation the Chancellor of the Exchequer Nigel Lawson suggested in a speech to the IMF Interim Committee that a more formalised system of managed exchanged rates should be instituted. The Lawson scheme sought to stabilise exchange markets in the long-term without stoking up inflation. He claimed that his proposed scheme would be a “medium term financial strategy for the world”.
However, two events then occurred which pushed stock markets towards a crash. Firstly, on 14 October 1987 the August US trade figures were published which showed a deficit of over US$15bn. This, and IMF figures published around the same time, suggested to financial markets that the US budget deficit would not decline appreciably in the near future unless the value of the dollar were to fall substantially. Secondly, the US Treasury Secretary, James Baker, accused the Bundesbank of not adhering to the Louvre Accord because they had endorsed a rise in German interest rates. Baker said that the US would retaliate by allowing the value of the dollar to fall.
International investors had not expected the G7 central banks to intervene indefinitely to keep up the value of the US dollar, but Baker's statements sent them into a panic. They began selling shares in vast quantities - and thus was generated the crash of 1987.
"Black Monday," as it became known, was nearly twice as bad as the crash of 1929, which started the Great Depression. In 1987, the market had been up more than 30 percent for the year up until a few days before the crash, reaching unprecedented heights. And that was after two consecutive years of gains exceeding 20 percent. But it had dropped by 11.6 percent over the last three trading days of the week before "Black Monday."
Things started out badly that Monday, with the Dow Jones dropping first 200 points - 9 percent - in the first hour and a half. It caught its breath and remained around that level through mid-afternoon. But the last two and a half hours saw a selling frenzy that drove the market down another 300 points.
Alan Greenspan of the US Federal Reserve Bank joked that in those days he felt like a seven-armed paperhanger, going from one phone to another, talking to the stock exchange, the Chicago futures exchanges, and the various Federal Reserve presidents. His most harrowing conversations were with financiers and bankers he'd known for years, major players from very large companies around the country, whose voices were tightened by fear. These were men who had built up wealth and social status over long careers and now found themselves looking into the abyss. "Calm down," Greenspan kept telling them, "it's containable." And he would remind them to look beyond the emergency to where their long-term business interest might lie.
The Fed attacked the crisis on two fronts. The first challenge was Wall Street: Fed had to persuade giant trading firms and investment banks, many of which were reeling from losses, not to pull back from doing business. Fed public statement early that morning had been painstakingly worded to hint that the Fed would provide a safety net for banks, in the expectation that they, in turn, would help support other financial companies: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system." But as long as the markets continued to function, it had no wish to prop up companies with cash.
Gerry Corrigan from Fed was the hero in this effort. It was his job as head of the New York Fed to convince the players on Wall Street to keep lending and trading, in other words to stay in the game. Gerry had the dominant personality necessary to jawbone financiers, yet he understood that even in a crisis, the Fed must exercise restraint. Simply ordering a bank to make a loan, say, would be an abuse of government power and would damage the functioning of the market. Instead, the gist of Gerry's message to the banker had to be: "We're not telling you to lend; all we ask is that you consider the overall interests of your business, Just remember that people have long memories, and if you shut off credit to a customer just because you're a little nervous about him, but with no concrete reason, he's going to remember that." That week Corrigan had dozens of conversations along these lines and some of those phone calls must have been very tough.
As this was going on, Fed was very careful to keep supplying liquidity to the system. The traders at the New York Fed were ordered to buy billions of dollars of treasury securities on the open market. This had the effect of putting more money into circulation and lowering short-term rates. Though Fed had been tightening interest rates before the crash, now was easing them to keep the economy moving.
Despite Fed’s best efforts, there were a half dozen near disasters, mostly involving the payment system. A lot of transactions during the business day on Wall Street weren't made simultaneously: companies will do business with each another's customers, for instance, and then settle up at day's end. On Wednesday morning Goldman Sachs was scheduled to make a $700 million payment to Continental Illinois Bank in Chicago, but initially withheld payment pending receipt of expected funds from other sources. Then Goldman thought better of it, and made the payment. Had Goldman withheld such a large sum, it would have set off a cascade of defaults across the market. Subsequently, a senior Goldman official declared that had the firm anticipated the difficulties of the ensuing weeks, it would not have paid. And in future such crises, he suspected, Goldman would have second thoughts about making such unrequited payments.
Local stocks didn't escape the market's wrath. Procter& Gamble Co. was the biggest loser, dropping by 27.8 percent in one day, from $85 to $61.38. Kroger Co. stock lost 20 percent of its value, dropping to $30.63. Black Monday also set off a number of changes in the market - and investors' attitudes - that continue to be felt 10 years later.
A drop of the same magnitude today would mean the Dow Jones would lose some 1,800 points. Impossible? That's what anyone involved with the market would have thought of a 500-points drop in 1987.
"I was laughing toward the end of the day, because the whole thing seemed so ridiculous," said John Bowling, president of Bowling Portfolio Management Inc. in Hyde Park. "There wasn't anything you could do about it. You couldn't get accurate (price) quotes, so if you wanted to do anything, you had to do it blindfolded."
President Reagan's initial reaction to Wall Street's calamity on Monday had been to speak optimistically about the economy. "Steady as she goes," he'd said, later adding, "I don't think anyone should panic, because all the economic indicators are solid." This was meant to be reassuring, but in the light of events sounded disturbingly like Herbert Hoover sounded when declared after Black Friday in 1929 that the economy was "sound and prosperous."
Tuesday afternoon, October 20, 1987, Allan Greenspan and some of his collaborators met with President Ronald Reagan at the White House to suggest he try a different tack. The most constructive response, Jim Baker and Allan Greenspan argued, would be to offer to cooperate with Congress on cutting the deficit, since that was one of the long-term economic risks upsetting Wall Street. Even though Reagan had been at loggerheads with the Democratic majority, he agreed that this made sense. That afternoon he told reporters that he would consider any budget proposal Congress put forward, short of cutting Social Security. Though this overture never led to anything, it did help calm the markets.
FED set-upped a crisis operation center which was manned around the clock. It tracked markets in Japan and Europe; early each morning it'd collect stock quotes on U.S. companies trading on European bourses and synthesize its own Dow Jones Industrial Average to get a preview of what the New York markets were likely to do when they opened. It took well over a week for all the crises to play out, though most of them were hidden from public view. Days after the crash, for example, the Chicago options market nearly collapsed when its biggest trading firm ran short of cash. The Chicago Fed helped engineer a solution. Gradually, prices in the various markets stabilized, and by the start of November the members of the crisis management team returned to their regular work.
Meanwhile, across town at Renaissance Investment Management Inc., managers were jumping for joy: It had pulled completely out of the stock market a few months before. At the time, Renaissance implemented a three-way asset allocation strategy that quickly became its signature. While it has since gotten away from the strategy, at the time that was its only method for managing money. In May 1987, its technical signals showed it should sell completely out of the stock market and move hundreds of millions of dollars into bonds. But as the market continued its dizzying climb, Renaissance's managers sweated. Did they make a mistake? "We weren't the only ones saying stocks were too high," said Michael Schroer, now Renaissance's president. "But I think we were the only ones acting on it." After sweating out the summer, Renaissance celebrated on Oct. 19. "That was a great day for us," Schroer said. "'Vindicating' is probably the right word for it. It doesn't get any better than that."
Renaissance made a name for itself nationally from the 1987 crash. While stocks were dropping by more than 20 percent that day, the bonds Renaissance investors were invested in rose during the day. The company was featured in Institutional Investor magazine, a highly respected national trade publication, for being one of "Three Heroes of October." Then-president Frank Terrizzi, who has since sold his share of the company and retired at age 52, became well-known across the country. When year-end performance figures came out, Renaissance had grown from $1 billion to about $1.3 billion in assets under management.
Renaissance's move sheds light on one of the primary differences in market conditions between then and now. Long-term bond yields that had started 1987 at 7.6 percent or so climbed to about 10 percent. That offered a lucrative alternative to stocks, especially since the market had already climbed about 25 percent for the year by early October. Another difference: the 1987 crash showed the power of buying stocks and holding them. Despite the stupefying crash, the market was actually up a couple of percentage points for the year. Total return, including dividends, was a little more than 5 percent. As Gaynor put it, investors who only checked their portfolios once a year would've thought of 1987 as just another mediocre year.
Investment professionals that day went through the full range of emotions associated with any traumatic event, disbelief, anger, fear, panic, resignation.
An investment tactic known as "portfolio insurance" was often cited as a primary cause of the 1987 crash. It essentially set up a program where investors would sell as the market declined. The more it declined, the more they'd sell. The idea was to lock in profits and "insure" an investment.
There was only one problem - every one of those sellers had to have a buyer, and the market didn't have the liquidity to support all those sales. Would-be buyers waited, knowing the more the market dropped, the more selling would have to take place. Lack of market liquidity was the biggest problem for portfolio insurers but there was no single event that caused it.
When the Great Crash from 1929 took place, it threw the entire U.S. financial system into chaos. Some feared the same might happen in 1987. But as quickly as it started, it was over. The whole thing was over in a day.
The Fed's job during a stock-market panic is to ward off financial paralysis - a chaotic state in which businesses and banks stop making the payments they owe each other and the economy grinds to a halt. Liquidity was helped enormously by the Fed's lowering key rates and pumping money into the system, not to mention unofficial Washington arm-twisting to get a host of stock buybacks off the ground.
The almost hysterical reaction to the crash had damaged confidence. The stock market didn't gain much for the rest of 1987, and a full year later the Dow industrials had recovered less than half of what they had lost from their 1987 high.
The impact of the October 1987 stock market crash is still being assessed in financial and political circles. Several trends could be discerned in the wake of the crash: commercial banks were allowed to underwrite securities; foreign acquirers were no longer interested in buying US corporations; bridge loans and junk bonds were in trouble; and the market in currency and interest rate swaps performed well during the crash. The Federal government was credited with helping to diffuse the impact of the crash by increasing the market's liquidity, but overall the government still does not seemed to have an in-depth understanding of the stock market. The crash has given the securities industry a sense of uncertainty and vulnerability.
The consequences of 1987 crash were mixed. Though many people saw it as a harbinger of epochal change, it led neither to epidemic bank failures nor to soup kitchens. It triggered no trade wars. It didn't even presage an enduring decline in the stock market. Many investors who stayed put - or, better yet, added to their holdings during the market's bleakest moments - were richer by the summer of 1989 than they had been just before Black Monday in October 1987.
The crash didn't change the world by then, but it did change the world's stock markets - it was thought for the better. The U.S. equities market in particular was a smoother-running, more resilient machine in the next decade precisely because Black Monday brought it to near collapse. For instance, the intricate computer network that manages the daily flow of trading data - disseminating price quotes, routing orders to buy or sell, confirming and settling transactions - is far more efficient, reducing the market's vulnerability to gridlock, which caused so much alarm in 1987. Better regulatory coordination between government agencies, stock and futures exchanges, and other overseers of the markets has added another layer of safety.
Top brokers say individual investors have gotten the message and in the aftermath were less likely to panic in the face of a market drop. In fact, one of the few potential negative effects of the crash affected not individuals but the large institutions so frequently blamed for dominating the market and making life tough for the small investor. Wall Street firms now seemed less willing to provide liquidity merely to accommodate their large customers' trading needs. That has made it harder, though not formidably so, for pension funds and other institutions to quickly buy or sell big blocks of stock.
After the crash, the New York Stock Exchange implemented circuit breakers designed to prevent another meltdown. Circuit breakers were controversial when they were put into place in 1988, and they have remained so. Their advocates have insisted that trading restrictions are essential to keep future market declines from turning into panics. Their critics have said that circuit breakers could make share prices more volatile, not less so. Ten years after the crash, it appears that both sides may have been wrong. Circuit breakers seem to have made little difference to the way America's securities markets work.
The circuit-breaker mechanism has three stages. The first and least restrictive stops arbitragers from sending orders to the New York Stock Exchange if the Dow has moved more than 50 points from the previous day's close, unless the order would help to reverse the move. When the rule was imposed, a 50-point move amounted to more than a 2% change in the Dow.
Stage two suspends "program trading" in stocks for five minutes whenever the futures contract on the Standard & Poor's 500-stock index drops by more than 12 points (roughly equivalent to a 96-point drop in the Dow) from the previous close. It also restricts new orders for the rest of the day, except from small traders. This rule, like stage one, was aimed at traders who use computer programs to place large orders exploiting price differences among various exchanges, and whom some had blamed for the crash.
The third circuit breaker used to cut off share trading on all of America's main exchanges for an hour if the Dow fell by 250 points in a day. If the Dow fell by a further 150 points after trading resumed, the market would then be suspended for two hours more. These rules have been revised, so that a 350-point fall triggers a half-hour halt in trading and another 200-point fall a further one-hour halt. The Chicago Mercantile Exchange introduced similar rules for big falls in the price of stock-futures contracts. So far, the Dow has yet to fall far enough in one day to force a suspension of trading - although it came close in 1996.
The debate over the usefulness of such restrictions boils down to an argument about what causes extreme changes in share prices. One possible cause is that economic fundamentals suddenly alter, leading investors to revise sharply what they think shares are worth. Such volatility is part of an efficiently working market, in which trading is the process by which prices adjust to the right level. On this line of reasoning, restrictions on trading are economically damaging, because they reduce the efficiency of pricing in the stockmarket. One alternative theory holds simply that share prices may be volatile because, at any given moment, there may be a temporary surge of supply relative to demand, or vice versa.
It is this second theory that lies behind the concept of circuit breakers. The reasoning is that calling a halt to trading gives investors a time-out in which to work out whether a large price move is merely a quirk in the workings of the market or the result of something more fundamental. Many market participants thought they may have the opposite effect. Mike Clark, former head of block trading at Credit Suisse First Boston, an investment bank, said that halts in trading "are more likely to make investors wretch than give them time to calm down."
Contrary to everyone's fears, the American economy held firm, actually growing at a 2 percent annual rate in the first quarter of 1988 and at an accelerated 5 percent rate in the second quarter. By early 1988 the Dow had stabilized at around 2,000, back where it had been at the beginning of 1987, and stocks resumed a much more modest, but a more sustainable, upward path. Economic growth entered its fifth consecutive year. This was no consolation to the speculators who had lost their shirts, or to the scores of small brokerage houses that failed in October 1987, but ordinary people hadn't been hurt (at least this time).
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***, Breaking a fall: how do the policies introduced to prevent a repeat of the Black Monday stockmarket crash look ten years on?, in “The Economist” (US), Oct. 18, 1997, p. 78.
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