Thomas Mayer: The Lessons of the '87 crash
[Mr. Mayer is chief European economist for Deutsche Bank.]
... When equity markets closed on Oct. 19, 1987, prices had fallen so much -- the Dow Jones Industrial Average, for instance, plummeted 508 points or 22.6% that day -- that no one knew what damage had been done to private and institutional investors' balance sheets. With the creditworthiness of almost every market participant in doubt, there was a serious danger that credit would dry up completely, causing the default of a great number of debtors and hence possibly a collapse of the entire financial system.
As Bob Woodward recounts in his book "Maestro: Greenspan's Fed and the American Boom," Fed Chairman Alan Greenspan and New York Fed President Gerald Corrigan took determined action to prevent this. They assured markets that the Fed would stand ready to "serve as a source of liquidity to support the economic and financial system" and had planned, as a secret contingency, even to directly guarantee payments between brokerage firms if lending money to the banks did not restore trust in the money markets. The moral suasion and liquidity injections by the Fed proved successful, and, with confidence gradually returning, a number of prominent companies announced that they would buy back their own stock at the depressed prices after the crash.
In a 2006 paper for the Fed, Mark Carlson described the set of tools central bankers used to restore confidence to the system, including "open market operations and lowering of the federal funds rate to support the liquidity of the banking system as well as liberalizing rules regarding lending securities from the system account. Finally, the Federal Reserve encouraged various market participants, in particular banks lending to brokers and dealers, to work cooperatively and flexibly with their customers." These measures were vital in restoring stability to the system and avoiding a more severe economic fallout from the stock-market downturn. In the event, U.S. real GDP grew by 4.1% in 1988 after 3.4% in 1987 despite the stock market losses in the fourth quarter of 1987.
As in October 1987, financial markets last week suffered a loss of trust. This time it came when a European institution revealed early on Aug. 9 that some of its investment funds had suffered losses in this sector, and that it was freezing investors' deposits until liquidity returned to the asset-backed securities markets. With money markets seizing up as lenders feared the disclosure of more such unpleasant surprises, central banks stepped in to provide liquidity and moral support, just as the script from 1987 suggested.
Now as then, the purpose of central-bank action has been to ensure a continuous flow of credit to borrowers in good standing by supplying commercial banks with the necessary amount of liquidity. Banks may feel reluctant to keep lending in present market circumstances, but they know that it is essential for their future business relations to pass on this liquidity to good customers....
Read entire article at WSJ
... When equity markets closed on Oct. 19, 1987, prices had fallen so much -- the Dow Jones Industrial Average, for instance, plummeted 508 points or 22.6% that day -- that no one knew what damage had been done to private and institutional investors' balance sheets. With the creditworthiness of almost every market participant in doubt, there was a serious danger that credit would dry up completely, causing the default of a great number of debtors and hence possibly a collapse of the entire financial system.
As Bob Woodward recounts in his book "Maestro: Greenspan's Fed and the American Boom," Fed Chairman Alan Greenspan and New York Fed President Gerald Corrigan took determined action to prevent this. They assured markets that the Fed would stand ready to "serve as a source of liquidity to support the economic and financial system" and had planned, as a secret contingency, even to directly guarantee payments between brokerage firms if lending money to the banks did not restore trust in the money markets. The moral suasion and liquidity injections by the Fed proved successful, and, with confidence gradually returning, a number of prominent companies announced that they would buy back their own stock at the depressed prices after the crash.
In a 2006 paper for the Fed, Mark Carlson described the set of tools central bankers used to restore confidence to the system, including "open market operations and lowering of the federal funds rate to support the liquidity of the banking system as well as liberalizing rules regarding lending securities from the system account. Finally, the Federal Reserve encouraged various market participants, in particular banks lending to brokers and dealers, to work cooperatively and flexibly with their customers." These measures were vital in restoring stability to the system and avoiding a more severe economic fallout from the stock-market downturn. In the event, U.S. real GDP grew by 4.1% in 1988 after 3.4% in 1987 despite the stock market losses in the fourth quarter of 1987.
As in October 1987, financial markets last week suffered a loss of trust. This time it came when a European institution revealed early on Aug. 9 that some of its investment funds had suffered losses in this sector, and that it was freezing investors' deposits until liquidity returned to the asset-backed securities markets. With money markets seizing up as lenders feared the disclosure of more such unpleasant surprises, central banks stepped in to provide liquidity and moral support, just as the script from 1987 suggested.
Now as then, the purpose of central-bank action has been to ensure a continuous flow of credit to borrowers in good standing by supplying commercial banks with the necessary amount of liquidity. Banks may feel reluctant to keep lending in present market circumstances, but they know that it is essential for their future business relations to pass on this liquidity to good customers....