Could the crash of ’87 happen again?

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.

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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.

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