Alan Greenspan settled quickly into his new berth at the Federal Reserve, getting to know the staff and other members of the board of governors.
While waiting to be confirmed, he had spent time in New York with Jerry Corrigan, no doubt hearing Corrigan fret aloud about the mismatch between the nation’s financial reality and its regulatory structure. The two men quickly came to respect each other and to trust each other’s judgment, even if they did not kindle the same rapport Corrigan had enjoyed with Volcker.
Though not visibly alarmed about the increasingly unsteady bull market, Greenspan was clearly uneasy. Soon after he took office, perhaps with Corrigan’s warnings in mind, he agreed to set up an informal team of senior aides from the Fed, the Treasury, the SEC, and the CFTC to develop plans for responding to a crisis, and he had the Fed staff put together an internal report on “how the Fed could best respond to various exigencies, including a sharp market correction.”
On Tuesday, August 18, 1987, Greenspan presided over his first meeting of the Federal Open Market Committee. Around the big conference table, worries were expressed about higher oil prices if tensions increased in the Persian Gulf, and comments were made about the dollar’s strength in currency markets. There was the ritual round-robin of regional economic assessments. As the clock approached noon, it was finally the new chairman’s turn.
“I’d like to make just a few observations,” Greenspan said. “We spent all morning, and no one even mentioned the stock market, which I find quite interesting in itself.”
Indeed, it was. The stock market had shaken off the jitters of January and was up about 40 percent for the year. Exactly a week after the FOMC meeting, on Tuesday, August 25, the Dow closed at another new high, 2,722.42 points. After five years, this remarkable bull market stood almost 1,950 points higher than in August 1982, a gain of 250 percent.
After his first two weeks on the job, Greenspan quietly negotiated with his fellow Fed governors for a small increase in short-term interest rates to tame what he later called the “speculative froth” in the financial economy—and, perhaps, to show that he would protect Volcker’s gains against inflation.
In a departure from custom, he let the news go out just as the markets opened on Friday, September 4, rather than after the closing bell. He then nervously watched the computer monitor on his desk, tracing the impact of the rate hike in the stock market, the bond market, and the foreign currency market.
The Fed’s news landed at the end of a dispiriting pre–Labor Day week in which the Dow had dropped every single day. The decline continued after the Fed’s news hit that Friday, pulling the Dow almost 6 percent below its peak on August 25.
The short week after Labor Day had a few bright moments, but the rest of September was increasingly erratic: an occasional oversize rally, followed by days of grinding losses. By the end of a seesaw session on September 30, the Dow had rallied to 2,596.28 points, still about 4.6 percent off the market’s high of five weeks earlier.
Of course, after five years without a bear market, no one was surprised that the Dow’s losing days had become more frequent. No bull market lasted forever.
As October arrived, Greenspan seemed confident the Fed was taming any excessive financial speculation. Perhaps now the stock market would finally settle into a long-overdue correction, with stock prices drifting down to a stable and more reasonable level.
Meanwhile, at the SEC, David Ruder faced a rockier introduction to life as a financial regulator. He was immediately confronted by an urgent management crisis in the SEC’s New York office. Not only was New York the agency’s biggest and most important outpost, it was also the commission’s closest contact with the stock exchanges and brokerage houses on Wall Street.
In the fall of 1986, John Shad—perhaps distracted by the unfolding Boesky case—had appointed a new regional director for New York, a longtime corporate lawyer with the Mobil Corporation. It had been a spectacularly poor fit. Within months, the New York staff began to complain that the new boss was undermining the office’s enforcement effort, but Shad did not intervene.
In Ruder’s first week on the job, the simmering unrest boiled over. The veteran enforcement chief in New York resigned, and three other senior staffers threatened to follow her out the door. The office uprising made headlines, provoking congressional concern and questions.
Ruder asked his senior aides to assess the situation and received a damning report about morale problems “so bad it would’ve taken a miracle to change them.” He firmly demanded the regional administrator’s resignation.
He could not summon a new regional administrator out of thin air—or, more accurately, out of the SEC’s thin budgetary rations. In late September he asked two senior Washington staffers to do double duty, one as a part-time administrator for New York and the other as a part-time enforcement chief there, in addition to their existing responsibilities. The arrangement was far from ideal, but at least Ruder prevented a larger exodus of experienced staffers from his most critical outpost.
* * *
ON MONDAY, OCTOBER 5, after a modest month-opening rally, the Dow stood at 2,640 points. But the rally fell apart the following day, in a grimly familiar way. The Dow dropped sharply at the opening bell, bounced mostly downward until late afternoon, and then fell off a cliff in the final half hour. By the closing bell, the Dow was down almost 3.5 percent—a record-setting 91.55-point loss.
In the absence of any notable economic news, there was a lot of theorizing about what had caused Tuesday’s epic decline. But what was clearly true was that index arbitrage trading had surged at the end of the day, most of it tied to offsetting trades in the S&P 500 futures pit at the Chicago Merc. Portfolio insurance trades had been sparse on Tuesday, but with the market’s recent declines, those hedges would likely need to be adjusted soon. That would mean heavy selling in Chicago. Moreover, some aggressive speculators on Wall Street had started to trade ahead of the portfolio insurers, to profit from their anticipated sales. That copycat short selling could add extra weight to whatever the portfolio insurers did.
For most investors, the rest of the week was truly awful. By Friday, October 9, the Dow had fallen to 2,482 points, which was almost 159 points and 6 percent below its level the previous Friday. Measured in points, it was the worst one-week decline in Wall Street history. Those who had grimly expected a stock market correction for months must have gone home feeling vindicated, if battered. The market was almost 9 percent below its August summit. The worst, surely, was over.
* * *
MONDAY, OCTOBER 12, was the Columbus Day holiday. Banks and government offices were closed, and trading was light on the Big Board as the Dow sustained a modest loss of about 10 points.
Stocks involved in the continuing takeover frenzy had been weak for days, as a House committee considered reducing the tax breaks for certain kinds of takeovers. Takeover speculators may have been selling down their portfolios, but that was not an exceptional source of selling pressure—no more than the prior week, really. If the market’s blue-chip stocks stayed steady, the takeover selling pressure wouldn’t be a problem.
Then Tuesday brought a welcome rally, with the Dow up by about 1.5 percent, to 2,508 points. With their spirits lifting, several traders said they were watching for the next day’s announcement of the nation’s August trade deficit. Market analysts had become obsessed with this monthly statistic, watching it for clues to future currency and interest rate movements. Traders hoped that a shrinking trade gap would reduce the odds that the Fed would try to cool the economy by raising interest rates again.
When the August trade deficit was reported at 8:30 a.m. on Wednesday, it had indeed gone down, but nowhere near as much as analysts had expected. The news hit the markets like a dart hitting a balloon.
Foreign currency traders immediately began to sell dollars, leaving the U.S. currency weaker against the German mark and the Japanese yen. Fearful that a weaker dollar would force the Fed to raise interest rates, which would depress Treasury bond prices, traders promptly phoned London to start selling Treasury bonds there, before the market opened in New York. When the New York market did open, they kept selling. The sell-off pushed up the interest rate on long-term Treasury bonds to just over 10 percent, a two-year high.
After some historically awful days in the stock market, a 10 percent interest rate on something as secure as a U.S. Treasury bond was something any uneasy investor would have to consider. If you could earn 10 percent on your money without any risk that you would not get that money back, why would you invest in stocks, whose prices had been falling for weeks?
Not long after the trade deficit headlines, the news broke that Democrats on the House Ways and Means Committee were filing bills to curb takeover tax breaks. It was barely news—such actions had been rumored for weeks, and some kind of legislative assault on hostile takeovers had been threatened for months, if not years. And it was hardly a “done deal”—the influential SEC was leery of the idea, the Senate was in Republican hands, and President Reagan would surely veto any bill that made it as far as his desk. No one could have rationally assumed, based solely on that report, that takeover tax breaks were doomed.
Psychologically, though, this news may have dented investors’ confidence, especially those professionals speculating in takeover stocks. By some accounts, these speculators began to sell stocks from their portfolios as soon as the opening bell rang at the NYSE on Wednesday morning.
By itself, that selling might not have been significant, but in Chicago, other newly pessimistic traders, and a number of indifferent portfolio insurers who were adjusting their hedging positions, were selling an enormous number of S&P 500 futures contracts. That drove the spooz price down until it was even cheaper than the slumping stocks in the index—a familiar invitation to the index arbitrageurs to go into action. So the relatively modest selling of takeover stocks on the NYSE merged into the much heavier selling by index arbitrage traders, who sent their huge trades directly to the specialists on the trading floor via the NYSE’s automated DOT system.
In its first thirty minutes of trading, the Dow’s fall was almost vertical. By 1:15 p.m., the index was down 89 points, or 3.5 percent. This nosedive was a textbook example of Phelan’s “cascade” theory: The price of the S&P 500 futures on the Merc fell first, driven down by portfolio insurers who were selling in response to previous declines. Then index arbitrage traders stepped in to buy the cheaper futures contract in Chicago and sell the more expensive stocks in New York, transmitting the price decline from the Merc to the NYSE. These concentrated index arbitrage trades were a stormy force, accounting for about a quarter of all the trading during this turbulent hour.
This wasn’t Main Street suddenly dumping stocks in a panic. Seventy-five percent of the selling on this day was coming from giant institutions and big brokerage houses trading for their own profit.
That was the story for the final hours of trading on the NYSE—heavy selling by index arbitrage traders concentrated within short windows of time, with similarly concentrated but not as abundant buying in the futures pits in Chicago.
As had happened before, however, the buying done by arbitrageurs in Chicago was never potent enough to push the futures prices into line with the cash prices on the NYSE. Briefly, just before 3:30 p.m., it looked like that would happen, but it didn’t last. After a few moments, spooz prices began to fall again, as portfolio insurers continued to sell while index arbitrageurs struggled to feed a smaller stack of buy orders into the unruly scrum of traders. By the end of the day, the NYSE had handled $1.4 billion worth of index arbitrage trades, twice the normal level and 17 percent of the entire day’s trading volume. But the flip side of those trades in Chicago had still not been enough to bring the two markets back into balance.
In New York, it was the worst one-day point loss in market history—95.46 points. At the closing bell on Wednesday, the Dow stood at 2,485.15 points, a one-day drop of 3.8 percent, the third largest ever.
* * *
THE NEW YORK Fed, led by Jerry Corrigan, had tried to calm the bond market’s fears that the dollar’s recent weakness would cause interest rates to climb and bond prices to fall. He let it be known early Thursday that the New York Fed was injecting cash into the system by purchasing Treasuries, which would help stabilize bond prices. In normal times, that would have eased such interest rate fears, but that didn’t seem to be working.
Trading on the Big Board on Thursday, October 15, began badly and ended worse, punctuated by tantalizing rallies that dissipated the faint whiff of panic the market had smelled on Wednesday. Volume was extremely heavy, though, and almost two-thirds of the first half hour’s volume was in the form of giant orders of 10,000 shares or more—additional evidence, if any was needed, that this was an institutional stampede. Portfolio insurers were among the big sellers in the Chicago futures pits as the day opened.
Fortunately, there was enough appetite for stocks to absorb the selling, and the Dow had recovered by late afternoon. At 3:30 p.m., it was down just four points.
Then, in the final half hour, the Dow fell an astonishing 53 points, or 2.2 percent.
While this should have been a grimly familiar pattern by now, one official report nevertheless concluded that “this sharp decline on heavy volume so late in the day bewildered investors.” Remarkably, in this enormous market, just seven “aggressive” institutions accounted for 9 percent of the entire day’s trading volume. By the end of Thursday, the Dow stood more than 13.5 percent below its August peak, a decline of almost 370 points.
Traders and analysts were calling it the “October Massacre.” A few told reporters this could be the advent of an official bear market, meaning a decline of 20 percent or more within two months of a market peak. If so, it would be the first in more than five years.
There was evidence of free-floating anguish in every market—bonds, currencies, precious metals. The stubborn lack of progress in tackling the federal budget deficit, hardly a new development, suddenly seemed intolerable. The heated diplomacy over foreign exchange rates, a fixture of financial life since at least the beginning of the year, suddenly looked more perilous. Bad news that the market had shrugged off all summer suddenly seemed to be all anyone could think about.
That evening, having done all he could in the bond market, Jerry Corrigan boarded a jet bound for Caracas, Venezuela. He would change planes there for the short hop to Maracaibo, on the nation’s far western coast, where he would be giving a speech on Friday, October 16. After the speech, he would return to Caracas to consult on Monday with Venezuela’s president. He planned to fly back to New York on Monday afternoon.
On the sixth floor of the NYSE, exchange president Bob Birnbaum was holding down the fort for the vacationing John Phelan, who was calling in frequently for updates. Volume had been heavy, but that wasn’t the problem. The problem was the way the volume was hitting the floor. What mattered to the DOT system was how many separate orders it had to deal with at any one time. One order for ninety thousand shares was a lot easier to handle than a hundred orders, each for nine hundred shares, especially if those orders all slammed into the market at once—as was more frequently the case.
This pattern was an unintended side effect of the NYSE’s decision to open its electronic order-processing system to larger and larger orders. Index arbitrageurs and other program traders wanted to use the DOT system, but even the higher DOT cap was too low to accommodate their vastly larger orders. Consequently, they would deliberately break large trades into many separate orders, each of which came in just under the DOT limit, adding to the number of orders the system had to handle.
It was not a sustainable situation.
* * *
THE MORNING NEWS on Friday, October 16, was upsetting. In the Persian Gulf, tensions simmering for months had suddenly boiled over with an Iranian attack on an oil tanker flying the American flag. From Washington, there were reports that Treasury secretary Jim Baker was annoyed about Germany’s recent interest rate hikes, which worried the currency and credit markets. At least the major foreign stock markets were not in turmoil: Tokyo’s market had declined just a bit, while London’s trading had been shut down by a freak gale that knocked out power across much of the region.
The calendar was still a threat: Friday was a witching hour day for the options markets, and it would be hard to imagine a less welcome one. Stock index options—notably the S&P 100 options on the Chicago Board Options Exchange and the Major Market Index options on the American Stock Exchange—were set to expire at the closing bell. Since the options markets had resisted the move to “morning-after” prices, which had helped calm expiration days in the futures markets, this witching hour was alive and unpredictable.
The Chicago Merc was in for a heavy day, too—again, thanks to developments in the options markets. There simply weren’t enough index option contracts available at prices that reflected the week’s sharply lower stock values. With nowhere else to turn, options traders were using the futures markets to hedge their own positions, linking those two derivatives markets more closely than usual.
Despite the morning’s worrisome headlines, the stock market opened firmly, and promptly rose 12 points. Then, in familiar fashion, it bounced down a lot and rallied a little, over and over, like a Slinky falling down a steep flight of steps—a very long flight of steps. The market dropped to new lows, then dropped further.
The institutional selling pressure was coming from all sides now—from big brokerage houses selling short, betting on further price declines; from endowments, pension funds, and hedge funds that had grown suddenly pessimistic; and even from a few mutual funds that were getting calls all day Friday from nervous investors who suddenly wanted to cash out. Those demands were running $750 million ahead of the selling that mutual funds were doing on this crazy day.
Before Friday’s trading was done, just four giant institutional investors had sold at least $500 million worth of stock from their portfolios. “To put this in perspective,” one official account noted, “an investor transacting $10 million [in trades] on a normal day would be considered an active trader.”
A momentary rally just before 2:30 p.m. jerked the Dow back to within 30 points of its noontime level, but then the dizzy index arbitrage dance began again. Arbitrage selling accounted for almost 20 percent of the trading volume over the next hour.
By 3:30 p.m., the Dow was 3.4 percent below the Thursday close, a drop of about 81 points. In the next twenty minutes, it plunged another 50 points. The gathering loss was astounding—a 5.5 percent nosedive.
Index arbitrageurs and portfolio insurance traders together sold more than $730 million worth of stock, accounting for more than 43 percent of the trading volume during this short white-knuckle period. Some traders later said it felt as if the floor had simply given way—“free fall” had become a threadbare phrase during the previous two months, but this time, they said, it really did feel as if the market were falling through thin air.
Ten minutes before the closing bell, the witching hour for stock index options struck—but, miraculously, its spell was benign and produced enough buying demand to move the Dow up 22 points. The rally was quick; prices plateaued for a moment, then started to slip—but with the Dow at just under 2,247 points, the closing bell rang. The last-minute rally, according to one account, produced “the odd spectacle of a market full of people relieved that the Dow is only down 108 points.”
In the context of the time, Friday’s 4.6 percent drop was a shocking, unprecedented loss. It was the largest one-day point loss in history, breaking a record set just two days earlier. It was also the first time the Dow had ever closed down more than 100 points. The week’s 235-point loss wiped out the previous week’s dismal record. This, now, was the worst week in Wall Street history. Unlike in the prior week, however, no one felt any confidence that the worst was finally behind them.
* * *
IN CHICAGO, THE torrent of trading in the stock index futures and options pits had mirrored the deluge in New York.
The options market had been under intense pressure. Some firms were racking up enormous losses. First Options, the Continental Bank subsidiary that was the largest clearing firm in the options market, was a special concern of the Options Clearing Corporation, the market’s central clearinghouse. First Options essentially backstopped all the trades of its twelve hundred client firms; and the clearinghouse backstopped First Options.
By the close of trading on Friday, nine First Options clients, all firmly in the black on Wednesday night, were in serious trouble. Only three of them had not run up big losses, and one of those was near the edge. First Options was on the hook for those accounts, no matter how big the losses got.
The Merc had made some progress in addressing problems in the S&P 500 pits, but it was still crowded, chaotic, and loud. Despite that, Leo Melamed had been making money like crazy there almost all week. Bearish about the market, he’d been piling up futures contracts that would rise in value if the market fell.
And boy, had the market fallen! It had been such a profitable run that Melamed almost decided to roll his positions into the next week. He shook off the temptation: “After a week like that, you get out, take your profits, and go home.” So, he closed out his bets, planning to head into Monday with a clean slate.
* * *
AROUND 4 P.M. on Friday afternoon, SEC chairman David Ruder left his sixth-floor office and went down to the division of market regulation, one floor below, to check the market’s status on the computers there. He learned that there likely had been heavy index arbitrage trading that day, and he told his staff to stay in close touch with John Phelan’s team at the New York Stock Exchange.
On Friday evening, the SEC office was busy as five dozen staffers called contacts on Wall Street and at the exchanges to get a sense of where things stood after the day’s historic debacle. Over the weekend, Ruder would confer with his chief of market regulation, Rick Ketchum, to review what they’d learned and to plan for Monday. Ketchum told Ruder that he was booked to serve on a conference panel in New York early Monday morning, but his deputy would be in the office. Ruder, too, was scheduled to give a speech on Monday, but thankfully it was just across town, at a Washington hotel.
* * *
THE WHITE HOUSE was in an uneasy holding pattern. First Lady Nancy Reagan had recently had a mammogram that required further investigation. She would have a biopsy and, if necessary, breast surgery over the weekend at the Bethesda Naval Hospital. The president was understandably worried and distracted.
For weeks, Beryl Sprinkel, an outspoken bank economist who was chairman of the Council of Economic Advisers, had been urging chief of staff Howard Baker to let him caution the president about the Fed’s unwise interest rate hikes and the Treasury’s clumsy diplomacy over the dollar’s exchange rate.
So, on Friday afternoon, Alan Greenspan was summoned to a meeting with the president in the family quarters at the White House. When Reagan arrived, he was met by Greenspan, Sprinkel, Howard Baker, and Jim Baker. No one seemed to have thought to invite David Ruder of the SEC, despite the historic events in the stock market that week, and indeed, on that very day. Nor did they invite the CFTC’s new acting chairman, a genial Kansas rancher named Kalo Hineman; they apparently did not think the futures market was relevant to their discussion.
There are slightly differing versions of what happened at this meeting, but the consensus is that first Jim Baker and then Alan Greenspan, under polite questioning by Howard Baker, assured the president that their current policies were sound and there was no reason to be overly concerned about the turbulent financial landscape. Then Sprinkel forcefully disagreed with them both, urging Greenspan to ease up on interest rates to reassure the markets and telling Jim Baker to leave the currency markets alone. In any case, “after considerable bickering, the meeting broke with nothing resolved,” according to one careful account.
Greenspan was scheduled to fly to Dallas on Monday to address the American Bankers Association. Jim Baker would appear on Meet the Press on Sunday morning; then he planned to fly to Stockholm for a hunting trip with the king of Sweden. Howard Baker would be left to man the White House into the next week, as the president focused on his wife’s anxieties, and his own.
* * *
ON SATURDAY EVENING, October 17, Hayne Leland and his wife were holding a dinner party in the high-ceilinged dining room at their home in Berkeley. The guest of honor was the economist Gérard Debreu, who had joined the Berkeley faculty in 1962 and won the Nobel Memorial Prize in Economics in 1983.
The conversation around the table turned quickly to the historic events in the market that week, and Debreu noticed how upset his normally urbane host was. The night before, Leland had learned that LOR’s chief (and only) trader in Los Angeles had not been able to sell enough futures contracts on Friday afternoon to fully hedge LOR’s client accounts. It had been too chaotic in the spooz pit in Chicago, and the trader hadn’t been able to get all the orders filled.
John O’Brien hadn’t seemed all that alarmed, but Leland could not shake the sense that something was going profoundly wrong with the markets. On Sunday morning, Mark Rubinstein answered the phone at his Marin County home and was shocked at Leland’s tone—he could not remember his campus colleague ever sounding so upset. Leland explained his concern, and said he was determined to catch a 6:30 a.m. flight to Los Angeles on Monday. He would be taking off just as the NYSE was opening.
Rubinstein decided that he would take a later flight and meet up with Leland at LOR’s offices in the First Interstate Tower. He thought his colleague was overreacting but trusted his instincts.
* * *
THE LARGELY INSTITUTIONAL rout of the previous week was rapidly becoming a public panic. Call centers at some major mutual fund houses and discount brokerage offices were ominously busy all weekend. At the scattered branch offices of Charles Schwab, a household name thanks to its national advertising, customers were getting incessant busy signals all through Saturday. The “phones were melting down,” one account noted, “but 99 percent of the calls that did go through were orders to sell.”
On Sunday, October 18, when Jim Baker arrived at NBC’s Washington studio for his Meet the Press appearance, he learned he would be appearing after a segment with Henry Kaufman, a prominent economist at Salomon Brothers. The journalists repeatedly pressed Kaufman for a market forecast, but he remained soothing and noncommittal. “Friday already had investors on edge and I had no intentions of adding to the turmoil,” he said later.
After Kaufman left the set, he watched on the studio monitor as Baker was quizzed about the apparent rancor between the United States and its allies over monetary policy. “We will not sit back in this country and watch the [trade] surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States … somehow will follow by raising its interest rates,” Baker said.
Kaufman cringed; he didn’t think the markets were going to hear the comments in the spirit Baker intended. They were going to hear sabers rattling and would worry even more about a currency crisis, a declining dollar, and an exodus of foreign investors. He said as much, politely, to Baker after the program. The treasury secretary replied firmly, “Henry, some things need to be said.”
* * *
IN EVERY MARKET, there was a foreboding sense that Monday would be difficult. These rumors felt different in Chicago than they did in New York because the two markets lived on different timetables. The investors who bought or sold during Friday’s frantic trading session on the NYSE didn’t have to come up with the stock or the cash until the following Friday—stock trades officially “settled” in five business days. Futures and options traders had to settle up their accounts overnight, or they couldn’t trade the next day.
The Merc’s clearinghouse, like all its counterparts across the markets, was the “other side” of every trade—it bought from every seller, sold to every buyer, and thereby ensured that traders could do business without fear of a default. Implicit in that arrangement was the expectation that the clearinghouse had the resources to cover any losses. The clearinghouse had to know everyone’s financial exposure before it could calculate its own.
On Sunday evening at his suburban home north of Chicago, Merc president Bill Brodsky picked up word about sharp price declines in the Asian markets, where it was already Monday. He called his head of market surveillance, the man who would have to monitor the financial stability of the firms doing business on the Merc, and asked him to be at his desk as early as possible the next morning.
* * *
BY FRIDAY’S CLOSING bell, the Dow had fallen almost 10 percent just since the previous Friday; since its August peak, it had fallen 17.5 percent, more than 475 points.
The short rally just before Friday’s closing bell didn’t comfort anyone but rank amateurs. The professionals knew the day “could have been—should have been—far worse.” All over the Street, people were whispering about the pent-up reservoir of selling waiting to engulf the market on Monday. The estimates were terrifying: by one calculation, portfolio insurers, who sold the futures market equivalent of $2.1 billion in stock on Friday, still had the equivalent of $8 billion more to sell.
It was frighteningly easy to see who would be coming back into the market to sell on Monday. Who would come back to buy?