Black Monday Recalled

By Roy C. Smith

October 19^th 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

Will Trump Take Half a Loaf on Taxes?

By Roy C. Smith

The Trump $1.5 trillion tax plan is really two-bills-in-one. A good one and a bad one.

The first is a legitimate effort at long overdue reform of the method and effect of collecting taxes from businesses. It would repeal a long out-of-date system of taxing income wherever earned around the world, after deducting local taxes paid, but allowing tax payments to be deferred until the income was brought back into the US. In a time of global business integration and competition, the present system is inefficient because (a) it applies a 35% tax rate to all income, the highest tax rate of any large, developed country, (b) but that tax rate is reduced by the deferment provisions to an average effect rate of about 26%, which happens to be the average corporate rate for OECD countries, (c) however, only a few hundred large global corporations get the benefit of deferral, so the vast majority of America’s 5.5 million corporations pay an exceptionally high rate, which clearly impedes their growth and development.  A rate cut to 25% for smaller and midsized businesses would benefit them a lot.  

By the way, the argument that the cash reflecting the deferred taxes, some $2.5 trillion or so, is “trapped” outside the country and cannot be used to fund domestic investment is phony. Corporations can and do lend money between subsidiaries, or borrow from banks with the deferred cash as collateral.

Two solid reasons for adopting these Trump corporate tax reforms are that it harmonizes the US tax system with those of our global competitors and levels the playing field. And, it will add sufficiently to after-tax cash flows from all `businesses and raise their returns-on-equity to enable more economic growth, a major objective of the Trump plan.

Another reform element of the Trump plan is the abolishment of the estate tax on inherited wealth. This tax is now only paid on wealth greater than $5.45 million ($10.9 million for married couples), but it is then taxed at the rate of 40%. Abolishing the tax would be a huge benefit for the very rich (just 0.2% of taxpayers), which, of course, attracts a lot of political heat. Yes, the heirs of Mr. Trump and much of his cabinet would prosper greatly from such a change, but the numbers are not big on a national scale, as the estate tax represents less than 1% of annual tax revenues. The estate tax was installed in 1916 and has endured since, largely because of the argument that without such a tax a permanent class of enriched “nobility” would emerge that would weaken our democracy. The counter argument to this was the America is the land of opportunity in which wealth could be created from very little, but an estate tax confiscated the fruit of such efforts – constitutionally protected private property on which federal, state and local income and property taxes had already been paid. The present estate tax law, enacted in 2016, is a trade-off between these points of view. There is not much appetite to bring estate taxes up again so soon after the last effort to reform it and eliminating, and, in any case, it won’t affect the economy much

The rest of the Trump tax plan is essentially bad because it will increase the fiscal deficit and probably won’t create much growth. It is a hodgepodge of business and personal tax cuts designed to satisfy traditional republican demands for lower taxes to stimulate growth. Mr. Mnunchin says the plan will pay for itself by increased tax revenues from added growth. Despite the popularity of the “Laffer Curve” that predicted such an outcome from the Reagan era tax cuts, it didn’t happen then and very few economists believe it will this time.

About 47% of tax filers don’t pay federal income taxes, so they won’t be affected.  Analyses to date suggest that the tax cuts for middle income people will be offset by the loss of deductions that leave the average taxpayer about where he or she was. Lower rates on higher income people won’t matter that much, as most wealthy Americans pay much lower effective tax rates than the 39.6% maximum because of allowable deductions and so much of their income is from capital gains that are taxed at 22.8%. Reducing the maximum rate to 35% won’t result in much additional consumption on which incremental growth depends.  The rich don’t spend their tax savings, but instead invest it in (already high-priced) securities. But at very low unemployment (4.2%) and inflation (1.5%), the odds are that whatever new spending there may be from the tax cuts will end up increasing wage inflation more than growth.

One feature of the Trump plan, however, could make a big, if unintended, difference. This is the provision that would allow corporations or individuals to utilize “pass-through” vehicles (limited liability corporations or partnerships) to benefit from a maximum rate of 25%. Pass through vehicles are entities that don’t pay taxes but pass income (and losses) on to shareholders to pay (or deduct) at individual rates. A small business owner can often lower taxes considerably by passing through, but some of the biggest users of these entities are hedge fund and private equity investors and real estate operators like Mr. Trump. If the 25% rate were adopted for pass-throughs, these types of investors would be major beneficiaries along with many wealthy lawyers, doctors, and others who would set up their own entities to channel income to get lower rates. But if the corporate rate is to be lowered to 25%, this provision really is unnecessary.

Certainly, the Trump tax plan has its share of political problems. To get passed, it will have to be presented to the Senate as a “budget reconciliation” measure that can be approved by a simple majority of 51 votes. For this to happen, the Senate must first pass a budget resolution based on the Trump budget submitted earlier this year (the House passed such a resolution last week). According to the bi-partisan Tax Policy Center, the budget will produce a deficit of $2.4 trillion over 10-years, or $240 billion per year (1.2% of today’s GDP, to be added to the existing fiscal deficit of 3.1%). This deficit will then have to be financed by additional government borrowings, which may upset the deficit hawks among Republicans (they have been quiet so far), the future debt ceiling bill that will have to be passed to accommodate it, and raise serious questions as to whether the $2.4 trillion estimate, or the Treasury’s of net deficit reduction is reliable.  The Treasury forecast is based on “dynamic scoring” which assumes incremental tax revenues from a 3%+ annual growth that it says the tax plan will generate. In the past, dynamic scoring forecasts have been very inaccurate -- the amount of derived growth has been less than promised, and the deficits have been greater. Continually missing these forecasts partly explains why the US government’s debt to GDP ratio (107%) has grown to be the highest since WWII. This has been very worrying to many finance experts, debt rating agencies and those fearful of a debasing of the currency, and it should put some serious loyalty stresses on Republican senators who properly understand these issues.

The tax plan is unlikely to attract any support from Democrats, who are in lock-step that the whole thing is a give-away to the rich. It might get through the Republicans, but it will be tough on those Congressmen running for reelection in high-tax states that would lose the deductibility of state and local income and property taxes. The loss of this deduction is one of the last surviving means (after abandonment of the “border tax”) to gather new revenues to pay for the other cuts and increased defense spending.

The best outcome might be for Congress to pass only the good bill, the corporate tax reforms, and let the rest (like health care repeal) go for another time. Doing this could add to growth without growing the deficit. Middle class tax cuts may have been promised, but what would be delivered won’t be that much. Pass-throughs and an aggressive program of accelerated depreciation create distortions and unintended economic consequences that are more trouble than they are worth. Even the rich are resigned to paying some form of estate tax, so its repeal won’t really be missed.

Doing this, of course, would be an example of a half a loaf being better than none, something our present all-or-nothing Congress has been unable to accept as a working principle of governance.