"[T]he real drama was not on Black Monday. The real drama was on Tuesday and several days thereafter when the fear of credit losses among major market participants threatened to produce market and credit gridlock, with all of its implications for market liquidity and further downward pressure on equity prices."
E. Gerald Corrigan, Former President of the Federal Reserve Bank of New York, 1998.
"'Will you open tomorrow?' he asked. That was the scariest moment because the truthful answer I gave was 'I do not know.' What the Fed Chair was really asking was: 'Will the longs pay the shorts?'"
Leo Melamed, former CEO, Chicago Mercantile Exchange (CME), recalling an October 19, 1987 late-night conversation with FRB Chair Alan Greenspan.
On Monday, October 19, 1987, the Dow Jones Industrial Average plunged 22.6 percent, nearly twice the next largest drop—the 12.8 percent Great Crash on October 28, 1929 that heralded the Great Depression.
What stands out is not the scale of the decline—it is far smaller than the 90 percent peak-to-trough drop of the early 1930s—but its extraordinary speed. A range of financial market and institutional dislocations accompanied this rapid plunge, threatening not just stocks and related instruments (domestically and globally), but also the U.S. supply of credit and the payments system. As a result, Black Monday has been labeled “the first contemporary global financial crisis.” And, a new book—A First-Class Catastrophe—narrates the tense human drama that it created for market and government officials. A movie seems sure to follow.
Our reading of history suggests that it was only with a great dose of serendipity that we escaped catastrophe in 1987. Knowing that fortune usually favors the well prepared, the near-collapse on Black Monday prompted market participants, regulators, the lender of last resort, and legislators to fortify the financial system.
In this post, we review key aspects of the 1987 crash and discuss subsequent steps taken to improve the resilience of the financial system. We also highlight a key lingering vulnerability: we still have no mechanism for managing the insolvency of critical payment, clearing and settlement (PCS) institutions.
We begin with three key points. First, no one can forecast the timing of the next crash (see, for example, Greenwald and Stein). In October 1987, many well-informed observers (including FRB Chair Greenspan) viewed the rise of the equity market that year as unwarranted by fundamentals. But, in retrospect, the degree of overvaluation does not seem large. For example, Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, one of our favorite indicators of fundamental value, was well below levels of the mid-1960s. And, viewed from today’s vantage point, the CAPE ratio at the time was only 5 percent above the long-run mean (see chart).
Cyclically Adjusted Price-Earnings Ratio (Monthly average), 1881-September 2017
Second, from a macroeconomic perspective, despite what some people might believe, the key concern arising from a plunge in U.S. equities generally is not the resulting loss of wealth. To see why we say this, note that the 1987 loss (based on the valuation of domestically held corporate equity in the Financial Accounts of the United States) was less than $1 trillion in an economy with a GDP of $4.9 trillion. Moreover, in the aftermath of Black Monday, the economy grew by 4 percent over the next year. Similarly, while the internet stock bust that started in 2000 led to a $9 trillion peak-to-trough loss of wealth (in an economy with a GDP of $10.3 trillion), the recession that followed was the mildest in U.S. postwar experience.
Instead, as we learned in the 2007-09 crisis, the key concern is whether sudden changes in asset prices undermine critical functions of the financial system. Will there be disruptions that lead to deep and prolonged downturns and, possibly, to diminished long-term economic growth? In our minds, the two most prominent concerns are the performance of the payments system and the continued supply of credit to healthy borrowers. Since neither PCS firms nor U.S. commercial banks hold stocks, direct exposure to the market collapse is not the issue. Instead, the vulnerability arises from the fact that other leveraged intermediaries—especially broker-dealers and investment banks—are highly exposed. And, in 1987, banks were important lenders to these firms. Similarly, the PCS firms are exposed to the failure of their members, including those firms that trade actively in derivatives (futures, options and swaps) or in the equities on which they are based.
Our third concern is confidence in the financial system itself. The U.S. equity market is arguably the crown jewel of U.S. capitalism. It is a marvelous machine, allocating resources and allowing people to hold and diversify their wealth. Perhaps the main function of any financial system is to channel private savings—the sum of business profits and the income that households don’t consume—into productive investment. When equity markets are working efficiently, prices aggregate information, signaling where investment opportunities are the most beneficial. The corollary also holds: a persistent loss of confidence in the equity markets—particularly in the price discovery process—reduces the mobilization and effective allocation of savings.
A few examples from 1987 serve to highlight our concerns about market function. Derivatives markets are a zero-sum game: for every long, there is a short. In the absence of bankruptcy, the net effect on wealth of any market movement, big or small, is zero. When price movements are large, it is not the net effect but the gross impact that matters. The reason is that, faced with large losses, some market participants may become insolvent. And, if the problem is large and widespread, this can lead to cascading failures.
The October 19 crash shifted wealth massively from longs to shorts, prompting a flood of margin calls. This, in turn, led to a surge in the longs’ demand for credit to meet these calls. For those unable to pay on time, clearing agents were contractually obligated to make the payments on their behalf, and bear the losses. Rumors about the solvency of some of the PCS entities probably diminished trading and—due to the presence of first-mover advantage—could have triggered a run by member firms still in the black.
A dramatic example of such disruption is the case of the largest options clearing firm at the time, First Options of Chicago, an affiliate of Continental Illinois. To avoid failure, on October 19 and 20, the bank injected several hundred million dollars of capital into the broker—against the explicit wishes of its federal supervisor, the Office of the Comptroller of the Currency. Keep in mind that, following Continental’s $4.5 billion-bailout in 1984, the Federal Deposit Insurance Corporation (FDIC) owned 60 percent of the firm’s equity (see House 1988 hearings, pages 1-3). Continental later reported more than $100 million in losses in the aftermath of the crash.
The morning of October 20 is a critical stage in this saga. As the initial quote from CME chief Leo Melamed highlights, even he did not know if the longs would be able to cover the estimated $2.5 billion transfer of wealth to the shorts in time to allow the Exchange, the home to equity futures trading, to open. In fact, they could not. To open, the Exchange borrowed $100 million—again from Continental Illinois (how fortunate to have a government-owned bank as your creditor in a crisis!)—to cover its contractual obligations (see Melamed’s 1997 Brookings panel remarks). One can only speculate about the wave of disturbances that might have resulted had the CME failed to open that day.
In addition to the exchanges, broker-dealers needed funds to meet margin calls and to provide credit to their customers. A loss of funding liquidity on October 20 would surely have amplified and extended the fire sales of October 19. This, in turn, could have led to problems similar to the ones that we saw in 2007. Lenders, including banks, would not have been able to distinguish sound from distressed counterparties, resulting in a disastrous credit freeze.
Instead of pulling back, banks increased lending to the securities firms, aiding a quick recovery (see, for example, Bernanke). Most observers attribute the banks' willingness to lend to risky securities dealers to the Federal Reserve’s response in its role as lender of last resort. The Fed kicked off the day on Tuesday, October 20, with a one-sentence statement: “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” (see Carlson). In addition, they conducted open-market purchases at an earlier time of morning than was normal, and in a manner that lowered the federal funds rate (interrupting the policy tightening pursued earlier that year to reduce inflation). Finally, and perhaps most important, the Fed engaged in moral suasion: New York Fed President Corrigan, whom we quote above, reportedly called big bank CEOs to impress upon them the “big picture, the well-being of the financial system” without instructing them to ignore solvency risk (see, for example, here and Henriques, page 240). Banks’ willingness to provide credit suggests that, when in great doubt, strong words and actions from their regulator matter.
Next, note that on October 19 the price discovery process collapsed. Surging trade volume led to delays in transaction reporting, resulting in the execution of many orders at prices far from the stale ones posted. On October 20, the intra-day price swings became enormous, with the S&P 500 futures opening up 17 percent, then plunging 25 percent, only to bounce back later in the day. The point is that, as Greenwald and Stein emphasize, because of the information they convey, market prices are like public goods. But, during and after the crash, delayed reporting and executions, combined with record volatility (see chart below), undermined this value. The risk was that people would lose faith in the system and hesitate to trade. If they had, the loss of information contained in prices would have persisted. Fortunately, any loss of confidence proved temporary, and the system recovered.
CBOE S&P 100 Volatility Index (VXO), 1986-September 2017
Looking back, since 1987, there have been numerous reforms aimed at improving the resilience of the financial system. A list of some of the most important starts with the enormous increase in capacity for speedy trade execution. Next is the implementation of circuit breakers designed to limit disorderly trading and maintain the integrity of price discovery. Third is the effort to damp the surge in credit demand arising from price swings—for example, through cross-margin arrangements that limit margin calls for institutions with hedged positions across different PCS platforms (see, for example, here). A fourth critical reform is the 2007-2009 crisis-driven re-structuring of the largest, formerly independent, securities firms as components of better-capitalized and better-supervised financial holding companies. Finally, there is the advent of a financial regulatory framework—fashioned by the Dodd-Frank Act of 2010—that explicitly focuses on monitoring and mitigating systemic risk.
Among Dodd-Frank’s important innovations is the power it grants the Financial Stability Oversight Council (FSOC) to designate critical PCS firms as systemically important financial market utilities (FMUs). At this writing, the Council has designated eight firms as FMUs, including the CME, the Depository Trust and Clearing Corporation (DTCC) and the Options Clearing Corporation (OCC), all of which are key to the operation of the U.S. equity market. As FMUs, each of these firms is now subject to Federal Reserve scrutiny (in addition to that of their own supervisor).
This all leads us to ask whether the reforms of the last 30 years’ worth are enough. Is the current financial market infrastructure sufficiently resilient to withstand the next, inevitable, crash? Dodd-Frank does give the Fed the authority to lend to solvent FMUs. But, it is difficult to envision crisis circumstances where these critical organizations would be solvent, but illiquid, with sufficient liquid collateral to borrow from the lender of last resort. Importantly, the Fed is not legally authorized to lend to an insolvent firm—however systemic. Were the Fed to act knowingly beyond its authority—even in a crisis—it would almost certainly sacrifice the policy independence that it cherishes and that has brought great benefit to the U.S. economy for several decades (see here).
Our conclusion: there is a gaping hole in the fabric of the financial system. As Tuckman highlights, neither the Dodd-Frank Act nor the CHOICE Act passed this year by the House address the need for a resolution plan for insolvent PCS firms (including those designated as FMUs). Instead, by mandating the shift of most over-the-counter derivatives to central clearing, Dodd-Frank has increased the systemic threat arising from the failure of a derivatives clearinghouse. If, as market participants probably assume, the government will inevitably act to sustain an insolvent FMU, it would be good to codify such a resolution plan—effectively an instantaneous nationalization—now, rather than wait for the inevitable chaos and risk from another Black Monday.