Black Monday, 1987: The Birth Of Stock Market Moral Hazard

Authored by Liam McPherson via Global Macro Monitor,

The following exchange took place between President Reagan and reporters after the market close on Black Monday, October 19, 1987.  Leaving to visit the First Lady in the hospital, President Reagan spoke just after the market lost over 20 percent of its value on the day.

Q: What about the market? Tomorrow will it go down again?

President Reagan:  I don’t know. You tell me.

Q: Is the market your fault?

President Reagan: Is it my fault? For what, taking cookies to my wife?

Q: Reaganomics?

President Reagan:  I just told you. Good Lord, we reduced the deficit over last year by $70 billion. And all the other things I’ve told you about the economy are as solid as I told you. So, no, I have no more knowledge of why it took place than you have.

Thirty-three years ago today, now infamously known as Black Monday, my grandfather, M. Peter McPherson, was Deputy Secretary of the U.S. Treasury and acting Secretary that day, while Treasury Secretary James Baker was in the air traveling to Europe. McPherson was the most senior Treasury official left in Washington to handle the crisis.

The stock market had already peaked in August after an almost 100 percent rally in the prior two years.  By late August, the DJIA had gained 44 percent in a matter of seven months, raising concerns of an asset bubble, and had become very volatile as interest rates had been rising rapidly since bottoming in September of the prior year.

Similar to 1929, where the stock market peaked in early September, the markets had already begun to unravel, foreshadowing the record losses that would develop that Monday in October.

As the markets around the world began to crash, my grandfather convened with the U.S. Treasury’s Undersecretary of Domestic Finance and the Department Chief of Staff to discuss the government’s appropriate response.  The Dow Jones eventually closed 508 points down, or a 22.61 percent, almost double the historic Crash of 1929, where the Dow fell 12.8 percent in one day.

Government Kicks Into Action

According to my grandfather, the situation demanded that his team put together a plan to calm the markets. The economy was doing fine, and there were no signs of recession.  Real GDP growth came in at 3.5 percent in 1987.

Jitters about the U.S. trade deficit, rising interest rates, and the path of the U.S. dollar during the Plaza Accord are oft-cited as the fundamental reasons that triggered the crash, but nobody knows for sure.  Trees don’t grow to the sky, and neither do markets.  Stocks markets do what stocks markets do, keep their own schedule, and march to their own drummer.

The team’s conclusion at Treasury that day was the market was under severe strain for technical reasons and complicated by the new computerized program trading related to portfolio insurance.  Nevertheless, the steep losses were causing significant dislocations in the financial markets.

Many large firms were under heavy liquidity pressure and were dangerously close to not making their margin calls and on the brink of failure.

My grandfather and his team placed a call to the then-new Federal Reserve Chairman, Alan Greenspan, only a month into the job, to encourage the issuance of a Fed statement that it would do whatever it takes to provide the liquidity to keep markets functioning.

It wasn’t the time to think about the policy’s broader economic implications, such as the potential moral hazard, as the plane was on fire and going down and desperately needed a rescue plan.

It was also clear Greenspan had been thinking along similar lines.

Fed officials drafted much longer statements for release, but Greenspan reasoned that a short, clear message would do the most to stabilize markets.

It is also important to point out that when Secretary Baker arrived in Europe late that day, he immediately began communicating with key finance ministers, such as those from Germany, Japan, France, and the UK to coordinate a global response to the financial crisis.

October 20

Greenspan issued his statement the next morning, October 20,

“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.” – FRB

In typical Greenspan fashion, the statement was vague in methodology yet resolute in purpose.

The market opened down and continued falling, there were no buyers and it appeared, at one point, the global financial system was headed for a complete meltdown.

“Tuesday was the most dangerous day we had in 50 years,” says Felix Rohatyn, a general partner in Lazard Freres & Co. “I think we came within an hour” of a disintegration of the stock market, he says. “The fact we didn’t have a meltdown doesn’t mean we didn’t have a breakdown.  – WSJ

Then at about 12:38 pm, with many stocks not trading and pressure growing to close the markets a miracle seemed to happen.

With the closing of the Big Board seemingly imminent and the market in disarray, with virtually all options and futures trading halted, something happened that some later described as a miracle: In the space of about five or six minutes, the Major Market Index futures contract, the only viable surrogate for the Dow Jones Industrial Average and the only major index still trading, staged the most powerful rally in its history. The MMI rose on the Chicago Board of Trade from a discount of nearly 60 points to a premium of about 12 points. Because each point represents about five in the industrial average, the rally was the equivalent of a lightning-like 360-point rise in the Dow. Some believe that this extraordinary move set the stage for the salvation of the world’s markets. – WSJ 

The rest, as they say, is history.

My grandfather felt that the Treasury’s phone call contributed to Greenspan’s thinking and as he made the decision to issue a statement to calm the market.  The statement was the most critical event in stabilizing the markets and preventing substantial economic damage to the U.S. and the global economy.

My grandfather spoke about how the simplicity of the message prevented speculation while instilling confidence.  Not unlike ECB President Mario Draghi’s, “whatever it takes” July 2012 speech, which saved the Euro currency, the European banking system, and ultimately the European Union during their debt crisis in 2011-12.

The Birth Of Stock Market Moral Hazard   

Some argue, including one of the regular authors on this website, the Fed’s response to Black Monday ushered in a new era of faux investor confidence and the moral hazard that the central bank will always backstop falling markets.  Thus, forever distorting market risk and real price discovery and contributing to the current boom-bust asset market cycle the global economy now experiences and will be extremely difficult to reverse.

Global Macro Monitor (GMM) often argues, which is not necessarily my own opinion, what was supposed to be a one-off market intervention in 1987 has now become the norm, which monetary policymakers will find it impossible to extract itself from, ultimately resulting in a major market and economic dislocation.  We shall see.

President Reagan’s Confidence And Sense of Calm

During the crisis, President Reagan, whose administration my grandfather served several key roles in, was an excellent communicator and never once conveyed a sense of panic in October 1987.

Though not having a financial background, President Reagan did have a degree in economics and understood the nature of markets and how they coveted a sense of calm and leadership from the government during such a crisis.

The following video is President Reagan speaking to the press at the White House on Black Monday as he is preparing to board Marine One to visit the First Lady in the hospital.

Skip to the dialogue, which starts 5:40 minutes in.

Note President Reagan’s incredibly calm demeanor and sense of confidence after the most massive stock market crash in U.S. history.

[ZH: Of course, it's different this time...

Source: Bloomberg

Now that would be an 'October Surprise'...

Excerpted from Art Cashin's reminisces of that day in 1987 (rings a lot of bells for 2020)...

The first two-thirds of 1987 on Wall Street was nothing short of spectacular... Fear seemed to disappear, and junior traders laughed at their cautious elders. The brash youngsters told each other to “buy strength” rather than sell it, as each buying wave was soon followed by another.

[ZH: Robinhooders?]

One thing that helped banish fear was a new process called “portfolio insurance.” It involved use of the newly expanded S&P futures. Somewhat counterintuitively, it involved selling when prices turned down.

[ZH: Nasdaq Whale buying calls, driving dealer gamma to extremes]

The rally topped out about Aug. 25, with the hitting 2,722 (less than a tenth of its current numerical value). Interest rates had begun creeping up amid concerns of early signs of inflation.

[ZH: Rally topped a week after that in 2020]

...

On Wednesday, Oct. 14, there were widely discussed rumors of a new punitive tax on takeover profits.

[ZH: Worries over Biden's tax plan?]

Friday the 16th was an option expiration day... selling intensified into the close.

[ZH: Today is op-ex day.. and selling intensified into the close]

The weekend was a rumormonger's delight.

[ZH: Well there is sure a lot of discussion about potentially shocking videos of Hunter Biden...]

And don't forget that we had margin increases across most of the major retail brokerages last week.