On October 19, 1987, the Dow Jones Industrial Average suffered the largest one-day drop in its history. The day’s 22.6% decline in the index was nearly as large as the 23% fall in the two days of October 28 and October 29 of 1929. The market collapse was not only unique in its severity but in that there was no obvious cause of the decline.
The crash, which would be labeled “Black Monday”, drew obvious parallels with the 1929 stock market crash. Unlike 1929, however, the Federal Reserve, under newly appointed chairman Alan Greenspan, acted swiftly and decisively in providing liquidity to the financial system. This action, among others, helped end the panic. Financial markets quickly recovered, with the S&P 500 ending 1987 with a slight gain.
For most of the 1980’s, financial markets were enjoying a renaissance. New markets were being developed and financial innovation proliferated. Two financial innovations of the era, portfolio insurance and program trading, would play a central role in the crash. The broader themes of the crash, such as the rise of quantitative risk models, counter-party risk, and the enhanced use of financial derivatives, would be seen in future financial panics. In subsequent decades, financial panics would occur with alarming regularity, with each panic eerily resembling the last.
The crash also forced many to rethink the efficient market hypothesis (EMH), a theory which had come to dominate academic finance and the thinking of many investment practitioners. The EMH states simply that stock prices fully reflect all available information. In an EMH world, stock prices fluctuate randomly around the stock’s underlying intrinsic value. But if this theory was correct, then stock prices were just as “right” before the crash as they were after the crash. To EMH proponents, the crash was an adjustment, albeit a rapid one, to new information. These EMH proponents, however, were as confused as anyone as to what exactly that new information was.
- The Bull Market
The inflation of the 1970’s demanded a strong response. Paul Volker, who had become Chairman of the Federal Reserve in 1979, decided to tame inflation by targeting the money supply directly. The result was several years of high interest rates and a deep recession. By the summer of 1982, it became apparent that inflation had been satisfactorily tamed and interest rates began to decline. In August of 1982, the bull market began. Lower interest rates, dampened inflation expectations, and a recovery in corporate in earnings all led to higher stock prices.
2.1. Stock Index Futures and Portfolio Insurance
In April 1982, the Chicago Mercantile Exchange (CME) introduced a futures contract which allowed participants to speculate on the future level of the S&P 500 index. Because of the logistical challenges of delivering 500 different securities, the settlement of the contact occurs in cash. Thus, the contract seller is obligated to deliver at contract settlement the difference between the contract price and the dollar value of the index at settlement. If the index value at settlement is less than the contract price, the buyer must pay the seller the difference. In other words, the contract buyer is bullish on the S&P index and the contract seller is bearish on the S&P index.
With an organized futures exchange, each party to the contact must deposit a fraction of the contract amount, known as the initial margin, with the exchange’s clearinghouse. The contract is then “marked-to-market” each day. This means that each day the buyer’s and seller’s margin account is debited or credited based on the day’s gains or losses. Through this mechanism the exchange greatly minimizes the risk that a party in the contact will default on its obligations. The exchange also requires that a certain minimum is kept in the margin accounts by requiring the violating firm to post additional funds into their margin account.
The market for S&P 500 futures contracts proliferated throughout the 1980’s. By late 1987, monthly trading volume in S&P futures was over $300 billion or roughly double the $153 billion monthly volume on the New York Stock Exchange. The futures market also created opportunities for institutions to profit from any discrepancies between the index value and the price of the contract. This activity, known as “index arbitrage”, was conducted by computer programs and executed on the NYSE through an automated system called the designated turnaround (DOT) system.
Another important innovation in the 1980’s was a mechanism known as “portfolio insurance”. Portfolio insurance was a sophisticated trading mechanism in which a portfolio’s equity exposure was reduced in a market decline. The idea for portfolio insurance had its roots in the work of several economists at U.C. Berkeley. These economists would eventually start a firm, Leland Obrien Rubinstein (LOR), which by 1987 was the largest purveyor of portfolio insurance.
2.2. Leveraged Takeovers and Stock Valuations
Before the 1980’s, high-yield or “junk” bonds were the bonds of companies which were once investment-grade but which had fallen into distress. Thus, their prices fell and their yields rose. Non-investment grade firms, however, could not issue bonds as no market for new-issue junk bonds existed. But this would change due to the work of an innovative investment banker at the firm of Drexel, Burnham, Lambert named Michael Milken. Milken had two major insights. First, Milken convincingly argued that the yields on a diversified portfolio of low-grade issues would more than compensate for the enhanced credit risk of the borrowers. And second, the more firms he could convince to invest in these high-yield issues coupled with Drexel’s willingness to be a buyer of last resort, the more Milken could develop a market for these bonds. Providing liquidity for these risky bonds made it easier for Milken and his firm to sell them. Thus, Milken created a market for new-issue junk bonds.
Milken also had a new buyer for these bonds. The sharp rise in interest rates in the late 1970’s and early 1980’s had decimated the savings and loan industry, whose funding costs exceeded the income earned on outstanding loans. To stabilize the industry, congress passed legislation in 1980 and 1982 which expanded the scope of investment activities for S&Ls and banks.
Despite being associated with later excesses, junk bonds provided funding for companies who otherwise would not have been able to raise capital. And these companies could use the capital to fund research and development, capital expenditures, and other expansion activities. By the mid 1980’s, however, junk bonds would become widely used in corporate takeovers.
For many companies, the bear market of the late 1970’s and early 1980’s coupled with over a decade of high inflation meant that the replacement costs of the companies’ tangible assets were higher than their stock prices. It was thus cheaper for corporations and independent buyout firms to buy entire companies rather than build them from the ground up. This environment bred the rise of specialized buyout firms such as Kohlberg, Kravis, and Roberts (KKR) and Forstmann, Little, as well as independent buyout entrepreneurs such Carl Icahn, Saul Steinberg, and Ronald Perelman.
In a typical takeover, borrowed money is used to finance most of the purchase price. Buyout firms provided a relatively small amount of equity, while traditional commercial banks provided loans backed by the saleable assets of the takeover target. But the bank loans and equity were often not enough to fully fund the purchase price. This funding layer between the equity and the bank loans was referred to as “mezzanine” financing. Mezzanine debt was difficult to locate, as it provided neither the upside of the equity nor the asset coverage protection of the bank loans. While certain insurance companies and specialty finance firms were active in underwriting mezzanine debt, the market was highly restrictive. Milken’s high-yield bond network was a more feasible alternative for mezzanine takeover financing. By the mid-1980’s, junk bonds came to dominate the takeover financing market, and leveraged takeovers proliferated. However, while the early buyouts were made at bargain prices, many buyouts later in the decade where being made at highly inflated prices relative to the takeover target’s earnings and asset values.
Higher takeover values helped inflate stock prices as many stocks “traded up” to their hypothetical takeover values. By August of 1987, the DJIA was up about 35% for the year. Stocks looked expensive, and many commentators began to predict a market correction. By the end of September 1987, the stocks in the S&P 500 were trading at over twenty times earnings. Conversely, the earnings yield, i.e., the ratio of earnings to price, was slightly under 5%. This compared with a 10% yield on long maturity U.S. Treasury securities. Given that stocks are riskier than government bonds and must compete for capital with those bonds (and all other asset classes), a yield which was half that of safer government bonds indicated that stocks were overvalued.
- The Crash
On Wednesday, October 14, 1987, several pieces of news emerged which raddled the stock market. First, several news organizations reported that the House Ways and Means Committee had proposed legislation to limit the tax deductibility of debt-financed takeovers. If the legislation was passed, it would certainly reduce the implied takeover values of many public companies. The second news event surrounded continued concern of higher interest rates. The Commerce Department had reported a larger-than-expected trade deficit, which weakened the dollar and sent bond prices down. The selloff in the stock market, which began on Wednesday, continued into Thursday and Friday. On Friday, October 16, The DJIA fell a full 108 points.
Before the open of the NYSE on Monday, October 19, portfolio insurers were programmed to reduce exposure to the stock market. In practice, portfolio insurers accomplished this by selling S&P 500 index futures contracts. By 1987, however, portfolio insurance would come to cover as much as $100 billion in equity exposure, large enough to move the market should a large enough decline occur.
The selling volume of S&P futures led to a large discrepancy between the price of the index futures contract and the price of the underlying stocks themselves. Index arbitrageurs seeking to profit from this discrepancy bought the futures contracts while aggressively selling the underlying stocks. This furthered the decline in stocks, which led to more selling of futures contracts by the portfolio insurers. And since the portfolio insurers couldn’t sell futures fast enough to match what their formulas dictated, traders sold both stocks and futures contracts in anticipation of the portfolio insurers’ actions. This feedback loop continued throughout the trading day.
Another source of stock selling for the day came from mutual funds. Mutual funds provide daily liquidity to their shareholders. When fund shareholders redeemed their shares, many fund companies which had policies to be fully invested in the market, were forced to liquidate shares.
John Phelan, then chairman of the NYSE, was committed to keeping the stock market open, although trading on certain individual stocks was closed periodically throughout the day. However, rumors of a market shutdown surfaced, particularly after comments made by the SEC Chairman, which triggered another flood of selling.
Despite the fall in stock prices, the carnage was worse on the CME. The S&P 500 futures contract dropped in price by 28.6%, a drop of 23.3% greater than that of the S&P 500 index itself. Since losses on futures contracts are settled daily, those on the losing side of the contracts had to present to the exchange’s clearinghouse approximately $2.5 billion, an amount roughly twenty times greater than on a typical trading day and an amount greater than the credit lines which the trading firms had access to. If the losing firms failed to settle with the clearinghouse by the next day, an even larger catastrophe could spread through the financial system. As Leo Melamed of the CME recalled: “If the world thought for a minute that some long at the Chicago Mercantile Exchange couldn’t pay a short for an S&P 500 futures position, it would mean Morgan Stanley, Goldman Sachs, Salomon Brothers, whoever, couldn’t make payment. Think about that for a second. It would set off a chain reaction of gridlock. Nobody would pay anybody if they suspected somebody wouldn’t pay them.”
- The Federal Reserve’s Response
Alan Greenspan, who had succeeded Paul Volker as the Federal Reserve Chairman in August, spent the afternoon of Monday, October 19 on a flight to Dallas. Greenspan was scheduled to give a speech to the American Bankers Association the next morning. Only upon arriving in Dallas did he learn that the DJIA has suffered the largest single day decline in its history.
Since the Federal Reserve was established in 1913, its central mandate was to be the “lender of last resort”, i.e., to provide liquidity to the financial system during times of crisis. Providing liquidity to banks would be easy enough. The Federal Reserve did this regularly as part of its open-market operations. When the Federal Reserve wanted to lower the Federal Funds Rate – the overnight lending rate which the Federal Reserve targeted – it did so by purchasing U.S. Treasury securities from member banks. It paid for these securities by increasing the reserves that member banks held on account at the Federal Reserve, thus increasing the amount of lendable funds in the banking system. The hard part would be ensuring that banks provided short-term credit to the distressed broker-dealers and trading institutions. During a crisis, cash is valued above all else.
Before the markets opened on Tuesday, the Federal Reserve put out the following statement: “The Federal Reserve, consistent with its responsibility as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” In communicating its intention with clarity, the Federal Reserve removed all doubt as to their readiness to act.
To get the large New York banks to actually lend, Gerald Corrigan, then president of the New York Federal Reserve, called the heads of the major New York banks and pleaded with them. The New York Fed serves a central role in the nation’s monetary system. Not only does the New York Fed oversee many of the nation’s largest lending institutions, but it also handles the logistics of open-market operations. Corrigan, however, did not have the authority to force the banks to lend, but he was able to persuade the bank executives to think of the broader systemic consequences of hoarding the increased reserves. The major banks initially poured the increased reserves into safe securities, and the interest rate on short-term U.S. Treasury bills fell sharply below the rate which banks charged to other banks in the inter-lending market. But banks would increase their lending. By the end of the week, the ten largest New York banks alone would nearly double lending to financial firms. The increased credit to broker-dealers and other financial institutions ensured that these firms could meet their obligations to counter-parties, and thus a broader crisis had been averted.
In addition to the Fed’s response, many corporations would use the selloff as an opportunity to repurchase their own shares. Despite tumult in the market on Tuesday morning, the market began to rally by Tuesday afternoon. By the middle of the week, the panic seemed to be over.
So, what exactly caused the crash? Stocks overall were overvalued by any objective measure, but the speed and severity of the correction was perplexing.
Shortly after the crisis, the Reagan administration commissioned a task force, The Presidential Task Force on Market Mechanisms, to analyze the crash and present recommendations. This commission would mostly place the blame on the use of portfolio insurance and computer-driven selling, but it also identified other fractures in the financial markets.
The rise of quantitative risk models and complex trading schemes created new risks in financial markets. By the 1980’s, finance had come into its own as an independent academic discipline. But the mathematical elegance of academic finance often created the illusion of precision. Most of the big ideas in academic finance and the quantitative risk models derived therefrom, assumed that security prices follow a normal probability distribution. But financial markets are a human, not natural, phenomena. The behavior of human actors can alter the environment in ways that mathematical models do not account for. Portfolio insurance was one example. Portfolio insurance was meant to reduce exposure to stocks during a large market decline. But as portfolio insurance became more widely used, more and more institutions would be net sellers during a selloff. Thus, portfolio insurance greatly enhanced the risk it was created to minimize. Another example of how human actions can alter the risk environment was the intervention by the Federal Reserve. While the intervention proved necessary to prevent a systemic collapse, it set the expectation among market participants that the central bank would intervene to prop up asset prices. By the mid 1990’s, the term “Greenspan put” would enter the financial lexicon, indicating how the market expected the Fed to accommodate rising asset prices.
The broader themes of the financial crisis would be subsequently repeated. The market for financial derivatives would increase drastically throughout the two decades after the ’87 crash, quantitative trading schemes would proliferate, and mathematical risk models would again break-down. In 2007, the CFO of Goldman Sachs complained that he was “seeing things that were 25-standard deviation moves, several days in a row.” Future financial crashes are likely to occur. By studying past crises, investors can be better prepared to deal with them.
 John Steele Gordan, The Great Game: The Emergence of Wall Street as a World Power 1653-2000 (New York: Scribner, 1999), 288.
 Justin Fox, The Myth of The Rational Market: A History of Risk, Reward, and Delusion on Wall Street (New York: HarperBusiness, 2009), 232.
 Maggie Mahar, BULL!: A History of the Boom, 1982-1999 (New York: HarperCollins, 2003), 48.
 David Dreman, Contrarian Investment Strategies: The Psychological Edge (New York: Free Press, 2011), 105.
 Ibid, 107.
 Fox, Myth of The Rational Market, 228.
 Edward Morris, Wall Streeters: The Creators and Corruptors of American Finance (New York: Columbia University Press), 236.
 Eric J. Weiner, comp., What Goes Up: The Uncensored History of Modern Wall Street as Told by the Bankers, Brokers, CEOs, and Scoundrels Who Made It Happen. (New York: Little, Brown and Company, 2005), 279.
 S&P 500 PE Ratio – 90 Year Historical Chart, accessed August 16, 2017, http://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart.
 Weiner, What Goes Up, 280.
 Mark Carlson, “A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response” (working paper, Division of Research and Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., 2007).
 Mahar, BULL, 64.
 Fox, Myth of The Rational Market, 228.
 Dreman, Contrarian Investment Strategies, 113.
 Mahar, BULL!, 66.
 Weiner, What Goes Up, 284.
 Carlson, “A Brief History of the Crash”, 9.
 Dreman, Contrarian Investment Strategies, 114.
 Sebastian Mallaby, The Man Who Knew: The Life and Times of Alan Greenspan (New York: Penguin Press, 2016), 350.
 Weiner, What Goes Up, 292.
 Mallaby, The Man Who Knew, 347.
 Carlson, “A Brief History of the Crash”, 10.
 Weiner, What Goes Up, 294-294.
 Mallaby, The Man Who Knew, 356.
 Ibid, 360.
 John Authers, “Lessons from the Quant Quake resonate a decade later,” The Financial Times, August 18, 2017.