How Black Monday sowed the seeds for the current financial crisis
The 1987 financial crash turned out to be the pricking of a stock market bubble, but many think it was the start of 'moral hazard', where bankers began to believe they would always be saved no matter how expensive their mistakes
Earlier today, apparently, a woman rang the BBC and said she’d heard there was a hurricane on the way. Well, if you’re watching, don’t worry, there isn’t.” So said BBC weatherman Michael Fish on October 15, 1987.
On Friday, October 16 that year, anybody surveying the Kent estate of Bank of England governor Robin Leigh-Pemberton would have been shocked at how it had been stripped of its trees. A freak overnight hurricane had wrecked his grounds, just as it had those of the property owned by the governor’s neighbour, City fund manager Richard Oldfield. Meanwhile, bankers living closer to the City were stepping over felled trees in leafy Chelsea on their way to the office. Those who arrived in the Square Mile found little to do: the money markets had been closed.
The scene was shocking for a country not used to serious natural disasters. But if anybody was cursing the predictive powers of Fish, they soon had cause to wonder whether the financial world’s crystal ball had also malfunctioned. By Monday morning it was clear the Great Storm of 1987 was being followed by a great financial crash. That was 25 years ago this week. Black Monday, as it came to be known, began in Hong Kong and quickly spread west to Europe, before hitting Wall Street, where the Dow Jones slumped by an unprecedented 23% to take the index 34% below its level earlier that October.
In London the FTSE fell by 11% on Monday, a further 12% on Tuesday and another 6% on Thursday; those who worked through the slide reported how the shock of share price slumps caused some traders to become paralysed, staring blankly at their screens, with “sweat running down their faces”.
It was not just the traders, either. Lord (Nigel) Lawson, then chancellor of the exchequer, recalls, “My reading of it at the time was that the Wall Street collapse and collapse of other stock markets around the world had rattled the Bank of England and they were in a state of panic. My judgment was that they weren’t thinking straight as they were panicked by what was going on.” Like any bull or bear runs, the mood was contagious, which exacerbated the market’s moves.
Oldfield, who was then the head of Mercury Asset Management’s US equity team, recalls, “We had returned early from a holiday to deal with the fallen trees when somebody called to tell me that the Dow had fallen by 500 points. Looking at the carnage outside I can remember thinking how (the trees were) so much more important and how (the Wall Street crash) was an unjustified fall. I felt strongly that it was a good time to buy shares…I then went into the office, which was a mistake. I was overwhelmed by the sense of panic.”
Within a few hours Oldfield was infected by the hysteria and changed his judgment from buy to sell - “the worst mistake of my career,” he says. History now tells us that shares swiftly recovered - two years later London’s blue-chip index was trading again at 1987 highs, and subsequently soared away during the 1990s. Unlike now there was no banking crisis to transmit the problems to the real economy. In fact, Black Monday was merely the pricking of a stock market bubble - a financial market crisis for sure, but not an economic one.
However, making such predictions in October 1987 would have seemed fanciful. The talk of the time involved comparisons with the crash of 1929 and the subsequent depression, while central banks reacted to those concerns by colluding to cut interest rates. On October 20, Alan Greenspan, then just two months into his role as chairman of the US Federal Reserve, started in his new job as he meant to go on, stating, “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.” That support for Wall Street was to become the defining theme of his tenure, known by investors as “the Greenspan put”.
Such unquestioning support of the markets is now considered a folly. Lawson says, “Greenspan is a nice, amusing and interesting man, and he is highly intelligent, but he got it completely wrong.” Many now believe that the way in which the 1987 crash was dealt with by central bankers - mirrored in subsequent crises in the 1990s and early 2000s - signalled the start of the creation of moral hazard, where bankers began believing that no matter how expensive their miscalculations, they would always be saved.
Stock market historian David Schwartz says, “The central bankers, whether they admitted it or not, were taking it on themselves to keep the markets afloat. Investors believed they would be rescued if things went bad, which boosted share prices. The stimuli had knock-on effects, so the stimulus provided in the late 1990s (during the Asian and LTCM crises) is viewed as the reason the tech bubble bubbled up so much. Each time a stimulus is provided there is an ill effect that nobody is looking at elsewhere.”
For his part Lawson, who in 1987 controlled UK base rates, made three separate half-point cuts before the end of 1987 - and while some economists have questioned whether those moves contributed to the unsustainable ‘Lawson Boom’, others viewed his actions as restraint. In hindsight, it may seem Black Monday should have provided a warning. But the former chancellor argues that the current crisis has nothing to do with policy decisions taken 25 years ago.
“You can’t trace it back (to 1987),” says Lawson. “You can see some signs of the way American investment banks operated. You can see this as a harbinger of worse behaviour and bigger problems 20 years later. But you can’t say what happened in 1987 that caused the financial crisis.” The bad behaviour that Lawson refers to is not a general statement - but a specific reference to his dealings with Wall Street over one very high-profile deal. The postponement of the UK government’s flotation of the water industry in July 1986 had created a hole in its privatisation timetable and in March 1987 a replacement was announced - the sale of the state’s remaining 31.5% stake in BP.
The oil group also wanted to raise £1.5bn for its own uses, meaning the total float would be worth £7.25bn, dwarfing the £5bn British Gas offer the year before. But by an awful coincidence, the world’s largest share sale was to coincide with the world’s most dramatic stock market crash.
A string of City and Wall Street banks underwrote the offer - providing an insurance policy taken out by the government whereby the banks committed to buy any unsold shares at a pre-arranged price. That price was agreed on October 14, but by Black Monday BP’s existing shares were trading 14% below that level. It was then that City and Wall Street banks tried to renege on the deal.
Lawson recalls. “(Wall Street) lobbied Alan Greenspan and got him to make representations to the Bank of England that I should be stopped from going ahead. They also lobbied the American administration...to try to get Margaret (Thatcher) to tell me to pull the issue. Margaret behaved impeccably. She not only immediately informed me of this but she totally supported me in the view I had taken to go ahead. It was enormous pressure they put on me. Quite extraordinary.”
The government did hold out, the banks were forced to pay up and the financiers’ warnings that their losses would create a banking crisis turned out to be total nonsense. As one City veteran says, “Most of the City, who weren’t involved with underwriting the BP offer, thought ‘good on the government’,” while failing to suppress a wry smile at the suggestion that here was a rare case of bankers getting stuffed by the taxpayer - rather than the other way around. Crazy as it may seem now, that was the way it once could work, albeit a quarter of a century ago.
The Observer / The Interview People
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