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Galaktion Volkov
Galaktion Volkov

The Crash Put Simply: Oct-87

Yes, there have been a number of stock market crashes since Black Monday, and so far the recipe of trading curbs seems to have worked, limiting daily declines. So while there have been abrupt short-term losses, nothing quite approaches the degree of Black Monday. Among stock market crashes since Black Monday are the bursting of the 2001 bubble, the 2007-2009 collapse of the U.S. housing market and major financial institutions (2008-2009 is frequently referred to as the Great Financial Crisis), and most recently, the Coronavirus pandemic in early 2020. In each case, circuit breakers were triggered and had the desired effect of stabilizing key markets, giving both policymakers and investors time to take action.

The Crash Put Simply: Oct-87

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Stock markets quickly recovered a majority of their Black Monday losses. In just two trading sessions, the DJIA gained back 288 points, or 57 percent, of the total Black Monday downturn. Less than two years later, US stock markets surpassed their pre-crash highs.

Black Monday is the name commonly given to the global, sudden, severe, and largely unexpected[1] stock market crash on Monday, October 19, 1987. In Australia and New Zealand, the day is also referred to as Black Tuesday because of the time zone difference from other English-speaking countries. All of the twenty-three major world markets experienced a sharp decline in October 1987. When measured in United States dollars, eight markets declined by 20 to 29%, three by 30 to 39% (Malaysia, Mexico and New Zealand), and three by more than 40% (Hong Kong, Australia and Singapore).[2][A] The least affected was Austria (a fall of 11.4%) while the most affected was Hong Kong with a drop of 45.8%. Out of twenty-three major industrial countries, nineteen had a decline greater than 20%.[4] Worldwide losses were estimated at US$1.71 trillion.[5] The severity of the crash sparked fears of extended economic instability[6] or even a reprise of the Great Depression.[7]

The degree to which the stock market crashes spread to the wider economy (or "real economy") was directly related to the monetary policy each nation pursued in response. The central banks of the United States, West Germany and Japan provided market liquidity to prevent debt defaults among financial institutions, and the impact on the real economy was relatively limited and short-lived. However, refusal to loosen monetary policy by the Reserve Bank of New Zealand had sharply negative and relatively long-term consequences for both financial markets and the real economy in New Zealand.[8]

The crash of 1987 also altered implied volatility patterns that arise in pricing financial options. Equity options traded in American markets did not show a volatility smile before the crash but began showing one afterward.[9]

On Black Monday, the DJIA fell 508 points (22.6%), accompanied by crashes in the futures exchanges and options markets.[18] This was the largest one-day percentage drop in the history of the DJIA. Significant selling created steep price declines throughout the day, particularly during the last 90 minutes of trading.[19] Deluged with sell orders, many stocks on the NYSE faced trading halts and delays. Of the 2,257 NYSE-listed stocks, there were 195 trading delays and halts during the day.[20] Total trading volume was so large that the computer and communications systems in place at the time were overwhelmed, leaving orders unfilled for an hour or more. Large funds transfers were delayed for hours and the Fedwire and NYSE SuperDot systems shut down for extended periods, further compounding traders' confusion.[21]

Frederic Mishkin suggested that the greatest economic danger was not events on the day of the crash itself, but the potential for "spreading collapse of securities firms" if an extended liquidity crisis in the securities industry began to threaten the solvency and viability of brokerage houses and specialists. This possibility first loomed on the day after the crash.[22] At least initially, there was a very real risk that these institutions could fail.[23] If that happened, spillover effects could sweep over the entire financial system, with negative consequences for the real economy as a whole.[24] As Robert R. Glauber stated, "From our perspective on the Brady Commission, Black Monday may have been frightening, but it was the capital-liquidity problem on Tuesday that was horrifying."[25]

"[T]he response of monetary policy to the crash," according to economist Michael Mussa, "was massive, immediate and appropriate."[31] One day after the crash, the Federal Reserve began to act as the lender of last resort to counter the crisis.[32] Its crisis management approach included issuing a terse, decisive public pronouncement; supplying liquidity through open market operations;[33][B] persuading banks to lend to securities firms; and in a few specific cases, direct action tailored to a few firms' needs.[35]

On Friday, October 16, all the markets in London were unexpectedly closed due to the Great Storm of 1987. After they re-opened, the speed of the crash accelerated, partially attributed by some to the storm closure. By 9:30AM, the FTSE 100 Index had fallen over 136 points.[48] It was down 23% in two days, roughly the same percentage that the NYSE dropped on the day of the crash. Stocks then continued to fall, albeit at a less precipitous rate, until reaching a trough in mid-November at 36% below its pre-crash peak. Stocks did not begin to recover until 1989.[49]

In Japan, the October 1987 crash is sometimes referred to as "Blue Tuesday", in part because of the time zone difference, and in part because its effects after the initial crash were relatively mild.[5] In both places, according to economist Ulrike Schaede, the initial market break was severe: the Tokyo market declined 14.9% in one day, and Japan's losses of US$421 billion ranked next to New York's $500 billion, out of a worldwide total loss of $1.7 trillion. However, systemic differences between the US and Japanese financial systems led to significantly different outcomes during and after the crash on Tuesday, October 20. In Japan the ensuing panic was no more than mild at worst. The Nikkei 225 Index returned to its pre-crash levels after only five months. Other global markets performed less well in the aftermath of the crash, with New York, London and Frankfurt all needing more than a year to achieve the same level of recovery.[50]

Although the stock exchange was in distress, structural flaws in the futures exchange, which was then world's most heavily traded outside the U.S., were at the heart of the greater financial crisis.[53] The structure of the Hong Kong Futures Exchange differed greatly from many other exchanges around the world. In many countries, large institutional investors dominate the market.[56] Their principal motivation for futures transactions is hedging.[57] In Hong Kong, the market itself, as well as many of its traders and brokers, was inexperienced. It was composed heavily of small, local investors who were relatively uninformed and unsophisticated, had only a short-term commitment to the market, and whose goals were primarily speculative rather than hedging. Among all parties involved, there was little or no expectation of the possibility of a crash or a steep decline, or understanding of the consequences of such a fall.[58] In fact, speculative investing that depended on the bull market to continue was prevalent among individual investors, often including the brokers themselves.[59]

The key shortcomings of the futures exchange, however, were mismanagement and a failure of regulatory diligence and design. These failures were particularly grave in the area of credit controls. In Hong Kong, the approach to credit control involved a system of margins and margin calls plus a Guarantee Corporation backed by a guarantee fund. Although on paper the Hong Kong exchange's margin requirements were in line with those of other major markets, in practice brokers regularly extended credit with little regard for risk. In a lax, freewheeling and fiercely competitive environment, margin requirements were routinely cut in half and sometimes ignored altogether. Hong Kong also had no suitability requirements that would force brokers to screen their customers for ability to repay any debts.[60] The absence of oversight creates an imbalance of risk due to moral hazard: it becomes profitable for traders with low cash reserves to speculate in futures, reaping benefits if they speculate correctly, but simply defaulting if their hunches are wrong.[61] If there is a wave of dishonored contracts, brokers become liable for their clients' losses, potentially facing bankruptcy themselves.[62]Finally, the Guarantee Corporation was severely underfunded, with capital on hand of only HK $15 million (US $2 million). That amount was obviously inadequate for dealing with any large number of clients' defaults in a market trading around 14,000 contracts a day, with an underlying value of HK$4.3 billion.[63] The Black Monday crash initially left about 36,400 contracts worth HK$6.7 billion [US $1 billion] outstanding. As late as April 1988, HK$800 million of this still had not been settled.[64] According to Neil Gunningham, the accumulative effect of these shortcomings was nearly fatal to the Hong Kong futures market: "Whereas futures exchanges elsewhere [in the world] emerged from the crash with only minor casualties, the crisis in Hong Kong has resulted, at least in the short term, in the virtual demolition of the Futures Exchange."[65] Finally, in the interest of preserving political stability and public order, the Hong Kong government was forced to rescue the Guarantee Fund by providing a bail-out package of HK$4 billion dollars.[66]

The crash of the New Zealand stock market was notably long and deep, continuing its decline for an extended period after other global markets had recovered.[67] Unlike other nations, moreover, for New Zealand the effects of the October 1987 crash spilled over into its real economy, contributing to a prolonged recession.[68] 350c69d7ab


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