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FINANCIAL REGULATION

25 Years Later: In the Crash of 1987, the Seedsof the Great RecessionBy Christopher Matthews @crobmatthews Oct. 22, 2012 3 Comments

Scott Eells / Bloomberg / Getty Images

“History doesn’t repeat itself, but it does rhyme.” This quote, often attributed

to Mark Twain, resonates with us for its pithy description of an irony we

encounter everyday: In a world marked by rapid technological, political and

social change, certain themes remain eternal.

Wall Street is not immune to this phenomenon. There have been few periods

in its history that have been more dynamic than the past quarter century.

Since the 1980s, Wall Street has seen the emergence of computerized trading,

the application of advanced mathematical techniques and theories to trading,

and the total upheaval of the very structure of the markets on which

securities are traded. Yet even with all these changes, the essence of The

Street has stayed the same.

This may be best illustrated by the great crash of October 1987. Twenty-five

years ago this week, American stock markets suffered one of its largest three-day declines in history, with the S&P

500 loosing 28.5% of its value between October 14 and 19. The total loss of wealth over that period was

approximately $1 trillion, according to a Presidential Task Force report on the crash.

At first glance the convulsions in the market in 1987 bear little resemblance to the financial problems we face

today. The 1987 crash was not the result of a financial crisis, nor did it lead to a prolonged recession. Look more

deeply at the causes and repercussions of the crash, however, and you find many that “rhyme” with those of the

2008 crisis.

(PHOTOS: Occupy Wall Street, One Year Later: Protesters Return to the Movement’s Roots)

For instance, some of the main causes of the 1987 crash were new and untested financial instruments deployed in

the market by computer programs. In addition, it was the first modern economic crash to be a truly international

phenomenon, as it spread from New York across the globe almost instantaneously. Finally, the crisis of 1987 was

coincidental with Alan Greenspan taking over the Federal Reserve — and Greenspan’s attitude towards crisis

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coincidental with Alan Greenspan taking over the Federal Reserve — and Greenspan’s attitude towards crisis

management and regulation greatly influenced the 2008 panic. With these themes in mind, I spoke with Charles

Geisst, a professor of finance at Manhattan College and author of Wall St: A History, to discuss what the 1987 crash

says about the stock market today.

It’s impossible to pin down for certain the cause of the ’87 market crash, but the most important ingredient was an

overvalued stock market. The years leading up to the crash had seen incredible gains in the market. But as a

Federal Reserve paper from 2006 puts it:

“The macroeconomic outlook during the months leading up to the crash had become somewhat

less certain. Interest rates were rising globally. A growing U.S. trade deficit and decline in the

value of the dollar were leading to concerns about inflation and the need for higher interest rates

in the U.S. as well.”

According to Geisst, there were two triggers, in addition to an overvalued market and deteriorating

macroeconomic environment, that led to an initial market break on October 17 and then a more-than 20% decline

in the S&P 500 a couple days later on the 19. One was the rumor of imminent interest rate hikes in defense of the

dollar by the new Fed chairman, Alan Greenspan. “The market had experienced very high interest rates between

1980 and 84, and was spooked by talk of a return to those rates,” says Geisst.

(PHOTOS: The Recession of 1958)

Another cause of the initial break was legislation filed by the House Ways and Means Committee that would have

eliminated tax breaks on debt used for mergers and acquisitions. Tax laws figure very prominently into valuations

of companies, and this caused investors to reconsider the value of their holdings.

Complex Financial Instruments

These factors caused investors to reevaluate their holdings, but one of the main reasons this market correction

turned into a full-fledged crash was the arrival of new, complex financial instruments on the scene. As during the

run-up to the financial crisis of 2008, Wall Street was in the 1980s growing enamored with new methods for

hedging risks. The shiny new financial instrument back then was a derivative called a stock index future, which is

tied to the value of stocks that make up the S&P 500 and other indexes.

Money managers would use these index futures as a means to hedge their portfolios, through the use of computer

programs that would automatically sell index futures if the market declined. But these new techniques hadn’t been

tested in volatile conditions. The automatic selling of the computers, combined with the efforts of other traders to

take advantage of precipitous declines in the market, helped create an atmosphere of panic which eventually led to

so much loss of wealth.

“It’s a parallel with 2008,” says Geisst. “There was new stuff being developed like stock index futures and the

techniques of arbitraging between them and developing portfolio insurance — that stuff did not fall under

regulation. That was the outer edge of regulation and nobody saw it and all of a sudden in causes an enormous

problem.”

(PHOTOS: The Global Financial Crisis)

Computerized Trading

It wasn’t just that the derivatives being traded were themselves poorly understood by many market participants.

The fact that computer programs were being used to trade them was also a prime contributor to the crash. And

twenty-five years later, computers continue to play a crucial but controversial role on Wall Street. In fact, some

estimate that upwards upwards of 75% of all trades made on a given day are initiated by computers. This so-called

high-frequency trading has caused numerous problems in the markets over the past two years – from the 2010

flash crash to an incident earlier this year that nearly caused the broker Knight Capital to go bankrupt.

International Financial Markets

We now take it for granted that financial markets are global. Multinational banks dominate the landscape and

investors can buy stocks and bonds across borders with relative ease. But this was not always the case. It was in the

1980s that stock markets around the world became deeply interconnected, with American companies increasingly

searching for capital abroad and vice versa. According to Geisst, the 1987 crash spread internationally in “a matter

of hours,” and was quickly a global phenomenon. Global regulations and standard practices increasingly allowed

“trading stocks away from their home exchanges,” Geist says.

This internationalization of the capital markets, of course, has only accelerated. One need only look to Europe —

and to the fear with which bankers and policy makers eye the possibility of financial contagion spreading from

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and to the fear with which bankers and policy makers eye the possibility of financial contagion spreading from

European to American banks — to see how this issue remains a problem today.

Central Bank Intervention

Alan Greenspan assumed the role of Federal Reserve Chairman in August 1987, just a few months before the crash.

The dollar had been declining for several years due to an international agreement in 1985 to devalue the dollar in

order to help American exporters. Fearing that the dollar had fallen too far, Greenspan took measures to raise

interest rates to defend the dollar. According to Geisst, this action spooked the markets, which had gone through a

painful period of high rates in the early 80s. “Greenspan learned his lesson,” Geisst says. “He didn’t want to get

blamed for something like that again.”

(MORE: Are We Already Planting the Seeds of the Next Financial Crisis?)

Greenspan and the Federal Reserve attacked the panic aggressively, issuing public statements confirming their

commitment to stabilizing the markets, and adjusting interest rates downwards. In fact, over the years, Greenspan

developed a reputation for aggressively combatting recessions and market convulsions — so much so that traders

began to feel that the Federal Reserve would bail them out whenever the going got rough. As a report in 2000 from

The Financial Times described the phenomenon:

“Some stock traders now call it the Greenspan put. It is a label borrowed from the world of options

trading for a widely held view: when financial markets unravel, count on the Federal Resere and

its chairman Alan Greenspan (eventually) to come to the rescue.”

The 1987 crash was the debut of the “Greenspan Put,” and some critics argue that the complacency it fostered in

market participants — economists call it moral hazard — helped foment the sort of risk taking that led to the 2008

crash.

Back to the Future

The Wall Street of 1987 was surely a very different place than it is today. Computers were an auxillary tool in the

late 1980s, while today they dominate every aspect of the business. “Complex” financial instruments have only

become more so — financial engineering the in late ’80 looks quaint to the hypereducated “quants” of today’s

Street. And financial markets across the globe are interconnected in a way that would have seemed inconceivable

twenty five years ago.

At the same time, all panics are essentially made of the same stuff. No matter how much the Street changes, there

will always be a tug of war between overconfident traders armed with new hedging mechanisms and the regulators

tasked with keeping them in check. Increasingly, humans will struggle with how to deploy computers to make

markets more efficient without having those computers hijack the process. And central banks will walk a tightrope

between protecting the public from economic calamity and distorting natural market mechanisms.

Sure, nobody will ever accuse Wall Street of being overly poetic, but even this industry full of hard-nosed capitalist

does, on occasion, rhyme.

MORE: Are We Already in A Recession?

Christopher Matthews @crobmatthews

Christopher Matthews is a Writer and Reporter for TIME.

6/5/2014 25 Years Later: In the Crash of 1987, the Seeds of the Great Recession | TIME.com

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MacroMusings

ScottConner

JamieWong

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This is an excellent article, Scott Conner's post is astute. The Great Recession was not caused by "subprime"mortgages. The seeds of the Great Recession had been built up over 20 years. Now in the past 5 years, thefinancial authorities are trying to use old tools to fight a new problem. We need a "Great Reset." If Obama isn'tthe one to put through the required initiatives, then find a replacement, but it's not Romney. I 100% blame theproblems of today on what George Bush called "Voodoo Economics."

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The common component is the lowering of capital gains, which encourages speculation and liquidation ofcapital. Higher cap gains would be tantamount to a financial transactions tax, and would mitigate some of thevalue of speculation, which has created the only "inflation" we see today in oil, debt instruments and the like. Why do none of you look at this? Is it because you keep asking the perps why we're in the mess we're in?

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The Great Recession was caused by subprime mortgages. Computerized trading only accelerated it, but it's atmost an "accomplice". The problem was that many banks took subprime mortgages into their porfolios (throughsecurity holdings or complicated derivative instruments, for example) and when the real estate price went downtheir value plunged.

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