Friday, October 20, 2017

Black Monday Recalled

By Roy C. Smith

October 19th is the thirtieth anniversary of “Black Monday,” the great US equities market crash in which the Dow Jones dropped 22.6 %, the largest single day decline then or since, and instantly spread to other markets in the world’s first massive liquidity event .

The event was sparked by the usual suspects – an overvalued five-year bull market (the S&P 500 index was up 44% on the year at its peak in August), some near-the-top volatility, and an early morning panic in Hong Kong that passed through Europe and hit NY like a hurricane.

When it did, it forced aggressive margin calls, revealed structural weakness in US trading systems, and sank the then new computer-based, automatic “program trading” and “index arbitrage” schemes.

The speed at which the crash developed created problems of its own. Price information was hard to get; many NYSE stocks (for which markets were made by “specialists” on the trading floor) failed to open on time, and closing prices from the day before quickly became meaningless. Program trading that required the purchase of futures contracts and simultaneous selling of shares in the cash markets quickly became disorderly and unbalanced, and further accelerated price declines, overwhelming whatever opportunistic buying there was. All this accompanied “defensive” (i.e., panic) selling by traditional institutional investors.

This crash spread instantly to other markets around the world. Global linkages and technology improvements had made this possible, but the consequences were severe. All markets with more-or-less modern trading platforms were affected, and most suffered plunges worse than in the US. Markets were down 27% in the UK, 31% in Spain, 46% in Hong Kong and, surprisingly, down 60% in far off New Zealand. Coping with shocks requires a large and well developed institutional base of investors with liquid reserves, which were scarce. This kind of global market contamination is now baked-in to our global financial system, and has occurred on several other occasions, most notably in 2008.

The crash also halted two related dynamic actvities that had developed during the 1980s, a global mergers and acquisitions boom, and a series of very large privatization sales of stock in nationalized companies by the UK government of Margaret Thatcher.

I was meeting with Sir Patrick Sheehy, CEO of BAT Industries, whom I was advising on a prospective $13 billion takeover offer for Farmers Insurance, a California company whose management and regulators would probably resist the deal. We were devising a price range for the yet unannounced deal and plotting our initial moves. I was nervous about the market that had been turbulent all the prior week. So, I got up periodically to check the office “Quotron” machine (a sort of electronic ticker tape) that was located outside my office. It was clear by early afternoon that all hell was breaking loose, and our merger experts advised me that we should postpone the deal until market conditions improved. This was because we would need the support of M&A arbitrageurs and other institutional investors to buy up stock on the contested deal’s announcement to show support for it. But the arbitrageurs were badly hurt by losses in their existing positions, so they had little room for new ones. My clients were disappointed, and left in a bit of a huff, ending our hopes for completing one of the largest deals of the year that we had been working on for months. (The transaction was completed in the next year).

At the same time, Goldman Sachs was in the middle of leading an underwriting of the US tranche of a $12.2 billion privatization sale of British Petroleum shares. This deal was truly enormous by 1987 standards. It was being conduicted under UK underwriting rules in which a price/per share was fixed at the announcement of the offering, which was followed by a two-week “subscription” period for investors to take up the shares. Any shortfall was left to the underwriters, which in the UK already had been placed with institutional investor sub-underwriters.  But, the crash occurred in the middle of the subscription period, and dropped the market price of BP shares to 224p., about 25% below the subscription price of 330p., which meant that no one would subscribe for the shares and they would all be left with the underwriters. The four US underwriters, under US rules, could not close on stock sales until the end of the subscription period, so they took a loss of about $250 million on this one deal alone, enough to threaten the viability of some of the firms.

There were a lot of other losses that day too, from trading positions and cancelled deals, which was frightening to everyone on Wall Street, but especially so to the partners of Goldman Sachs, a New York partnership with unlimited personal liability of partners, with all their money tied up in the firm.
So, it is understandable that October 19, 1987 was and is still very memorable to me. At the end of the year I retired as the senior international partner of the firm to join New York University as a finance professor, something that had been in the works before the crash.

After the crash, the market recovered quickly and by the end of December closed 2%  above where it had begun in January. (Overseas equity markets, however, recovered much more slowly). The government appoint a commission to consider causes, etc. and some reforms were put in place.  The “Roaring Eighties” did not end, however, until late December in 1989, when there was a mini-crash and a recession began. The merger boom died out then too, after the junk bond market that had financed a large part of it collapsed with the failure of Drexel Burnham, its principal advocate.

As bad as the 1987 crisis was, however, the event did not trigger any significant form of government intervention. The Federal Reserve said it would do its job to provide liquidity to banks wanting to lend to security firms on good collateral, but not much else. The exchanges stayed open, losses were absorbed, wounds licked and business went on. The market’s quick recovery eased the pain considerably.

Indeed, in the case of the massive BP stock offering, the US underwriters did what they could to persuade the UK government to postpone the deal because of force majeure; they had help in this from some sympathetic government officials worried about systemic failure, but Mrs. Thatcher said Absolutely Not! – contracts must be honored in free markets – and the deal went on despite the massive losses. If it had been pulled, then the value of underwriting contracts (especially under the UK system) may have been subject to question.

Thirty years later, we operate in markets that are ten times larger (in today’s dollars) than in 1987. Today’s US equity markets have a market capitalization of $27 trillion; but all the world’s stock, equities and tradable bank loans, according to McKinsey, are valued at over $300 trillion. Liquidity panics and global linkages continue to present a serious systemic risk to the system, as was demonstrated in 2008. New measures to contain such risks have been adopted, but are untested.

Not much is predictable about the future, but another financial crisis probably is.

Roy C. Smith, an Emeritus professor at New York University,  was a partner of Goldman Sachs in 1987.

From: Financial News, Oct 19, 2017


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