|Front Page of the NY Times October 20, 1987 (now a poster in my home office)|
Black Monday, Terrible Tuesday: The Stock Market Crash of October 1987: For a few short days in October 1987 the U.S. financial system came perilously close to completely collapsing. Dramatic shifts in the flow of capital between interrelated markets occurred as a sudden swing in expectations from optimism to pessimism among market participants overwhelmed the worlds financial systems. Panic selling led to a complete loss of liquidity and a breakdown in the clearing and settlement process that hindered capital flows between markets (Eichenwald, 1).
On Monday, October 19, 1987, the Dow Jones Industrial Average fell 22.6%, its greatest one day loss ever:
On the following Tuesday, it was up to the Federal Reserve Bank to pick up the pieces and prevent financial gridlock. There is not much debate today as to what caused the crash, as there were fundamental reasons that did not justify the level of valuation given to the stock market. One of the main factors that pushed stock prices so high throughout 1987 and created the speculative bubble was the large influx of foreign capital, especially from Japan (Solomon, 48). Also, a large amount of highly leveraged corporate takeovers reduced U.S. corporate equity while at the same time raising corporate debt levels to record levels.
|Dow Jones Average (10/12/1987 - 10/26/1987)|
Going into the fall of 1987, large U.S. trade and budget deficits combined with rising interest rates throughout the world put pressure on the dollar to depreciate and led market players to lose confidence in the G-7's ability to maintain target rates for currency exchange set by the Louvre accord (Soros, 346). There was a series of bad news beginning on Wednesday, Oct 14, beginning with the raising of interest rates in Germany by the Bundesbank, followed by a larger than expected U.S. trade deficit (Solomon, 49)
The rise in interest rates leading up to the crash was creating a large and untenable spread between returns on bonds and stocks. This can be shown by the large rise in the spread between the 30yr U.S. T-Bond yield and the dividend yield on the Dow Industrial Average throughout 1987 leading up to the crash as indicated in the following graph.
|Spread between 30yr T-Bond Yield and Dow Ind. Yield% (weekly 6/5/87 - 12/25/87)|
Many market makers simply stopped buying from sellers despite their obligation to do so (Solomon, 67). As a result, on Tuesday, many stocks stopped trading and this in turn had a domino effect on the futures and options markets (Hertzberg, 23). The S & P 500, which is a popular hedging instrument for owners of stock who sell futures to protect their stock portfolios against losses, ceased trading from 12:15pm to 1:00pm (Hertzberg, 23). Rumors that the NYSE was going to close put the stock indexes in a further freefall but Fed officials strongly encouraged NYSE Chairman John Phelan to keep the NYSE open despite desperate pleas from brokerages and market makers (Hertzberg, 23).
With sellers outnumbering buyers 40 to 1, arbitrage became impossible as intermarket linkages broke when liquidity dried up in the stock market (Antoniou, 1459). The result of this was a vicious downward spiral in both the stock and stock index futures markets (Antoniou, 1460). The record volume overwhelmed the clearing and settlement systems, creating confusion and significant delays with one system suffering a complete overload, losing both orders and trade reports (Lindsey, 285).
Following the NYSE close on Monday, as foreign markets opened, the result was similar. In Tokyo, 95% of the stocks could not open for trading due to extreme selling pressure and the Nikkei Average closed down -14.9% (Solomon, 82). Australia had no formal pauses in trading but the All Ordinaries Index closed down -24.9%. In Germany on the Frankfurt exchange, Indexes fell -5.08% and in England the FT-30 Index fell -11.7%. In European markets, there was generally no breakdown in trading as there was in the U.S. This can be attributed to more heavily regulated markets and capital controls that made it more difficult for international investors to buy and sell at will (Toporowski, 132). The worst damage may of occurred in Hong Kong, whose stock and futures markets closed for a week. This locked many large brokerage firms into positions that they wanted to liquidate (Solomon, 102). These same brokerages were the underwriters of a large rescue fund that the Hong Kong government used to bailout speculators and reopen the Hong Kong Stock Exchange (Toporowski, 131).
The biggest problems occurred on Tuesday following the crash when differences in the clearing and settlement obligations of the stock, options and futures markets further increased the demand for loans (Garcia, 154). The transfer of funds, or settlement as it is called, occurred in the stock market on the fifth business day after a trade was made. In the options market, settlement occurs at the market open of the next day and in the futures markets, margin calls to firms were payable within the hour (Garcia, 154). Gerald Corrigan, then president of the Federal Reserve Bank of New York said after the crash, "The greatest threat to the stability of the 1987 market break was the danger of a major default in one of these clearing and settlement systems." These asymmetries forced further liquidation as traders scrambled to meet margin and settlement requirements (Garcia, 154). The disruptions in the flow of funds threatened not only br kerage firms, but also central clearinghouses that are vital to the operation of the financial markets (Eichenwald, 1). The large volume of trades on Oct 19 and 20 greatly increased the demand for short-term credit that was needed by market players to fulfill their settlement obligations.
Alan Greenspan was appointed Chairman of the Federal Reserve Bank in August of 1987 and at this time was standing in the shadow of Paul Volcker, whom Wall Street trusted as a tested leader in moments of crisis (Murray, 26). One of the first things Greenspan did upon assuming his role as Chairman was to set up a task force to make sure the Fed was ready for any financial crisis that might arise (Solomon, 47). The result of this task force was a large notebook that became known as the Pink Book (Solomon, 47). The Pink Book described strategies for responding to certain financial crisis, one of which was a hypothesized stock market crash of 150 points (Solomon, 47). This was nowhere as severe as the 508 point drop on October 19, but Chairman Greenspan and other members of the Federal Reserve rose to meet the challenge. Fed officials established a crisis center in an office at the Fed's headquarters where they stayed round the clock and monitored worldwide markets (Murray, 1). There they opened channels to other officials at major exchanges, banks and brokerages to assess the situation.
The Fed officials knew that liquidity would be a problem on Tuesday. As losses mounted, banks became reluctant to extend credit to brokerages and market makers. If credit dried up, securities firms would collapse and economic gridlock would ensue and it was the goal of the Federal Reserve Bank not to let that happen. The crash placed a huge demand for credit on the banking system as securities firms and their customers had to meet margin calls that were 10 times precrash levels (Garcia, 153). At the same time, banks became reluctant to lend out of fear of adverse selection and a further market collapse that would expose them to losses.
Aside from serving as a source of liquidity, the Federal Reserve Bank also played the role of psychologist, trying to restore confidence by sending the message that the system would not be allowed to fail. Particularly important was the role of New York Federal Reserve President E. Gerald Corrigan. Being in New York and connected to Wall Street, Corrigan played a crucial role as the Fed's eyes and ears on Wall Street. He personally urged bankers in New York not to seize up and to continue lending to securities firms (Eichenwald, 1). Because of the Fed's moral suasion and reassurance to bankers that they would not have to worry about running out of funds, the banking system did not turn its back on Wall Street and handled the special needs created by the crash (Quint, 10).
On the morning of Oct 20 at 8:15 am the Fed released a statement that said "The Federal Reserve, consistent with its responsibilities as the nations central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system." (Garcia, 1). The Fed then backed up its words with action by supplying liquidity through open market purchases of U.S. government securities which drove down interest rates as displayed in the following chart.
|Yield Curve, Daily (10/16/1987 - 10/21/1987)|
The actions of the Federal Reserve dramatically lowered interest rates. Not only did the yield curve drop lower, but the Federal Funds rate fell from 7.5% on Monday to 6.75% on Tuesday (Murray, 1). The Fed was liquefying banks who would in turn liquefy securities firms (Soloman, 56). In this way, the Fed could avoid the moral hazard of bailing out the securities firms directly.
U.S. Federal Reserve officials requested that Japanese and German Central Banks follow suit in easing credit conditions (Solomon, 85). The fear was that if the U.S. Fed strongly eased but Japan and Germany did not, the resulting widening of interest rate differentials would cause capital flight from the U.S. and a similar move in bonds resulting in a rise in interest rates (Solomon, 85). In response to this, Japanese officials at the Ministry of Finance encouraged major brokerage houses not to sell and encouraged investors to focus on the fundamentals of the economy (Solomon, 84). The Bank of Japan modestly eased credit and several large brokerage firms agreed to buy shares in the Japanese bellwether Nippon Telegraph and Telephone (Solomon, 84). Further moves to limit selling pressure included the lowering of margin requirements by Tokyo stock exchange officials. As a result of the above moves, the loss in Japan's Tokyo's Nikkei Average was limited to -14.9% on Tuesday. After the close, Bank of Japan Governor Satoshi Sumita issued a statement: "The Bank of Japan is determined to continue to pursue firmly the cooperative framework of the Louvre Agreement" and followed up with foreign exchange intervention for the next few days to prevent a dollar plunge (Solomon, 88).
However, on Tuesday morning, things got worse before they got better. The NYSE opened on time but many sectors were at a standstill. When trading did resume, there was a brief rally during which market makers and major firms unloaded the large inventories they had accumulated. (Hertzberg, 23). This brought a barrage of sell orders which caused the closure of trading in many of the stocks and options as market makers simply stood aside and let them collapse (Hertzberg, 23). All selling and no buying caused the stock index futures to sell at a large discount to the underlying cash value of the stocks.
|"Terrible Tuesday" (October 20, 1987) S&P Cash to Futures Spread vs. MMI Cash to Futures Spread|
This is an example of how extreme the selling pressure was, there weren't even any arbitragers willing to buy the futures at such a large discount and as a result, trading in the Standard and Poors 500 futures contract ceased from 12:15 pm until 1:00 pm.
The turning point came early Tuesday afternoon when the Major Market Index futures contract on the Chicago Board of Trade, a little known stock index similar in content to the Dow Jones Average index, staged a powerful rally, apparently due to manipulation, driving the futures to a premium to the cash index (Hertzberg, 23). This triggered buying of the underlying stocks included in the Major Market Index as arbitragers attempt to profit by buying the underlying stocks when they are undervalued relative to the futures. Because many of the stocks that comprise the MMI are also included in the Dow Jones Average, the buying carried over to that average as well (Hertzberg, 23).
Also important in reversing the downtrend that Tuesday afternoon were the announcements of stock buybacks by several large corporations, apparantly under the encouragement of major investment banks (Hertzberg, 23). These developments combined with the Fed's actions caused market sentiment to swing to optimism just as rapidly as it switched to pessimism the prior day and at the close on Tuesday the DJIA was up 5.88% and followed through with record gains of 10.1% on Wednesday, October 21.
The dollar held up reasonably well in the days following the crash, due in large part to a capital flight to safety into the most liquid asset available, U.S. Government Bonds.
The crash signaled the arrival of high-speed global financial markets that overwhelmed the credit and settlement processes. Market players wanted more liquidity and when they feared they couldn't get it, panic ensued. The structure of the financial markets in 1987 simply could not handle the volatility during the crash. Prone to excess, the systems structure was outdated. This led the Brady Commission Study of the crash to suggest that a simpler, single mechanism should be developed for settlement in the Stock, Futures and Options Markets (Lindsey, 103). Since that time, there have been many innovations and improvements to the clearing and settlement process that make a repeat of the events of October 1987 very unlikely.
Because of the Fed's quick action in using its lender of last resort power, its quickness in increasing the money supply and their calming effect on the banking sector, a disaster was averted and the crash of 1987 turned into an economic non-event. At the time, there was some fear that the crash would cause a decline in consumption and thus result in a decline in Gross Domestic Product due to the loss in wealth, but it was essentially a financial crash and not an economic crash and did not reflect the real economy (Toporowski, 142). The 87' crash did provide a wakeup call to the world and especially the U.S to modernize its financial systems to be able to handle the coming advances in technology and the speed of information flows. By John Bardacino, CAIA (written in the fall of 1999).
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