25 Years Later: In the Crash of 1987, the Seeds of the Great Recession

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“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.

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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 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.

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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.”

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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 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.”

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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.

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3 comments
MacroMusings
MacroMusings

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, the financial authorities are trying to use old tools to fight a new problem. We need a "Great Reset." If Obama isn't the one to put through the required initiatives, then find a replacement, but it's not Romney. I 100% blame the problems of today on what George Bush called "Voodoo Economics."

ScottConner
ScottConner

The common component is the lowering of capital gains, which encourages speculation and liquidation of capital.  Higher cap gains would be tantamount to a financial transactions tax, and would mitigate some of the value 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?

JamieWong
JamieWong

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