YEAR OF THE CRASH 1987 : After Historic Run-Up, the Bulls Take a Long, Hard Tumble Back to Earth

Drama and disaster: No Broadway or Hollywood producer could ask more of the financial markets in 1987, in which Wall Street firms were racked by multimillion-dollar losses and were forced to pare their professional staffs by thousands of employees at a lop.

The past year will be remembered as the one in which the self-correcting mechanisms of a market economy finally kicked in. Five years into a bull market, stocks had reached a stratosphere of fantastic valuations. On Oct. 19, they came crashing back to earth. The bond market had ignored the federal government’s spendthrift policy to the point of irrationality and corrected itself with its own crash during the spring.

But the first and longest-running market correction of the year was delivered by the dollar. While the stock market was turning in a landmark January rally, the dollar was falling by nearly 7.5%, or from 164 yen at the close of 1986 to 152 yen by the first week of February. (At the end of 1985, the dollar had purchased 205 yen.)

That was just a harbinger. For the dollar continued its slump all year. The most disheartening drop came at the very end of 1987. Two days before Christmas, the finance heads of seven leading industrial countries including the United States, known as G-7, issued a bland statement designed to express their intention to stabilize the dollar and inter alia , their hope that its value would level off. Instead, the dollar went into a free fall that brought its December loss to 10 yen.

“The U.S. didn’t bring anything new to the table, nor did the foreign governments,” remarked Donald Straszheim, chief economist for Merrill Lynch & Co.

If the dollar’s fall was the most inexorable of the collapses of 1987, it also lacked the drama of the others. It was not only for Oct. 19 that 1987 deserves to be known as the year of the crash.

For bond markets in the United States and London also experienced crashes, if not as epochal as the stock market’s catastrophe. In each case, however, the markets managed to signal that the exotic and novel securities concocted by the financial world’s legion of computer-reliant young innovators were both less and more than their users expected.

More, in that such securities as “stripped” mortgage bonds, perpetual floating-rate notes, and stock-index futures and options were riskier than anyone anticipated. Less, in that none of these contrivances delivered the kind of risk deferral on which its buyers relied.

It was a byword of the 1980s that the most gratifying investment-banking profits were to be made in the most innovative and unique new trading instruments, and a hallmark of 1987 that many of the innovations flunked their first tests.

“A lot of these new financial animals created by the rocket scientists of Wall Street have never been tested,” remarked Raymond DeVoe of the firm of Legg Mason Wood Walker, one of the more sour observers of the trend. “Every time they have been, there’s been blood all over the floor.”

One bloodletting came in mid-February, in the otherwise unremarkable market in London for a species known as the perpetual floating-rate note. The “perps” were issued by leading British banks, mostly to Japanese buyers. They resembled U.S.-style preferred stocks in having no maturity or redemption date, and resembled certain bonds in paying a fluctuating dividend.

Euphoria Dims

The perps market crash occurred after the Bank of England--the British counterpart to the Federal Reserve Board--placed sharp restrictions on their issuance and their holders realized that the notes had no value as equity investments. Holders lost as much as $2 billion.

It was the first crack in the euphoria. April brought a much more serious breach, as interest rates in the U.S. bond market soared from about 7.5% to more than 8% (marked by yields on long-term U.S. government bonds) in less than a month. Because bond prices move in equal and opposite direction from bond yields, the bond market collapsed.

Typically, the most pain was felt in the most innovative markets--in this case, the mortgage-backed securities market. The ache was widespread. One day in May, Salomon Bros. Chairman John Gutfreund smugly announced to a gathering of New York financial writers that his competitor, Merrill Lynch, had just disclosed a $150-million-plus loss in its mortgage trading for April and allowed as how Salomon traders were so well-trained that his own firm no doubt had averted such a foolish embarrassment. By the end of the day it was learned that Merrill’s loss was traced to a Salomon-trained trader on its mortgage desk, and within a few weeks Salomon was disclosing its own losses of about $100 million in that market.

Ultimately Merrill Lynch said its loss was closer to $300 million and concentrated in “stripped” mortgage securities, in which the rights to principal and interest are traded separately in markets that, under stress, behave unpredictably.

Trend Reversed

Throughout the year the bond market confounded economists. “This was the year of surprises,” remarked Timothy Howard, senior economist of the Federal National Mortgage Assn., the quasi-government mortgage house known as “Fannie Mae.”

At the beginning of the year, he remembers, “there was an extraordinary consensus that interest rates were going to be lower because of worldwide economic growth and a G-7 agreement to lower the dollar to turn the trade deficit around.” (As the dollar falls in relation to the Japanese yen and West German mark, U.S. goods become cheaper overseas and thus more exportable.)

“The trend suddenly reversed itself in the spring, primarily because of fears of a trade war and of inflation.”

Global Connections

By fall, interest rates had risen another full percentage point; the long government bond yield was more than 9.5% at the beginning of October. It took the stock market crash of mid-October to bring rates back down. In fact, the week of Oct. 19, when stock traders were losing their shirts, made the year for many bond traders as the fixed-income market rallied in inverse sympathy to the stock market.

The economic forecasters might have foundered on the increasing interdependence of the world’s capital markets, a trend that had been building for most of the decade but came to dramatic light in 1987 in the linked behavior of markets in New York, Tokyo, London, Hong Kong and elsewhere.

A failure of global vision may also account for the Reagan Administration’s failure to translate its downward manipulation of the dollar into a genuine improvement in the U.S. balance of trade, Straszheim argues.

“Since its peak in 1985, the dollar has fallen 50% against the yen and the mark, but very little against other currencies,” he says. “So our trade problem is simply migrating from Japan to South Korea and Taiwan and the other Pacific Rim countries. Instead of buying a Japanese TV or car, Americans are buying Korean TVs and cars.”

To Straszheim, that “calls into question the strategy of pulling the dollar down” to quell protectionist sentiment in Congress--but also means that the dollar may be headed much lower.

The dollar’s drop also underscored the futility of international jawboning. “Each individual nation makes monetary policy to serve its own needs,” said David A. Levine, chief economist at the brokerage firm of Sanford C. Bernstein & Co. Referring to the December G-7 communique that so underwhelmed the foreign exchange markets, he added: “There’s no evidence that the governments have the commitment to take the necessary actions to stabilize the dollar”--meaning exceptionally heavy buying of dollars in the currency markets.

Impressive Cataclysm

Without that, he argues, the dollar will drop until the point where it does affect the balance of trade. Levine reasons that it has yet to happen not because Americans have taken to buying their TV sets and cars from Korea rather than Japan but because Japanese manufacturers--fretting about losing market share--have not raised their U.S. prices enough to compensate themselves for the strong yen. The necessary 10%-15% increase would begin to make Japanese cars uncompetitive with domestic models, and the balance of trade would change.

In any case, the fall in the dollar, the continuing trade imbalance, and the rise in interest rates all became a backdrop to the year’s truly impressive cataclysm: Oct. 19, and the stock market crash.

After gaining steam inexorably through the year, rallying almost without respite from January on, the Dow Jones industrial average closed on Aug. 25 at an all-time peak of 2,722.42. The bull market had been in force for at least five years, and a cosmic euphoria had taken hold. Traders and professional investors were buying record volumes of hedges in the futures and options markets against stock drops.

The Cracks Appear

“Portfolio insurance,” a maneuver aimed at recovering in futures markets what one was losing in stock portfolios as the stock market dropped, was popular.

In the week of Oct. 12, the cracks began to show. Stampeded by word of a House Ways and Means Committee proposal to tax corporate takeover financing, takeover speculators dumped their heavily mortgaged stocks by the bushel. The market dropped 95 points in a day.

Then, on Friday, Oct. 16, the market fell a record 108 points on record volume of more than 300 million shares, and many on Wall Street thought the worst was over.

They were wrong. Over the weekend, panic began to build as Treasury Secretary James A. Baker III asserted that the Treasury would take no steps to prop up the dollar. By Monday morning, Oct. 19, traders could see that stocks had crashed in Tokyo, stock index futures were being heavily sold down in Chicago and potential buyers in New York had vanished into the woodwork.

All the year’s euphoria disappeared in a single day as the New York Stock Exchange was swamped by a selling tide of 600 million shares. The Dow fell 508 points, setting a record that easily outstripped the previous high-water mark of financial disaster--the crash of 1929.

Many of the elaborate computerized hedges erected by traders in earlier months failed their tests in October. Customers of portfolio insurance discovered that futures were selling so cheaply they could not possibly recover their stock losses.

Since then, regulators and analysts have focused their attention on how the market’s mechanisms may have contributed to the disaster, as if the event were not so much a market crash as an exchange crash. But many analysts have argued that, if anything, the markets functioned well, if hysterically, on that day--something seriously out of whack in stock values was corrected in a hurry.

“A lot of people were saying all year that the market was overvalued, price-earnings ratios were too high, and so on,” says Maury Harris, first vice president and chief economist for Paine Webber. Why was it going up? “Foreign buyers, takeover fever, (corporate) stock buybacks. . . . Ultimately, the fundamental values reigned. In the short run, we were given a lot of head fakes.”

THE DOW: RECORD GAIN, RECORD PAIN

The Dow gets off to a roaring start in January, breaking through 2,000 and then 2,100 while setting a record of 13 consecutive rises.

The 2,200 level is breached in early February, but clouds are forming in the shape of an unfolding insider trading scandal.

The Dow’s rise continues but bond prices tumble in April as the prime rate ticks higher.

The bull market celebrates its fifth anniversary in August as the Dow breaks 2,600 and 2,700. It finally tops out at 2,722.42 on Aug. 25.

October sees some breathtaking drops in the Dow, but nothing approaching the 508-point avalanche Oct. 19--Black Monday.

Amid global financial turmoil, the Dow manages a record 186-point rise Oct. 21. But the rally is short-lived.