Veterans of the stock market insist that the four most dangerous words on Wall Street are “this time is different.”
It rarely is. In the autumn of 1929, Irving Fisher, a prominent economist at Yale, assured Americans that stock prices had reached “what looks like a permanently high plateau.” That was on October 15, just days before the opening stumble in an epic crash that, by its nadir in 1931, would cut the American stock market’s value by almost 90 percent. In early 2000, exuberant tech analysts argued that revenues and profits were no longer the metrics that mattered in the internet age. Then the dot-com bubble burst and the technology-laden Nasdaq Composite Index fell almost 80 percent between March 2000 and October 2002. Clearly, when the market is soaring, it can be ruinous to believe that its highs are the mark of some fundamental financial shift.
But sometimes, the market really is different. One of those times was October 19, 1987—Black Monday, the day of the largest percentage declines in Wall Street history. Then as now, a typical day might see the Dow Jones Industrial Average wiggle a few tenths of a percentage point; in the wake of calamitous news, the index might plunge as much as 5 percent. But on that single devastating day, the Dow lost 22.6 percent. Other market barometers, including the broad Standard & Poor’s 500 index, also plummeted on Black Monday. The declines, swift and seemingly unstoppable, were twice as bad as the worst day of the 1929 crash, and no single day’s decline during the meltdown in 2008 even came close, in part because regulators imposed some restrictions on the trading of shares when it was clear the financial sector was getting battered.
As I write in my recent book about Black Monday, what made that decline so different was not just its scale and speed. In hindsight, it clearly was the first modern market crash, reflecting significant and lasting changes in how Wall Street works—changes that, even after they intensified and did damage again in 2008, regulators still puzzlingly have yet to fully address.
Before 1987, crashes typically were confined to specific markets—the stock market, the gold market, the bond market, or the commodity markets. On Black Monday, the turmoil hit everywhere at once: in the futures trading pits and options markets in Chicago, on Treasury trading desks in New York, in the gold trading pits in New York, as well as on every stock exchange in the country. The panic spread around the world, leaving the Hong Kong market shuttered for a week and causing record-setting declines in other financial capitals. The speed with which the crisis bypassed the traditional financial safeguards exposed a balkanized regulatory system that struggled to respond in a coherent, coordinated way.
The 1987 crash was also the first market crisis to involve widespread use of financial derivatives—specifically, futures contracts and options contracts that tracked various stock-market indexes. The first of these novel derivatives was introduced in 1982. By mid-1983, they were being used by nearly a dozen giant pension funds, almost half of the 300 largest banks doing business in the United States, and a host of giant insurance companies, according to an authorized history of the Chicago Mercantile Exchange by the journalist Bob Tamarkin. The cross-market strategies used by these big investors linked the futures, options, and stock markets together in ways that were unforeseen and unprecedented.
There were different types of investors in 1987, too. While pension funds and other giant institutional investors had long populated the bond and mortgage markets, they were relative newcomers to the stock market. When they first started to shift assets into stocks in the 1970s, they did so with astonishing speed and on an enormous scale. In a 2000 book on the impact of pension funds on the stock market, the longtime Pensions & Investments editor Michael Clowes noted that the size of these funds’ stake in the stock market grew by nearly 20 percent each year between 1974 and 1980. And that was before a robust bull market arrived during August 1982, attracting even more institutional cash. The potential consequences of this extraordinary migration of titan-sized investors into the stock market was poorly studied and poorly understood in the years before Black Monday.
The 1987 crash was also the first meltdown to be vastly accelerated by a growing reliance on computers to deliver orders to the market and move cash around from market to market. The New York Stock Exchange had automated parts of the process of handling customer orders, but its systems were overwhelmed by all the orders delivered during the panic by the computers hooked up to Wall Street trading desks. The automated Federal Reserve system that banks relied on to transfer cash was disabled for hours at a time by the sheer volume of business on Black Monday.
As a result of all these tectonic changes, Black Monday was truly a different sort of crash—a crash that allowed Wall Street and Washington to look into the future, if they dared. In that future, there were no isolated markets—there was one market, where giant investors surged in and out of a variety of investments at a speed and on a scale never seen before. In short, the 1987 crash reflected permanent changes in the way markets worked.
And yet Black Monday didn’t lead to any meaningful reforms. No wonder, then, that the two most devastating market meltdowns of the past 30 years, in 1987 and 2008, sound so much alike. In each case, poorly understood derivatives being used on an unprecedented scale by large-scale investors put major banks, insurers, institutional investors, and brokerage firms in the same precarious position. Regulators, whose jurisdictions were limited to small patches of this vast unified market, were hard-pressed to coordinate their response as the panic spread.
The story of how the financial system survived the 2008 crisis also includes echoes of what happened in 1987. The easing of credit by the Federal Reserve was crucial in both instances. The emergence of pragmatic leaders willing to step outside their traditional lines of authority helped restore public confidence and calm the rising panic. In 1987, those leaders included New York Federal Reserve Bank President E. Gerald Corrigan and New York Stock Exchange Chairman John J. Phelan Jr. In 2008, they included Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke.
Not everything these people tried in 1987 or 2008 worked, but they seemed to intuitively understand the lesson Franklin D. Roosevelt invoked in the dark spring of 1932, as cited by the author, lawyer, and former banker Charles R. Morris in his recent book, A Rabble of Dead Money: The Great Crash and the Global Depression: 1929-1939. Speaking to the graduates of Oglethorpe University, outside Atlanta, Roosevelt said: “The country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.”
Even the postmortems of the two meltdowns were similar. In the aftermath of 1987, a blue-ribbon commission led by Nicholas F. Brady—a Wall Street veteran, a former New Jersey Republican senator, and a future Treasury secretary—tried to persuade Washington to adapt to the fundamentally new fact that the individual markets for stocks, futures, and options now, for all practical purposes, made up a single marketplace. The Brady commission urged that a single regulator be empowered to take a comprehensive view of this newly unified market and to act whenever and wherever a systemic risk emerged.
That advice, in almost the same words, was repeated after the 2008 crisis. At a congressional hearing in October of that year, former Treasury Secretary John Snow, who had served earlier in the George W. Bush administration, complained that “no single regulator has a clear view, a 360-degree view” of the labyrinthine modern market. Christopher Cox, who was the chairman of the Securities and Exchange Commission during the crisis, testified at the same hearing that “coordination among regulators, which is so important, is enormously difficult in the current balkanized regulatory system.”
There is another stark similarity between the 1987 and 2008 crises. In both cases, those warnings about fundamentally new market risks and a fragmented regulatory system were largely ignored. The current mechanisms for policing financial risk actually give regulators even less latitude for improvised emergency measures than they previously had, thanks to provisions of 2010’s Dodd-Frank legislation aimed at deterring financial “bailouts” during a meltdown.
In 1987, the financial situation truly was “different this time,” and it remains different three decades later. But while high-speed trading and social media mean the market can respond to panic rapidly, regulators can’t respond much faster than they could three decades ago. Bank regulators, market regulators, and insurance regulators still operate largely as separate fiefdoms; there is no single agency with the comprehensive view the Brady Commission recommended after Black Monday.
Why were so few safeguards put in place between 1987 and 2008, and even after 2008? The status quo always has many defenders, of course. For years after the Great Depression, the embedded powers of Wall Street resisted any wholesale change in how markets were regulated. When the U.S. economy avoided a recession after the 1987 crash, the Brady Commission’s warnings seemed less worrisome. Soon, a rapidly escalating crisis in the savings-and-loan industry confronted financial regulators and Congress with urgent, politically weighted problems that took time and attention away from any broad effort to modernize the way stocks and derivatives were regulated. After 2008, political leaders might have set out to design a new, modern regulatory system. But with health-care reform at the top of the agenda and an obdurate Republican party in opposition, the best Congress could do was patch a few gaping holes and add some embellishments to the Rube Goldberg-like construction already in place.
Back in the 1980s, Phelan, of the New York Stock Exchange, could see what he was up against as he tried to prepare his enterprise to withstand the forces that nearly capsized it on Black Monday. In an interview printed in Investment Dealers’ Digest in March 1987, Phelan said, “Nobody wants to change anything until it’s raining disaster, and then they all start running around.” That, at least, is emphatically not different this time.