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Black Monday (1987)

FTSE 100 Index (June 19, 1987, to January 19, 1988).
DJIA (June 19, 1987, to January 19, 1988).

Black Monday on October 19, 1987 was the date when a sudden, severe and largely unexpected[1] systemic shock impaired the functioning of the global financial market system, roiling its stability through a stock market crash, along with crashes in the futures and options markets. The crisis affected markets around the world; however, no international news event or change in market fundamentals has been shown to have had a strong effect on investor behavior.[2] Instead, contemporaneous causality and feedback behavior between markets increased dramatically during this period.[3] In an environment of increased volatility and uncertainty, investors were reacting to changes in stock prices and to communication with other investors[4] in a self-reinforcing contagion of fear.[5] The Dow Jones Industrial Average (DJIA) fell exactly 508 points to 1,738.74 (22.61%).[6] In Australia and New Zealand, the 1987 crash is also referred to as "Black Tuesday" because of the time zone difference.

The terms Black Monday and Black Tuesday are also respectively applied to October 28 and October 29, 1929, which occurred after Black Thursday on October 24, which started the Stock Market Crash of 1929.

Background

Timeline compiled by the Federal Reserve.

In late 1985 and early 1986, the United States economy shifted from a rapid recovery from the early 1980s recession to a slower expansion, resulting in a brief "soft landing" period as the economy slowed and inflation dropped. The stock market advanced significantly, with the Dow peaking in August 1987 at 2,722 points, or 44% over the previous year's closing of 1,895 points. Further financial uncertainty may have resulted from the collapse of OPEC in early 1986, which led to a crude oil price decrease of more than 50% by mid-1986.[7]

On October 14, the DJIA dropped 95.46 points (3.8%) (a then record) to 2,412.70, and it fell another 58 points (2.4%) the next day, down over 12% from the August 25 all-time high.

On Friday, October 16, when all the markets in London were unexpectedly closed due to the Great Storm of 1987, the DJIA fell 108.35 points (4.6%) to close at 2,246.74 on record volume. Then–Treasury Secretary James Baker stated concerns about the falling prices.

The crash began in Far Eastern markets the morning of October 19 and accelerated in London time, largely because London had closed early on October 16 due to the storm. By 9:30 a.m., the London FTSE100 had fallen over 136 points.[8]

Market effects

Frederic Mishkin suggested that the greatest economic danger was not events on the day of the crash itself, but the potential for "spreading collapse of securities firms" if an extended liquidity crisis in the securities industry began to threaten the solvency and viability of brokerage houses and designated market makers (also known as "specialists"). This possibility first loomed on the day after the crash.[9] At least initially, there was a very real risk that these institutions could fail.[10] If that happened, spillover effects could sweep over the entire financial system, with negative consequences for the real economy as a whole.[11]

The source of these liquidity problems was a general increase in margin calls; after the market's plunge, these were about ten times their average size and three times greater than the highest previous morning variation call.[12] Several firms had insufficient cash in customers' accounts (that is, they were "undersegregated"). Firms drawing funds from their own capital to meet the shortfall sometimes became undercapitalized; for example, 11 firms had a margin call from a single customer that exceeded that firm's adjusted net capital, sometimes by as much as two-to-one.[10] Investors needed to repay end-of-day margin calls made on the 19th before the opening of the market on the 20th. Clearinghouse member firms called on lending institutions to extend credit to cover these sudden and unexpected charges, but the brokerages requesting additional credit began to exceed their credit limit. Banks were also worried about increasing their involvement and exposure to a chaotic market.[13] The size and urgency of the demands for credit placed upon banks was unprecedented.[14] In general, counterparty risk increased as the creditworthiness of counterparties and the value of collateral posted became highly uncertain.[15]

Every one of 23 major world markets experienced a decline in October. When measured in a common currency (US dollars), 8 of them declined by 20 ~ 29%, 3 by 30 ~ 39% (Malysia, Mexico and New Zealnd), and 3 by more than 40% (Hong Kong, Australia, Singapore)[16][A] New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and would take several years to recover. The damage to the New Zealand economy was compounded by high exchange rates and the Reserve Bank of New Zealand's refusal to loosen monetary policy in response to the crisis, in contrast to countries such as West Germany, Japan and the United States, whose banks increased short-term liquidity to forestall recession and would experience economic growth in the following 2–3 years.[17]

Federal Reserve response

The U.S. central banking system (the Federal Reserve or "the Fed") acted swiftly and decisively as lender of last resort to counter the crisis.[18] The Fed utilized tools it had at its disposal to meet the market disruption: crisis management via public pronouncements, supplying liquidity through open market operations,[19][B] persuading banks to lend to securities firms, and intervening directly in a few cases.[21]

On the morning of October 20, Fed Chairman Alan Greenspan made a brief 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".[22] Fed sources suggested that the brevity was deliberate, in order to avoid misinterpretations.[19] This "extraordinary"[23] announcement probably had a calming effect on markets[24] that were facing an equally unprecedented demand for liquidity[14] and the immediate potential for a liquidity crisis.[25]

The Fed then acted to provide market liquidity and prevent the crisis from expanding into other markets. It immediately began injecting its reserves into the financial system via purchases on the open market. This rapidly pushed the federal funds rate down by 0.5%. The Fed continued its expansive open market purchases of securities for weeks. The Fed also repeatedly began these interventions an hour before the regularly scheduled time, notifying dealers of the schedule change on the evening beforehand. This was all done in a very high-profile and public manner, similar to Greenspan's initial announcement, to restore market confidence that liquidity was forthcoming.[26] Although the Fed's holdings expanded appreciably over time, the speed of expansion was not excessive.[27] Moreover, the Fed later disposed of these holdings so that its long-term policy goals would not be adversely affected.[19]

Causes

Possible causes for the decline that were suggested included program trading, overvaluation, illiquidity and market psychology.

A popular explanation for the 1987 crash was computerized selling dictated by portfolio insurance hedges.[28] However, economist Dean Furbush pointed out that the biggest price drops occurred during light trading volume.[29] In program trading, computers execute rapid stock trades based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies. As computer technology became widespread, program trading grew dramatically within Wall Street firms. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized that the speculative boom leading up to October was caused by program trading, and that the crash was merely a return to normalcy. Either way, program trading ended up taking the majority of the blame in the public eye for the 1987 stock market crash. U.S. Congressman Edward J. Markey, who had been warning about the possibility of a crash, stated that "Program trading was the principal cause."[30]

New York University's Richard Sylla divides the causes into macroeconomic and internal reasons. Macroeconomic causes included international disputes about foreign exchange and interest rates, and fears about inflation.

The internal reasons included innovations with index futures and portfolio insurance. I've seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard – the portfolio insurance people were also trying to sell their stock at the same time.[31]

Regulation

After Black Monday, regulators overhauled trade-clearing protocols to bring uniformity to all prominent market products. They also developed new rules, known as "trading curbs" or colloquially as circuit breakers, allowing exchanges to temporarily halt trading in instances of exceptionally large price declines in some indexes; for instance, the DJIA.[32]

See also

Footnotes

  1. ^ The markets were: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Singapore, South Africa, Spain, Sweden, Switzerland, and the United States.
  2. ^ Discount window borrowing did not play a major role in the Federal Reserve's response to the crisis.[20]

References

  1. ^ Bates 1991; Seyhun 1990.
  2. ^ Shiller 1987, p. 23; Bernanke 1990, p. 133.
  3. ^ Malliaris & Urrutia 1992, pp. 362–63.
  4. ^ Shiller 1987, p. 23.
  5. ^ Goodhart 1988.
  6. ^ Browning 2007, pp. C1–C2.
  7. ^ Therramus 2010.
  8. ^ Black Monday 10th 1997.
  9. ^ Mishkin 1988, pp. 29–30.
  10. ^ a b Brady Report 1988, Study VI, p. 73
  11. ^ Cecchetti & Disyatat 2009, p. 1; Carlson 2007, p. 20.
  12. ^ Brady Report 1988, Study VI, p. 70; Carlson 2007, pp. 12–13.
  13. ^ Carlson 2007, pp. 12–13.
  14. ^ a b Garcia 1989, p. 153.
  15. ^ Kohn 2006; Bernanke 1990, p. 146–47.
  16. ^ Roll 1988, pp. 20 (table 1), 21.
  17. ^ Grant 1997, p. 330.
  18. ^ Garcia 1989.
  19. ^ a b c Garcia 1989, p. 151.
  20. ^ Carlson 2007, p. 18, note 17; Garcia 1989, p. 159.
  21. ^ Bernanke 1990, p. 148.
  22. ^ Greenspan 1987, p. 915.
  23. ^ Mishkin 1988, p. 30.
  24. ^ Carlson 2007, p. 10.
  25. ^ Mishkin 1988, pp. 29–30; Brady Report 1988, Study VI, p. 73
  26. ^ Carlson 2007, pp. 17–18.
  27. ^ Carlson 2007, p. 18.
  28. ^ Bookstaber 2007, pp. 7–32.
  29. ^ Furbush 2002.
  30. ^ Bozzo 2007.
  31. ^ Lobb 2007.
  32. ^ Bernhardt & Eckblad 2013, p. 3.

Bibliography

  • Bates, David S. (1991). "The Crash of ʼ87: Was It Expected? The Evidence from Options Markets". The Journal of Finance. 46 (3): 1009–1044.
  • Bernanke, Ben S. (1990). "Clearing and Settlement during the Crash". The Review of Financial Studies. 3 (1): 133–151.
  • Bernhardt, Donald; Eckblad, Marshall (2013). "Black Monday: The Stock Market Crash of 1987". Federal Reserve History. Retrieved 1 September 2019.
  • "Black Monday 10th Anniversary 1987 Timeline". The Motley Fool. 1997-10-19. Archived from the original on 2007-03-06. Retrieved 2007-10-15.
  • Bookstaber, Richard (2007). A Demon Of Our Own Design. USA: John Wiley & Sons. ISBN 978-0-470-39375-8.
  • Bozzo, Albert (2007-10-12). "Players replay the crash". Remembering the Crash of 87. CNBC. Retrieved 2007-10-13.
  • Browning, E.S. (2007-10-15). "Exorcising Ghosts of Octobers Past". The Wall Street Journal. Dow Jones & Company. pp. C1–C2. Retrieved 2007-10-15.
  • Carlson, Mark A. (2007). A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response (PDF) (Technical report). Finance and Economics Discussion Series. Washington, D.C.: Federal Reserve Board. 13.
  • Cecchetti, Stephen Giovanni; Disyatat, Piti (2009). Central bank tools and liquidity shortages (PDF) (Technical report). Federal Reserve Bank of New York.
  • Furbush, Dean (2002). "Program Trading". In David R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty. The precipitous price declines occurred when the normal index-arbitrage relation was most disrupted, not when index arbitrage was prevalent. OCLC 317650570, 50016270, 163149563
  • Garcia, Gillian (1989). "The lender of last resort in the wake of the crash". The American Economic Review. 79 (2): 151–155.
  • Goodhart, Charles (1988). "The international transmission of asset price volatility". Financial market volatility: 79–120.
  • Grant, David Malcolm (1997). Bulls, Bears and Elephants: A History of the New Zealand Stock Exchange. Wellington: Victoria University Press. ISBN 0-86473-308-9. Retrieved 18 July 2016.
  • Greenspan, Alan (1987). "Statement by Chairman Greenspan on providing liquidity to the financial system". Federal Reserve Bulletin. 73 (12): 915.
  • Kohn, Donald L. (May 18, 2006). The Evolving Nature of the Financial System: Financial Crises and the Role of the Central Bank (Speech). Conference on New Directions for Understanding Systemic Risk, Federal Reserve Bank of New York and The National Academy of Science. New York, NY: Board of Governors of the Federal Reserve System.
  • Lobb, Annelena (2007-10-15). "Looking Back at Black Monday:A Discussion With Richard Sylla". The Wall Street Journal Online. Dow Jones & Company. Retrieved 2007-10-15.
  • Malliaris, Anastasios G.; Urrutia, Jorge L. (1992). "The international crash of October 1987: causality tests". Journal of Financial and Quantitative Analysis. 27 (3): 353–364.
  • Mishkin, Frederic S. (17–19 August 1988). Commentary on 'Causes of Changing Financial Market Volatility' (PDF). Symposium on Financial Market Volatility. Jackson Hole, Wyoming: The Federal Reserve Bank of Kansas City. pp. 23–32.
  • Roll, Richard (1988). "The international crash of October 1987". Financial analysts journal. 44 (5): 19–35.
  • "Setting the Record Straight on the Dow Drop". New York Times. 1987-10-26.
  • Seyhun, H. Nejat (1990). "Overreaction or fundamentals: Some lessons from insiders' response to the market crash of 1987". The Journal of Finance. 45 (5): 1363–1388.
  • Shiller, Robert J. (1987). Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence (PDF) (Technical report). NBER Working Paper Series. Cambridge, MA 02138: National Bureau of Economic Research. 2446.
  • Therramus, Tom (2019-08-30). "Oil Caused Recession, Not Wall Street". Oil-Price.net. Retrieved 2019-08-30.
  • United States Presidential Task Force on Market Mechanisms; Brady, Nicholas F. (1988). Report of the presidential task force on market mechanisms (Technical report). US Government Printing Office.

Further reading

  • "Brady Report" Presidential Task Force on Market Mechanisms (1988): Report of the Presidential Task Force on Market Mechanisms. Nicholas F. Brady (Chairman), U.S. Government Printing Office.
  • Securities and Exchange Commission (1988): The October 1987 Market Break. Washington: U.S. Securities and Exchange Commission (SEC).
  • Robert Sobel Panic on Wall Street: A Classic History of America's Financial Disasters – With a New Exploration of the Crash of 1987 (E P Dutton; Reprint edition, May 1988) ISBN 0-525-48404-3.

External links