Very early on Wednesday morning, October 21, 1987, Goldman Sachs was supposed to pay $700 million to the hard-pressed Continental Illinois bank to cover some trading debts, but it was holding back until it received money it was owed by others. “Then, Goldman thought better of it, and made the payment,” Alan Greenspan later recounted. If it had not, he said, “it would have set off a cascade of defaults across the market.”
It was going to be that kind of week, each day threatening to be worse than the dreadful day before.
A little before 9 o’clock that Wednesday morning, David Ruder sat at his desk, listening intently and taking notes as top staffers outlined the day’s possible nightmares.
A floor below, staffers in the SEC’s market regulation division were sweeping the Street for rumors of firms slipping into failure; some were true, some weren’t—or, weren’t yet. Still, the market situation could be severe, a key aide told Ruder, pointing out that the “total numbers are bad.” The aide added that if any big firms were “screwed up, we’re going to have problems.”
The overarching worry was that a major firm would fail. In the wee hours of Wednesday morning, an NYSE specialist firm had been quietly merged with Merrill Lynch; three small trading firms and a Midwest broker had faltered, but few people had ever heard of them. While First Options in Chicago was a desperate worry—the firm had “gone to the wall” during Tuesday’s trading, an aide reported—it was hardly a household name.
The same could not be said for Charles Schwab and Company. The aggressive discount brokerage firm, with 1.8 million customer accounts, had been advertising heavily for years and signing up tens of thousands of new customers every month. Schwab had embodied Main Street’s growing obsession with the stock market during the long bull rally that began in August 1982.
In the spring of 1987, Chuck Schwab had bought his company back from Bank of America, and in mid-September he sold a stake in the firm to the public. The stock initially traded on the NYSE for $16.50 a share, and Schwab customers were among the most ardent buyers.
But by Wednesday morning, Schwab was in total disarray. Its telephone system had been disabled by the storm of weekend calls from nervous investors, and now callers were lucky if they even got a busy signal. Its stock price had fallen 30 percent from its initial value. Its computer system had finally crumpled, too, and some orders had not been executed, leaving Schwab on the hook for any subsequent drop in market prices.
Without its computer systems, the firm was struggling to calculate its own financial position. Even without those calculations, though, Schwab’s top executives knew that the firm was in terrible trouble—indeed, with the Bank of America no longer there to bail it out, its very survival was in doubt—because of a $124 million margin debt run up by one brash speculator in Hong Kong.
If Schwab had to shut its doors in the aftermath of the crash, the psychological impact among individual investors would be horrendous.
Main Street was already complaining loudly about the breakdown of the Nasdaq market on Monday and Tuesday, complaints that were echoed by professional investors. By Wednesday morning, the Nasdaq, which had branded itself “the market of tomorrow,” was still digging out from two days of bungled business, during which it had fallen almost 20 percent. The flow of price quote updates and inquiries through its electronic system had been twenty times the normal volume. Investors had trouble reaching their brokers by phone, trading desks could not cope with the crush of business, and the pace of orders moving through the system slowed from a few minutes to more than an hour. Rapid fluctuations in price quotes had left the electronic markets frozen for much of Black Monday. Nasdaq president Joseph Hardiman, in office for barely three weeks, was trying to address the rising level of complaints and rally his shell-shocked dealers.
As for the options markets, trading was still curtailed for hours at a time as traders struggled to establish opening prices. For two nights running, the automated pricing service relied on by clearing firms and the Options Clearing Corporation had failed, and prices had to be entered into the system manually. As a result, First Options had opened for business on Tuesday morning unsure of its actual financial status. Its parent, Continental Illinois, had been steadily lending it cash, and so far, a default had been averted. Everyone knew how much was hanging in the balance; Alan Greenspan noted later that “the Chicago options market nearly collapsed” under the weight of the First Options cash crunch.
To make matters worse, the First Options rescue operation had hit a surreal roadblock.
Continental Illinois’s primary regulators in the Office of the Comptroller of the Currency had balked at the bank’s effort to save its subsidiary. The comptroller’s staff had complained on Tuesday, as the markets were teetering on the edge of chaos, that the bank’s $130 million loan to First Options on Monday had exceeded limits set by the FDIC when it saved Continental Illinois back in 1984. Nevertheless, the resolute bank had lent another $138 million to its desperate subsidiary on Tuesday, preventing a default that would have torn a gaping wound in the options market on that terrible day.
Now the comptroller himself, the less experienced successor to the crisis-tested Todd Conover, was adamant that he would not waive the loan limits. The bank’s support for First Options had to be hastily rerouted through the bank’s holding company—the very holding company that Donald Regan had wanted to kill in 1984 as the price of saving the bank. If the comptroller’s obstruction became public, it could fuel the options traders’ panic and intensify the run on the clearing firm.
In New York, Jerry Corrigan must have been flabbergasted by the comptroller’s unilateral action. If the largest options clearing firm in the country—moreover, a firm owned by a major bank—had failed, it undoubtedly would have damaged the options markets, frozen cash owed to other firms active in other markets, and further traumatized every trader in Chicago. It also could have alarmed Continental’s depositors around the world, putting the bank’s hard-won financial stability at risk.
And if all that happened because one regulator would not allow Continental Illinois to do what other regulators desperately wanted it to do? It was absurd. The failure of any linchpin financial firm in the coming days could be disastrous. Every financial crisis since Silver Thursday had made clear how quickly, and unpredictably, a financial crisis could spread beyond regulatory control.
After his morning briefing on Wednesday, Ruder called the other regulators to touch base. Then he reached out to his fellow commissioners at the SEC and got their approval for a request from John Phelan. The Big Board chairman wanted permission to close the exchange a few hours early for the next few days, so it and its member firms could catch up on processing the 1.5 billion shares that had changed hands since Friday morning. The market’s unspoken fear was that the immense backlog of orders, scribbled or punched in during the most chaotic trading days in history, concealed errors that would spell financial ruin for the firms on the losing side of the mistakes. Until all those trades had been tallied and paid for, no one really knew which firms were in trouble, and how deep that trouble was.
* * *
BY WEDNESDAY MORNING, the task of getting Charles Schwab, and likely the entire market, out of a desperate situation was in the hands of an adventurous Schwab executive named Robert Rosseau, an argumentative Vietnam veteran dispatched from San Francisco to collect the unpaid debt that threatened the firm’s survival from halfway around the world.
The debt was owed by Teh-huei “Teddy” Wang, the biggest customer of Schwab’s small Hong Kong office.
Wang was a wealthy businessman with a somewhat lurid past. Six years earlier, he had been kidnapped and released after an $11 million ransom demand was calmly paid by his formidable wife, Nina, who had teenybopper pigtails and bear trap instincts. He traded stock index options on a huge scale—tens of thousands of contracts at a time, when a few hundred were typical. He had profited greatly in recent years by betting on a rising stock market, using money borrowed through his margin account at Schwab.
The market’s relentless decline since August and the historic collapse the previous week had cost Teddy Wang a lot of money. By sunrise in Hong Kong the previous Saturday morning, Wang owed Charles Schwab $124 million, and if he didn’t pay, Schwab would be on the hook for the full sum. In response to two margin calls from the firm, Wang paid $40 million. Then, with his margin debt at the still-fatal level of $84 million, he stopped returning Schwab’s calls.
Wang’s disappearance ratcheted up the pressure. As a publicly traded company, Schwab had ten days under U.S. securities law to disclose any material change in its financial condition; time would run out on Thursday, October 29.
Bob Rosseau flew to Hong Kong early on Black Monday. He found the entire financial community there in turmoil, with both the stock exchange and the futures market closed. His first request for a court-ordered freeze of Wang’s assets was denied, and he hastily hired a new law firm to revise the request. Rosseau went into “special ops” mode—by one account, he taped paper over the windows of a rented office to deter telescopic snooping, swept his phones constantly for wiretaps, hired private detectives, and used unconventional methods to track down Wang’s far-flung bank accounts.
The Schwab troubleshooter finally connected with the elusive options trader and arranged a meeting for Wednesday. Wang knew exactly where things stood. “Well, Mr. Rosseau,” he said, “it appears that Schwab is worth $72 million and I owe the company $84 million.” Then he stepped out, leaving the rest of the negotiating to Nina. This was not going to be easy.
* * *
ON THAT SAME Wednesday, October 21, the stock market barreled into a nervous rally that eased the financial stress on the NYSE floor, with the Dow gaining almost 187 points. But the rally vastly increased the financial stress for Hayne Leland, John O’Brien, and Mark Rubinstein.
The Berkeley professors had remained in Los Angeles following their hasty morning flights on Black Monday, struggling to maintain some part of the hedges they had put in place to protect their clients’ portfolios. On Tuesday afternoon they had been able to establish some protection in the futures market, but Wednesday’s rally meant they had to come up with more cash margin to maintain those positions. The only way to raise that cash in their clients’ accounts was to sell stocks, but because of the different settlement schedules in the two markets, they would have to shell out additional cash in the futures market before they collected their cash in the stock market.
John O’Brien explained the situation carefully to the firm’s clients: they would either have to come up with the cash from a different source, or they would have to sell stock for immediate payment, which meant they’d get a lower price.
As it was, Leland estimated that clients probably had been protected against only about 80 percent of the market’s decline, and would have to bear the remaining 20 percent as a loss. It was better than no protection at all, he and his partners reasoned, but it was not what they had advertised and expected.
Rubinstein was angry over media reports singling out portfolio insurance as the single cause of the crash. He and Leland believed the blame should be shared with those who effectively banned or abandoned index arbitrage on Monday and Tuesday. As early as September 1986, they understood that they and other portfolio insurers sat on one end of the market seesaw, and index arbitrageurs sat on the other end. It wasn’t just the selling by portfolio insurers that drove prices in the spooz pit so far below prices in the cash market; it was also the absence of buying by index arbitrageurs. Try explaining that to journalists, few of whom could grasp either strategy.
What was harder to explain was how Black Monday could have happened at all in an efficient market where prices instantly adjusted to changes in “rational expectations” about future stock values. That model of how markets operated, the “efficient market hypothesis,” had become so deeply embedded in the traditional world of quantitative finance that experiencing Black Monday and Tuesday was like tossing a rock out a window—and watching it float up.
* * *
WHILE SCHWAB’S FATE was being decided in Hong Kong, the fate of four other linchpins of Wall Street was being haggled over in London, with the same weeklong fuse and the same enormous psychological risks to the market’s fragile stability.
On the previous Thursday, October 15, a consortium of investment banks in London, New York, and Toronto had eagerly taken up the British government’s proposal to sell off its stake in British Petroleum. The $12 billion underwriting was one of the largest stock offerings in history, with 2.1 billion shares scheduled for sale at a price established by the underwriters at roughly $5.45 a share. Then came the worst stock market crash in U.S. history, with collateral damage in markets around the world. The BP shares were certainly worth much less now than the investment banks had agreed to pay for them. If the British government did not cancel or amend the deal, the underwriters could be looking at a global loss of about $840 million—and roughly $500 million of that would be sucked out of New York at the worst possible moment.
Goldman Sachs and three other flagship firms on Wall Street, Salomon Brothers, Morgan Stanley, and Shearson Lehman Brothers, had been caught midstream in the deal. Goldman, a private partnership, would take the biggest hit, with a loss of up to $150 million; the other three firms, whose shares traded on the NYSE, would each face losses of around $120 million.
The London market had remained weak on Tuesday, partly because of worry about the BP deal. Bankers in Britain were lobbying for relief, but the Tory government was in a difficult spot. Under Prime Minister Margaret Thatcher, it had invoked free-market principles on issues that had cost working-class jobs, so how could it now abandon those principles to rescue a lot of rich bankers? The government insisted the deal would close on schedule on Friday, October 30, at the agreed-upon price.
On Wall Street, where brokerage industry stocks had already declined much further than the Dow that week, the shares of the three firms caught in the deal were starting to slip even further, and rumors began to brew. At the New York Fed, Jerry Corrigan knew how even a little doubt could quickly strip a brokerage firm of the overnight loans that financed its daily existence. He added his voice to those urging the British authorities to amend the deal.
* * *
ON THURSDAY MORNING, October 22, shortly before the opening bell, John Phelan and a trio of board members climbed up to the stone balcony overlooking the NYSE trading floor. Traders, specialists, and clerks listened appreciatively as Phelan read them a message from President Reagan complimenting the “calm and professional manner” in which they had done their jobs that week.
Then Phelan rang the opening bell, and the Big Board plunged into another dreadful day.
With sickening déjà vu, specialists looked at an opening avalanche of sell orders from giant institutions, with few buyers in sight. For some, it felt like the prelude to another meltdown like Monday’s, and many no doubt knew their firms might not survive if that meltdown came. “When I can’t trade IBM, I know I’m in big trouble,” one trader told the New York Times.
On the crowded trading floor that morning, traders juggled their orders, and their fates. At its low point, the Dow fell to 1,837.86 points, more than 9 percent below Wednesday’s close. Then the index recovered some of its morning loss and closed at 1,950.43 points, down 77.42 points, a drop of 3.8 percent. Not many weeks ago, this day’s loss, like Tuesday’s gain, would have looked epic; three days after Black Monday, it looked like a reprieve. As it was, both the broader NYSE Composite index and the S&P 500 index were hit harder in the sell-off than the Dow.
At a press conference after Thursday’s closing bell, Phelan announced that the exchange would close early, at 2 p.m., beginning on Friday and continuing into the following week. The mood at the press conference was tense, but Phelan and his team hadn’t lost their sense of humor. During that dismal day, staff members and floor traders were wearing orange buttons that read, “Don’t Panic.”
* * *
BY THURSDAY, THE big worry among regulators was why the historically large and stubbornly persistent price gap between the S&P 500 futures contract and the S&P 500 stocks hadn’t gone away.
Regulators at the CFTC thought it was because John Phelan had told NYSE firms not to use his DOT system for program trading, which inhibited index arbitrage. At midmorning on Thursday, the CFTC’s acting chairman, Kalo Hineman, spoke with David Ruder at the SEC about that.
Ruder understood Hineman’s argument to be that a futures market cut off from the stock market would give investors the wrong impression about market values. But it would do far worse damage than that: it would prevent arbitrage from bringing the two markets back into alignment. Portfolio insurers were continuing to sell heavily in the S&P 500 pits, so there had to be buyers there, too. And those potential buyers included the index arbitrageurs, who relied on the DOT system to place their stock market trades. Without the DOT system, many of them were not trading in either market, and the futures price gap wasn’t closing. As a result, potential stock buyers were holding back, seeing the discount in Chicago as evidence that prices on the NYSE would soon fall.
Hineman was right, of course. With the adoption of index arbitrage strategies by a number of giant institutional traders, the two markets had been shackled together and neither market’s prices could remain in equilibrium without that arbitrage activity. And the ban on DOT-assisted program trading blocked a lot of that now-necessary trading.
But the spooz pit’s prices had swung wildly out of line even when index arbitrage was unfettered, which may have cast doubt on Hineman’s case. More important, Phelan wanted to reserve the DOT system for individual investors, who were the bedrock of the stock market Phelan believed in—and the market Ruder regulated. Ruder did not order the NYSE to reverse its ban on program trading.
So, the price gap persisted—providing additional evidence that however connected they were by investing strategies, New York and Chicago were still galaxies apart in their view of how markets worked and whom markets served.
There were other cross-border arguments. As the market made its terrible plunge on Thursday, the SEC was wrestling with whether to ask the CFTC “to urge or even force” the futures markets to delay their daily stock index trading until the NYSE had been able to get all its stocks open for trading, to buffer the impact of the selling that hit at the instant of the opening bell in New York. There was a spirited discussion among the SEC commissioners on Thursday, but no agreement, and Chicago was firmly opposed to the change.
But Merc president Bill Brodsky, the tireless diplomat trying to find some common ground, had been able to help persuade the Merc, at least temporarily, to impose daily price limits on the S&P 500 index contract—the very step that Leo Melamed had been unable to sell eight months earlier. The Merc board of governors, meeting on Thursday night, approved the price limits as an “emergency action.”
* * *
AT 8 P.M. on Thursday, after the day’s market nosedive, President Reagan stepped to the podium in the East Room of the White House for his first news conference in seven months. “Well, it just seems like yesterday,” he mused to some rueful laughter from reporters. His first words were about his wife, who had returned home after surgery. “It sure is good to have Nancy back home, and she’s doing just fine,” he said.
No one could have missed how distracted Reagan was by Nancy Reagan’s medical crisis, or how uninformed he seemed about Wall Street’s financial crisis. On Black Monday, he had fielded reporters’ questions through the thumping din of the helicopter that would take him to visit his wife.
“What? Oh, the stock market,” he said after figuring out what the shouted questions were about. “I think everyone is a little puzzled, and I don’t know what meaning it might have, because all the business indices are up. There is nothing wrong with the economy.” Aides cringed: it sounded too close to Herbert Hoover’s optimistic pronouncements after the 1929 crash.
The next question was about panic. The president was blasé. “Maybe some people are seeing a chance to grab a profit, I don’t know,” he said. He almost visibly shrugged off the biggest market crash in history. Carrying a gaily wrapped present for Nancy, he climbed into the helicopter.
On Wednesday, with the market up more than 186 points, the president was asked if he thought the Wall Street crisis was over, again over helicopter noise.
“Well, it would appear to be,” Reagan said, casually. “Certainly, when more than half of the loss has already been regained.”
Thursday’s steep market plunge once again shook everyone in the West Wing, and the president’s evening news conference was an effort to deliver a more coherent message.
“While there were a couple of days of gains after several days of losses, we shouldn’t assume that the stock market’s excess volatility is over,” Reagan said, looking earnestly into the television cameras. “So while there remains cause for concern, there is also cause for action. And tonight I plan to take the following steps to meet this challenge.”
He said he would sit down with the leaders in Congress to discuss ways to reduce the budget deficit, and he would also urge Congress to reject any protectionist policies that could tip the country into a recession. Finally, he would set up a task force “that over the next 30 to 60 days will examine the stock market procedures and make recommendations on any necessary changes.” The leader of this team would be Nicholas F. Brady, a former U.S. senator from New Jersey and a lifelong member of Wall Street’s old guard.
* * *
BY THE TIME the NYSE opened for business on Friday morning, foreign markets had already shown dissatisfaction with President Reagan’s response to the financial crisis. Hong Kong markets remained closed, but the Tokyo stock market opened just as Reagan’s press conference began, and prices immediately plunged. Australia’s market fell almost 7 percent; Singapore and Taiwan also piled up big losses. Europe was similarly unsettled—Switzerland’s leading index set a new low for the year, and London fell sharply until stronger domestic trade numbers spurred a small midday rally that cut the day’s losses in half.
In the first thirty minutes of trading in New York, prices fell sharply. From his office at the SEC, David Ruder spoke with a Goldman Sachs executive to get a sense of the market’s mood and was told, “All is well.” Indeed, the market did rally sharply over the next half hour, but prices gradually weakened through the shortened afternoon session.
Ruder decided to hold a press conference at the end of this tumultuous week, and he used the occasion to disparage the notion that his off-the-cuff comments about a possible trading halt on Black Monday had precipitated that day’s final disastrous plunge. “I would be amazed if I had the power by a single comment of that kind to cause a major decline in the stock market,” he said.
Responding to questions, Ruder described his midday conversation on Tuesday with John Phelan, asserting that Phelan had been “very close” to shutting down the Big Board, and affirming that the SEC would have backed him if he had taken that step. The NYSE immediately disputed that account, with Phelan insisting, “We didn’t come close to closing.” He added, “We let them trade out. By closing you almost exacerbate something that is intolerable to begin with.”
In Chicago, traders on the Merc were confronted for the first time ever with limits on how much the prices of the spooz contract and its related options could fluctuate during the day. Under the new rule, trading would close for the day if the futures or options rose or fell the equivalent of 30 points on the S&P 500 index. Bill Brodsky told reporters that “price limits are anathema to a free market, but we’re reacting to a very extreme situation. It was the responsible thing to do.” Other futures exchanges had followed suit.
By Friday’s closing bell on the NYSE, which rang two hours earlier than on Thursday, the Dow stood at 1,950.76 points. That was almost 300 points below its level the previous Friday, but nearly flat with Thursday’s close. It was a remarkable anticlimax to a week that had opened with the worst trading day in market history. For an exhausted John Phelan, though, it was “the ideal script. The market needs time to breathe.”
Outside the exchange, the sidewalks were a spectacle. By one account, the scene featured “vendors, sidewalk preachers, artists, protestors and spectators” mingling with television camera crews and workers from Wall Street firms, who “poured out of their offices and onto the streets for the exchange’s final moments of trading.”
One Wall Street worker said, “We’re out here to see what’s going on. After all, this is history.” Another observed, “Everybody talks about ’29, and this is going to be talked about as long as that was.”
But anyone expecting an exodus of exhausted traders after the closing bell was disappointed. As one departing exchange worker explained, “Everybody’s still in there, and they will be for a long time. Trading stopped. Work didn’t.”
The most pressing work was the final tally for the trades done during that grim and briefly historic session on Friday, October 16. Trades on the exchange had to be settled and closed out in five business days; for Black Monday’s trades, that day of reckoning was just a weekend away.
* * *
LEO MELAMED WAS intensely worried about the political backlash from Black Monday. In a few days, Chicago’s futures exchanges had been transformed from obscure markets of little interest to the general public into targets of international attention and Washington controversy.
Melamed was hardwired to play offense. David Ruder lived in Highland Park, a lakefront suburb north of Chicago, and Bill Brodsky suggested to Ruder, through an intermediary, that he and Melamed visit him when he was home from Washington for the weekend. At 3:30 p.m. on Saturday, October 24, they arrived at Ruder’s home.
It had already been an eventful day for the SEC chairman. A few hours earlier, he’d gotten a call from President Reagan, asking a few questions about the backlog of orders and thanking Ruder and the SEC staff for “the tremendous job that you have done this week under very difficult circumstances.” It had been gratifying, if a little stilted.
After welcoming his visitors and getting them settled, Ruder took out a legal pad and sat down to listen. For almost ninety minutes, Melamed and Brodsky reviewed the week from their perspective—explaining Tuesday’s decision to temporarily stop trading, and insisting that the pressure on the NYSE would have been even greater if the futures market had not existed to absorb so much of the institutional selling.
Their point was that, for giant institutional investors, Chicago was becoming the market where prices for NYSE stocks were being “discovered,” and there was no way to put the genie back in the bottle. Ruder listened, but he was skeptical. Stock markets had set stock prices for hundreds of years. Had that changed in the five short years since the S&P 500 index futures contract started trading in Chicago?
Brodsky, feeling the dialogue had been healthy and helpful, was determined to keep the lines of communication open. He and Melamed were scheduled to be in Washington the following Wednesday, October 28, to meet privately with the key committees on Capitol Hill and make the case that the Chicago markets were blameless in the Black Monday crash. Brodsky suggested that Ruder and Rick Ketchum join them for dinner the evening before. The invitation was accepted, and the Merc leaders left.
That afternoon visit was the opening volley in a tireless Merc campaign that would extend for months—indeed, for years. As the exchange’s official history put it, “Like a frustrated teenager screaming at parents that ‘you don’t understand,’ the Merc sought to explain itself.”
David Ruder returned to Washington on Sunday night, knowing that the next day’s back-office work, settling the transactions from Black Monday, would be the acid test for many Wall Street firms.
* * *
ONCE AGAIN, ON Monday morning, October 26, stock prices started plummeting in Asia, and the decline rolled west with the sun.
It was still Sunday night in Manhattan when Monday’s trading opened in Hong Kong, the first trading session in ten days. The fall was stunning—stock prices there declined by more than 30 percent, which some cited as the largest one-day drop ever in any stock market in the world. The Hong Kong futures market fared even worse, falling 44 percent. In Tokyo, the Japanese stock market fell 4 percent, the third-worst decline ever, after the records set on two precipitous days the previous week. The German market dropped 6 percent. The stock market in Paris gyrated wildly, and ended down almost 8 percent.
So, when Monday morning trading opened in New York, John Phelan was braced for a disaster. He got one.
“Tough, again,” one staffer would tell David Ruder that morning, after detailing the global tumult. “Worldwide panic selling,” an economist told the New York Times that night. The Dow fell 8 percent (just under 157 points) to close at 1,793.93 points, which was within 56 points of its level at the closing bell on Black Monday.
Near the close, Phelan spoke with Ruder and gave him some comfort. The Black Monday trades had settled without any disastrous problems. As for the market, “it’s soupy but not panicky,” Phelan said. “The market’s doing its thing, we just have to trade it out, let it test its lows.”
These global, east-to-west market nosedives were unsettling. Phelan knew there wasn’t a single major firm in New York that didn’t also have at least some business in Hong Kong—and in London and Tokyo and Europe, for that matter.
* * *
TUESDAY, OCTOBER 27, was still bleak for traders in London’s stock market, but it brought a narrow and welcome rally to New York, with rising stocks slightly more numerous than declining ones. Wednesday, October 28, was rockier; the Dow managed to close up by an eyelash, but most other market barometers (and most foreign markets, including Hong Kong) declined.
Schwab’s troubleshooter, Bob Rosseau, was still in Hong Kong on Wednesday, inches away from a deal with Teddy Wang. With Chuck Schwab himself due to announce the firm’s financial results early Thursday morning, the firm’s public relations staff had prepared two scripts, and by late Wednesday night, Schwab’s founder still did not know which one he would be using.
One announced an awful $22 million loss, which would wipe out most of the firm’s profits for the year and drive its stock price even lower than it already was—and that was the one that Chuck Schwab fervently hoped he would be able to read.
The other script announced a loss of $100 million, which would wipe out the firm’s net capital, violate the terms of its bank loans, and force it to seek an emergency buyer or close its doors. That was the one that knowledgeable regulators feared would ignite a Main Street panic and shove Wall Street back into Black Monday territory again.
At 5 a.m. in San Francisco on Thursday morning, October 29, Chuck Schwab got a call from Rosseau, reporting that Wang had proposed settling his $84 million margin debt by paying 80 cents on the dollar—$67 million. Schwab swallowed hard and agreed. He picked up the script that announced the $22 million loss, most of it attributable to Teddy Wang, and headed to his 6 a.m. news conference.
“I am profoundly unhappy,” he told reporters, who did not yet know that he was far less unhappy than he had feared he would be.
When the stock market opened in New York a few minutes later, there was an honest-to-goodness rally. The market opened strong and stayed strong all day, and even the battered Nasdaq stocks gained ground. By the closing bell at 2 p.m., the Dow was up more than 91 points, its third gain in a row—although Wednesday’s had been barely visible to the naked eye. The Dow was still almost 30 percent below its August peak, and everyone was still skittish, but the daily and hourly threats of some new crisis seemed to have eased.
At 4 p.m. that day, John Phelan was in Washington, testifying at a closed-door session of the House Commerce Committee’s finance panel. It was a remarkably prescient and earnest presentation.
In that secret session, Phelan acknowledged that if widespread trading halts in individual stocks hadn’t worked on Black Monday and on Tuesday, “I suppose as a backup, we would’ve had to close the market down.” He did not sugarcoat the fears he had confronted between 10:30 a.m. and 1 p.m. on Tuesday.
He also spoke about the lessons offered by the market’s experience with portfolio insurance. “One is that when everybody wants to leave the room at the same time, it is not possible to get out,” he said. The other was that insurance is only easy to get when you’re healthy: “When the market is under extreme pressure, you just cannot get the kinds of insurance that they were hoping for.”
Most insightfully, he warned about the new derivative products that, like a lever and fulcrum, allowed an investor to boost his profits or expand his losses beyond what they would have been if he had been using just cash.
“See, I don’t see the root problem on the floor of the Chicago pit or [a] New York options exchange,” Phelan said. “I see it with the customer up here who has $3 trillion they are managing, and that up until two years ago[,] when they bought equities, they put up a dollar and bought a dollar’s worth of equities. Now, they can put up five cents and buy a dollar’s worth of equities. You have gotten that incredible leverage into the institutional part of the market.”
Somehow, he said, the crucially important issues of leverage and scale had to be addressed.
“We must decide, here in the next year to 18 months, what kind of equity market we want in this country,” he said. The stock market was rapidly approaching a level of volatility and institutional dominance that had long been commonplace in the commodities markets, where high levels of leverage were built into the futures contracts by design. “If the volatility continues in this way,” he warned, “we are going to drive out all [investors] but the professionals in the market, and I don’t think that that is going to be very good for this country.”
The congressional panel listened politely but showed no sign that it actually heard what this battle-scarred market veteran was saying. His warnings were almost a forecast of the future facing Wall Street, and the world.
* * *
BY THURSDAY AFTERNOON, David Ruder dropped his shoulders for the first time in what seemed like months. Schwab’s stock had fallen a full point, to $6.50, after it announced its quarterly loss. That was about a third its value in September, but the firm—and, more important, the market—could survive that. First Options, too, would muddle through, no thanks to the comptroller of the currency. It was meeting all its required margin calls, its cash cushion had stabilized, and its parent, Continental Illinois, was quietly negotiating a settlement with the comptroller over the way the emergency rescue had been carried out.
And a deal was in the works to address the British Petroleum underwriting losses. At around 5 o’clock that afternoon, right at the deadline, word of a compromise finally came from London: the deal would not be postponed, but the Bank of England would buy back any unsold shares at a price that would reduce, but not eliminate, the losses the firms would face.
The stock market rallied again on Friday, October 30, gaining 55 points to close at 1,993.53; it had clawed back more than half the losses from Black Monday. It was the first four-day rally since before the crisis. It was not the end of the 1987 market crash, but it was perhaps the beginning of a new post-crash “normal.”
The toll of the crash had been enormous. More than a trillion dollars in wealth had been lost since the market peak in August, half of that on Black Monday, along with a great deal of investor confidence. Layoffs at weakened Wall Street firms already threatened the economy of New York City and other financial centers, and a wider recession seemed a plausible threat.
As Wall Street closed the books on a disastrous October, few people except the regulators and market insiders knew that, as bad as it was, the damage from Black Monday came very close to being far, far worse.
Catastrophe had been averted, not through careful political oversight and astute regulatory foresight, but through sheer luck: an eleventh-hour deal with an options trader in Hong Kong; a belated willingness to compromise at the Bank of England; an extremely persuasive Irishman at the New York Fed; a pension fund manager who may have shown uncommon restraint; two momentarily cooperative stock-trading rivals in Manhattan; and, in Chicago, some time-tested friendships, a few bankers willing to defy their regulators and their own fears, a timely payment by Goldman Sachs, and one fortunately timed purchase in the Major Market Index pit at the Chicago Board of Trade.
Subtract even one of those elements, and the aftermath of Black Monday would have been cataclysmic for the nation’s financial system.
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THE REVISED TERMS for the British Petroleum deal, the final bit of luck the market needed to reach November, unfortunately meant that the official underwriting statements had to be revised as quickly as possible, so the brokerage firms could start to sell off their risky inventory.
On Friday evening, David Ruder’s chief of corporation finance, Linda Quinn, stepped into his office and handed him the revised documentation. Surprised to see it so soon, Ruder took the document, looked for the new terms—and smiled.
In neat block letters, Quinn herself had written out, by hand, the lengthy new section disclosing the new terms of the deal.
Ruder approved the document, marveling that a market almost brought to its knees by high-technology trading was righting itself partly on the strength of a corporate document produced much as it would have been in the early days of the stock exchange.