Black Monday (also known as Black Tuesday in some parts of the world due to time zone differences) was a global, severe and largely unexpected stock market crash on Monday, October 19, 1987. Worldwide losses were estimated at US$1.71 trillion. The severity sparked fears of extended economic instability or a reprise of the Great Depression.
Possible explanations for the initial fall in stock prices include a fear that stocks were significantly overvalued and were certain to undergo a correction, persistent US trade and budget deficits, and rising interest rates. Another explanation for Black Monday comes from the decline of the dollar, followed by a lack of faith in governmental attempts to stop that decline. In February 1987, leading industrial countries had signed the Louvre Accord, hoping that monetary policy coordination would stabilize international money markets, but doubts about the viability of the accord created a crisis of confidence. The fall may have been accelerated by portfolio insurance hedging (using computer-based models to buy or sell index futures in various stock market conditions) or a self-reinforcing contagion of fear.
The degree to which the stock market crashes spread to the wider (or "real") economy was directly related to the monetary policy each nation pursued in response. The central banks of the United States, West Germany, and Japan provided market liquidity to prevent debt defaults among financial institutions, and the impact on the real economy was relatively limited and short-lived. However, refusal to loosen monetary policy by the Reserve Bank of New Zealand had sharply negative and relatively long-term consequences for both its financial markets and real economy.
United States
Background
During a strong five-year bull market, the S&P 500 index tripled from 102.42 on August 12, 1982, to 336.77 on August 25, 1987. The Dow Jones Industrial Average (DJIA) rose from 776 in August 1982 to a peak of 2,722 in August 1987. The same bullish trend propelled market indices around the world over this period, as the nineteen largest enjoyed an average rise of 296 percent.
On the morning of Wednesday, October 14, 1987, the United States House Committee on Ways and Means introduced a bill to reduce the tax benefits associated with financing mergers and leveraged buyouts. Unexpectedly high trade deficit figures announced on October 14 by the United States Department of Commerce had a further negative impact on the value of the US dollar while pushing interest rates upward and stock prices downward. As the day continued, the Dow Jones Industrial Average index dropped 95.46 points (3.81 percent) to 2,412.70, and it fell another 57.61 points (2.39 percent) the next day, down over 12 percent from the August 25 all-time high. On Friday, October 16, the DJIA fell 108.35 points (4.6 percent). The drop on the 14th was the earliest significant decline among all countries that would later be affected by Black Monday. The S&P 500 index fell 9% over this week.
Though the markets were closed for the weekend, significant selling pressure still existed. The computer models of portfolio insurers continued to dictate very large sales. Moreover, some large mutual fund groups had procedures that enabled customers to easily redeem their shares during the weekend at the same prices that existed at the close of market on Friday. The amount of these redemption requests was far greater than the firms' cash reserves, requiring them to make large sales of shares as soon as the market opened on the following Monday. Finally, some traders anticipated these pressures and tried to get ahead of the market by selling early and aggressively on Monday, before the anticipated price drop.
The crash
Before the New York Stock Exchange (NYSE) opened on October 19, 1987, there was pent-up pressure to sell. When the market opened, a large imbalance arose between the volume of sell and buy orders, placing downward pressure on prices. Regulations at the time allowed designated market makers (or "specialists") to delay or suspend trading in a stock if the order imbalance exceeded the specialist's ability to fulfill in an orderly manner. The imbalance on October 19 was so large that 95 stocks on the S&P 500 Index (S&P) opened late, as also did 11 of the 30 DJIA stocks. Importantly, however, the futures market opened on time across the board, with heavy selling.
On that Monday, the DJIA fell 508 points (22.6 percent), accompanied by crashes in the futures exchanges and options markets, the largest one-day percentage drop in the history of the DJIA. The DJIA fell from 2,246.74 at the open to 1,738.74 at the close. By the end of the day, the S&P 500 had fallen 20%. The Wilshire 5000 index fell 18%. Significant selling created steep price declines throughout the day, particularly during the last 90 minutes of trading. Deluged with sell orders, many stocks on the NYSE faced trading halts and delays. Of the 2,257 NYSE-listed stocks, there were 195 trading delays and halts that day. Total trading volume was so large that the computer and communications systems were overwhelmed, leaving orders unfilled for an hour or more. Large funds transfers were delayed and the Fedwire and NYSE SuperDot systems shut down for extended periods further compounding traders' confusion.
Margin calls and liquidity
Frederic Mishkin suggested that the greatest economic danger was not events on the day of the crash itself, but the potential for "spreading collapse of securities firms" if an extended liquidity crisis in the securities industry began to threaten the solvency and viability of brokerage houses and specialists. This possibility first loomed on the day after the crash. At least initially, there was a very real risk that these institutions could fail. If that happened, spillover effects could sweep over the entire financial system, with negative consequences for the real economy as a whole. As Robert R. Glauber stated, "From our perspective on the Brady Commission, Black Monday may have been frightening, but it was the capital-liquidity problem on Tuesday that was horrifying."
The source of these liquidity problems was a general increase in margin calls; these were about ten times their average size and three times greater than the highest previous levels. Several firms had insufficient cash in customers' accounts (that is, they were "undersegregated"). Firms drawing funds from their own capital to meet the shortfall sometimes became undercapitalized; 11 firms received margin calls for a single customer that exceeded that firm's adjusted net capital, sometimes by as much as two-to-one. Investors needed to repay end-of-day margin calls made on October 19 before the opening of the market on October 20. Clearinghouse member firms called on lending institutions to extend credit to cover these sudden and unexpected charges, but the brokerages requesting additional credit began to exceed their credit limit. Banks were also worried about increasing their involvement and exposure to a chaotic market. The size and urgency of the demands for credit placed upon banks was unprecedented. In general, counterparty risk increased as the creditworthiness of counterparties and the value of collateral posted became highly uncertain.
Federal Reserve response
"[T]he response of monetary policy to the crash," according to economist Michael Mussa, "was massive, immediate and appropriate." One day after the crash, the Federal Reserve (Fed) began to act as the lender of last resort to counter the crisis. Its crisis management approach included issuing a terse, decisive public pronouncement; supplying liquidity through open market operations; persuading banks to lend to securities firms; and in a few specific cases, direct action tailored to a few firms' needs.
On the morning of October 20, Fed Chairman Alan Greenspan made a brief statement: "The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system". Fed sources suggested that the brevity was deliberate, in order to avoid misinterpretations. This "extraordinary" announcement probably had a calming effect on markets that were facing an equally unprecedented demand for liquidity and the immediate potential for a liquidity crisis. The market rallied after that announcement, gaining around 200 points, but the rally was short-lived. By noon the gains had been erased and the slide had resumed.
The Fed then acted to provide market liquidity and prevent the crisis from expanding into other markets. It immediately began injecting its reserves into the financial system via purchases on the open market. On October 20 it injected $17 billion into the banking system through the open market – an amount that was more than 25 percent of bank reserve balances and 7 percent of the monetary base of the entire nation. This rapidly pushed the federal funds rate down by 0.5 percent. The Fed continued its expansive open market purchases of securities for weeks. The Fed also repeatedly began these interventions an hour before the regularly scheduled time, notifying dealers of the schedule change on the evening beforehand. This was all done in a very high-profile and public manner, similar to Greenspan's initial announcement, to restore market confidence that liquidity was forthcoming. Although the Fed's holdings expanded appreciably over time, the speed of expansion was not excessive. Moreover, the Fed later disposed of these holdings so that its long-term policy goals would not be adversely affected.
The Fed successfully met the unprecedented demands for credit by pairing a strategy of moral suasion that motivated nervous banks to lend to securities firms alongside its moves to reassure those banks by actively supplying them with liquidity. As economist Ben Bernanke (who was later to become Chairman of the Federal Reserve) wrote:
The Fed's key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed.
The Fed's two-part strategy was thoroughly successful, since lending to securities firms by large banks in Chicago and especially in New York increased substantially, often nearly doubling.
Recovery
The S&P 500 index fell to 230.30 by November 1987, a 31.6% drop. The index took until July 26, 1989, to recover to its pre-crash high of 336.77.
International
All of the twenty-three major world markets experienced a sharp decline in October 1987. Stock markets crashed worldwide, first in Asian markets other than Japan, then Europe, then the US, and finally Japan. When measured in United States dollars, eight markets declined by 20 to 29 percent, three by 30 to 39 percent (Malaysia, Mexico and New Zealand), and three by more than 40 percent (Hong Kong, Australia and Singapore). The least affected was Austria (a fall of 11.4 percent) while the most affected was Hong Kong with a drop of 45.8 percent. Out of twenty-three major industrial countries, nineteen had a decline greater than 20 percent. Worldwide losses were estimated at US$1.71 trillion. The severity of the crash sparked fears of extended economic instability or even a reprise of the Great Depression.
United Kingdom
On Friday, October 16, all the markets in London were unexpectedly closed due to the Great Storm of 1987. After they re-opened, the speed of the crash accelerated. By midday, the Financial Times Stock Exchange 100 Index (FTSE 100) had fallen 296 points, a 14 percent drop. It was down 23 percent in two days, roughly the same percentage that the NYSE dropped on the day of the crash. Stocks then continued to fall, albeit at a less precipitous rate, until reaching a trough in mid-November at 36 percent below its pre-crash peak. Stocks did not begin to recover until 1989.
Japan
In Japan, the October 1987 crash is sometimes referred to as "Blue Tuesday", because of the time zone difference, and its effects were relatively mild. According to economist Ulrike Schaede, the initial market break was severe: the Tokyo market declined 14.9 percent in one day, and Japan's losses of US$421 billion ranked next to New York's $500 billion, out of a worldwide total loss of $1.7 trillion. However, systemic differences between the US and Japanese financial systems led to significantly different outcomes during and after the crash on Tuesday, October 20. In Japan the ensuing panic was no more than mild at worst: the Nikkei 225 Index returned to its pre-crash levels after only five months. Other global markets performed less well in the aftermath of the crash, with New York, London and Frankfurt all needing more than a year to achieve the same level of recovery.