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Could the crash of ’87 happen again?

In retrospect, the conditions were ripe and the signals were all there for two of the biggest financial crises in recent memory —  the crashof  '87 and the credit crunch of '07. And as long as human beings are making the investments decision, there's little chance of insulating the financial market from future full-blown panics.  By msnbc.com's John W. Schoen.
A slide quickly turned into a panic on the floor of the New York Stock Exchange on Oct. 19, 1987.
A slide quickly turned into a panic on the floor of the New York Stock Exchange on Oct. 19, 1987.Peter Morgan / AP
/ Source: msnbc.com

For most of today's investors, the stock market collapse of Oct. 19, 1987, was a defining moment — the biggest financial crisis in memory and a stern reminder about the nature of investment risk.

On that Black Monday 20 years ago, the Dow Jones industrial average dropped a stomach-churning 508 points or 23 percent — the equivalent of 3,200 points for today's high-flying Dow. It was the second-biggest drop ever for the market, eclipsed only by the war-related Panic of 1914.

While the causes are still debated, the biggest question remains: Could it happen again?

For a quick answer, it is instructive to compare the crash of '87 with the credit crunch that swept through financial markets in August, challenging an untested Federeral Reserve Chairman Ben Bernanke much as his predecessor Alan Greenspan was tested two decades ago.

The credit crunch roil financial markets and depressed stock prices briefly, although this year's event played out largely behind closed doors in the murkier waters of the credit market. The crunch of '07 underscored the fact that as long as investment decisions are made by human beings, financial markets will remain vulnerable to future selloffs fueled by runaway emotions. But the stock market today is very different than it was 25 years ago; the odds have been sharply reduced that we will see a a replay of the crash of '87.

Black Monday
While most recollections of the 1987 crash focus on Oct. 19 the slide was well under way when Black Monday rolled around. In fact, the seeds of the crash had been sown years before.

After a decade of economic stagnation in the 1970s sent stocks trading in a sawtooth pattern — and sent many investors fleeing the market — the bulls returned in full force in 1982 after the news sank in that war on inflation finally had been won. With the bulls once again in charge, the market began one of the longest and strongest advances in history, tripling the Dow over the next five years.

The 1980s saw individual investors pour money into the stock market through mutual funds and the rapid expansion of 401(k) retirement plans. By 1989 some 32 percent of U.S. households owned stocks, up from 19 percent just six years earlier, according to the Investment Company Institute.

Institutional investors were also piling into stocks. Private investment firms, relying on research that purported to show that “high yield” debt (aka junk bonds) weren’t as risky as market prices reflected, generated a multibillion-dollar wave of leveraged buyouts paid for with freshly printed paper. All that money had to go somewhere, and much of it ended up pushing stock prices to new highs.

The party began to unravel in the summer of 1987, when the Dow hit an interim high of 2,722 on Aug. 25 and then began to slump. At first, the decline looked like a routine pullback; the Dow began bouncing back a bit in September after an 8 percent decline. To many, it looked like stocks were just taking a breather after years of rapid advance.  But by early October, the downdraft was back — and gaining speed. In the four trading days preceding Black Monday, the Dow dropped 10.4 percent.

Economists and financial analysts have attributed the decline to a number of causes. Worries about inflation and a weakening dollar had pushed interest rates higher, making the safe haven of Treasury bonds more appealing. Congress was debating raising taxes on capital gains from stock investments. Fresh data in mid-October showed the U.S. trade deficit widening. Though most of the data pointed to continued strength in the U.S. economy, some analysts had been warning clients that stocks looked “overvalued.”

After a weekend of mulling all of this over, Wall Street reported to work on a mild, summery day in lower Manhattan — and started selling. After first, the decline was fairly orderly. But as the day wore on, computerized sell programs — set to bail out of stocks en masse at preset levels — overwhelmed the trading system, which still relied heavily on human beings matching buy and sell orders. Prices posted on the Quotron terminals of the day plunged from one trade to the next. By day's end, more than 600 million shares made it through the system — more than triple normal levels. But many more never made it. That erratic trading — including the periodic "seizing up" of some of the 30 stocks in the Dow — contributed to the steep drop in prices recorded at the close.

When the dust settled, and traders, analysts and investors saw what had happened, many returned the next day believing the sell-off was overdone. That widespread assessment — coupled with a highly visible announcement by the Fed that it stood ready to flood the system with money to put the fire out — touched off a huge buying spree on heavy volume. Over the next two days, the stock market recouped more than half of Monday’s losses. The panic appeared to have ended as quickly as it began.

The uncertainty bogeyman
Contrast that with the financial panic that swept the credit markets this summer. The root causes of what would become the credit crunch of '07 had been widely reported well before the panic hit, including the rise in risky subprime lending backed by complex securities valued primarily by computer, not market pricing. A boom in mega-buyouts backed by cheap money helped fuel what amounted to a credit bubble. One major danger signal that investors were ignoring risk and money was flowing too freely — that interest rates on risky bonds were not much higher than much safer Treasuries —  had been flashing red for months.

But the murky world of credit derivatives and computer valuation models played out largely behind the closed doors of hedge funds, big investments firms and other institutions. Unlike the crash of '87 — when the sickening slide played out publicly — the credit crunch of ’07 was a members-only event. With much of the questionable debt held by unregulated hedge funds, even the Federal Reserve had only anecdotal information, including conversations with the heads of top financial institutions, to guide it.

That’s why the credit crunch played out in slow motion. Without the transparency of a public  market, no one could be sure where the fire was burning — or how badly. As it did in 1987, the Fed fire brigade responded this year by flooding the market with money until the smoke began to subside. Only in the past few weeks, as banks and brokerages have fessed up to huge losses in quarterly earnings reports — have investors been offered a glimpse of how bad the damage was. With a clearer picture of the extent of the losses, financial markets have begun to gain confidence that the worst is over.

Could it happen again?
In every meltdown, market players adjust to try to prevent a repeat. Since 1987, massive investments in technology and electronic trading systems have vastly expanded the stock market's capacity. Exchange-managed “circuit breakers” — designed to shut down trading when certain thresholds are reached — have averted potential one-day plunges in stock prices. The '80s-era, computer-driven trading models — once thought to be so foolproof they were referred to as “portfolio insurance” — were long ago rewritten to avert another rush to the exits in the event of a panic.

The credit crunch of 2007 is still unwinding, but much of the easy-money lending that fueled the bubble has already receded. Some of the megamergers announced before the bubble burst have been quietly shelved.  Mortgage standards have tightened sharply, and state and federal regulators are prosecuting cases of lending and appraisal fraud. But it remains to be seen whether the now-burst housing bubble — the legacy of easy-money mortgage lending since 2001 — will create a wider drag on the economy.

While it’s unlikely that either the stock market or the credit markets will replay the scripts that led to their collapses, nothing can rule out the possibility of future panics. The stage for both events was set by hubris as the wizards of Wall Street thought they had somehow outsmarted the risks that had reined in their forebears. Investors — both individuals and institutional money managers — willingly went along for the ride. Once that confidence began to unwind, the resulting panics fed on themselves, fueled by fear.

So as long as investment decisions are ultimately made by human beings – governed by those primal emotions of fear and greed — there’s little chance that financial markets can be insulated from future panic-driven sell-offs.