Diana Henriques: Lessons from Black Monday
Also: Janney research chief Dan Wantrobski sees reason to believe stock values will keep rising
Diana B. Henriques, veteran Wall Street reporter and author of books on corporate raiders, public-authority scams, and big-dollar investors (successful and failed), returned to Philadelphia, her old journalistic base, to discuss her latest book, A First Class Catastrophe: The Road to Black Monday, The Worst Day in Wall Street History, for the Philadelphia Fund Association's yearly Gala (which raised $65,000 plus silent-auction proceeds for the homeless-children group Cradles to Crayons) at the Logan on Thursday, Nov. 2.
Q You wrote for the Inquirer back when Philly was still a big-finance town —
A It was lively! I worked for Larry Williams, who built up the business section. The stock market boom began in August 1982, and the Inquirer led the pack with its expansion of business coverage among the major city dailies.
The Philadelphia Stock Exchange and the PHLX trading firms were joining the competition to trade currency options and useful financial derivatives, to cater to institutional investors in global activity. They were training people in foreign-currency options. Philadelphia still had major banks, they were part of the consortia that led the lending effort in response to the Latin American debt crisis. So you had a period when reporting horizons had to widen. It was an extremely exciting time.
I got my first taste of financial markets with investigations of public authorities and state agencies. I had never covered finance, my undergrad degree was in international affairs. I scrambled to get my brain around how the market pays for sports arenas, highways, airports. All plugged into this mysterious thing, the bond market.
I met my first bond issue statement and it was love at first sight. All this information for people to read. And no one ever did! If you read far enough, you'd see when your Turnpike tolls were going to go up. I hadn't been as excited since I discovered how limited partnership papers were filed in county courthouses.
The bigger story — the metastory — was the emergence of finance as such a forceful part of our nation’s systems and people’s lives.
Q Wait a minute. Finance has always been central to the American struggle. Hamilton, Girard, Jay Cooke, J.P. Morgan, the Crash of 1929 —
A Compared to manufacturing, agriculture and basic services, finance was a small fraction of what it is today, as a share of our Gross Domestic Product. Middle-class people had a bank account. If they worked for a company they got a pension. They didn't have to invest… Fast forward to the 1980s, the (end of corporate) pensions, with 401(k) plans we all became do-it-yourself pension managers. Not investing in the market is not an option anymore for a middle-class American saving for retirement.
So more people have a stake in how our markets are regulated than ever before. And now with indexing everyone owns the same 500 stocks — mutual funds, exchange-traded funds, options and other derivatives — they move as a portfolio. Markets fluctuate. Maybe you can wait it out. But diversification is illusory.
Q But the market always comes back, doesn't it? It came back from 1987, from 2008, from the "flash crash" of 2010, to new highs. Why should we care about what happened 30 years ago?
What I'm talking about is different. I'm talking about, how long does it take to rebuild market machinery that is broken?
Any crash that damages the financial machinery of a country is far more serious. When a market falls, people lose money. But when a market falls apart, people cannot rebuild the financial systems that allow them to make money. That was the Great Depression. Banks closed their doors. It wiped out people's nest eggs. Money could not get through the system anymore.
I'm trying to tell people in 1987, we got frighteningly close, closer than people knew, to the market falling apart.
Q We take it for granted the stock and bond markets will snap back —
A Yes. Too much. The stock market is a machine, with a structure, whose product is where the Dow closes tonight. The Dow falls, it doesn't mean the machine is broken. But if the machine does break, you have a systemic risk to the nation's ability to make money and move money through the financial landscape.
In A First Class Catastrophe [Henry Hold & Co.], I document years of bizarre market behaviors, where a tiny default in a government bond market produces runs on banks in Ohio and Maryland, where a computer breakdown in a New York bank can bring the Treasury market to standstill for one horrible afternoon, where witching hours emerge, and where there are bizarre movements in stock prices that the pros cannot explain, which produce gigantic volumes of trading the system struggles to process. All of that had been happening years ahead of Black Monday. These events were red flashing lights on the console of an overheated, undermaintained, poorly-understood machinery.
We haven't fixed any of this.
Q Charles Plosser, former President of the Federal Reserve Bank here in Philadelphia, said all through the 2008-09 crisis that the Fed was acting within its power, but it ought to set rules and benchmarks and threshholds for such rescues, and avoid ad hoc policymaking.
A No. That is backwards. In the next financial crisis, today's rulebook will be worse than useless; it may tie regulators' hands, and prevent them from taking exactly the kind of ad hoc, seat of the pants regulatory steps that got us through 1987 and 2008.
Thank God we were flying by the seat of our pants and making it up as we go along. Because we could not possibly have created a set of rules that would prepare us for the particular things that happened in 2008 — or in 1987, with the Options Clearing Corp. getting hit by a run that could bring the options markets to their knees, and through it the commercial banks that lent money to market players.
No one would have picked that clearing firm in Chicago to serve as the flashpoint for the crisis. And in the midst of the crisis, if Continental Illinois had not been willing to defy bank regulators and the (Treasury Department) Office of the Comptroller of the Currency, and keep funding his options-clearing stake in Options Clearing Corp. through the rescue — I call these 'rescues,' not 'bailouts' — there would have been a collapse.
In the midst of a crisis you must be able to respond to the events on the ground.
Q In the run-up to the 2008 crisis some observers saw Commodities Futures Trading Commission chief Brooksley Born as Cassandra, arguing for derivatives regulation while everyone from Clinton Treasury Secretary Larry Summers to Fed chief Alan Greenspan ridiculed the idea and said the market could police itself.
A That argument was a decade old by the time Born stepped in. CFTC introduced rues to regulate swaps in 1987 after the crash (which the Commission had failed to prevent.) The crash weakened its authority and doomed that effort.
Swaps (interest-rate and credit-default derivatives) were finally recognized in 2008 as a destabilizing force.
Of course we need rules for how markets operate. We need intelligent oversight and monitoring. We don't need an itemized checklist for what you do in the next crisis.
Q Sounds like what bankers call 'principles-based' regulation, instead of 'rules-based.'
A I don't like putting the problem that way. Labels and orthodoxy gets in the way of dealing with the financial crisis while it's unfolding.
Bill Isaacs, who headed the FDIC back then, was hauled before the Democratic-controlled Congress. They told him, 'Little banks are dropping; why should we bail out the big guy?' They accused him of exaggerating the importance of the big banks. He gives an eloquent description of what would have happened if Continental Illinois, for example, had failed: Uninsured depositors would have been months without grocery or mortgage payments. All loans would have gone into collection mode. Business clients would have gone bankrupt. It would have taken years to unwind uninsured deposits. The impact would have spread to other banks. It would have been catastrophic.
Q So your argument comes down to, we need good people running regulatory agencies, and banks.
A Absolutely. Look, the markets came back, so people forgot what happened. I recently ran into a man who works on Wall Street, he was an intern at Continental Illinois when this happened. His memory was that the market had been going up, they were all celebrating, until suddenly it was Black Monday. I reminded him that actually the two weeks before Black Monday had been the worst in the market's history…
The bottom-line lesson is that the crisis responders, people like Jerry Corrigan at the New York Fed, John Phelan at the New York Stock Exchange, Bill Brodsky at the Chicago Mercantile Exchange, had no idea what they were sailing into. They were sailing into history. People were juggling hand grenades for more than a week, to see if Charles Schwab would survive, or close its doors. Which would have deeply intensified the panic on Main Street. The Merc almost could not open its doors. They were $400 million short.
Q Until Continental Illinois stepped in, defying its own very worried regulators —
A Yes. And you look back on the Treasury Department Report on Capital Markets covering the period of the crisis. On Page 9-10 of the Executive Summary. It calls for "significant changes" to end "overlapping mandates and jurisdictional friction." That's exactly the regulatory machine we had on the eve of Black Monday. The problems it caused then and again in 2008, it will cause in our next financial crisis.
Q You argue that blow-ups are unavoidable and we need smart people running markets, regulators and trading firms to come up with ways to keep stressed markets running.
A That's it. We can't predict the next crisis. We can regulate the risks. Regulators should be demanding that Wall Street upgrade the resilience and strength of its computer systems. And demand visibility on financially-engineered toys before they blow up.
Regulators have to know what the market is trading, what the risks are. Don't think your little rule book in the storm will get us through. Every crisis is different. You take different steps at different times. We have to have creative, cooperative, respectful regulators who can work together with industry to get us through this storm.
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At Janney Montgomery Scott, the biggest brokerage based in Philadelphia, research chief Dan Wantrobski also wanted to talk about the 30-year anniversary of Black Monday.
Q Are stocks too high?
A I'm a quantitative analyst. We see trends, and cycles. The 1987 crash was in the midst of a massive secular bill market. There were market drivers under the surface. But even a short-term, violent event was temporary.
We've had two major corrections since 2009. People forget, in May 2010 we had the flash crash, down 20 percent. And again in late 2011, especially with the small-term midcaps.
I see three drivers of long-term market trends: Valuations (price-to-earnings); Demographics (are there more people working?); the private-sector credit environment. When all three evolve (positively), we have massive structural bull markets, in excess of a decade.
Back in 1999-2000, the end of the last secular bull market, we had the S&P 500 at 1,500, but that price was 47 times earnings. So that was a down signal. And then the credit bubble, and the crash.
So in 2012-13 the S&P broke out, to new alltime highs. And now we have price-to-value is high again, yet the multiple is coming off low interest rates. That says we are in a new cycle.
Q So you don't expect a crash soon?
A We are not at the peak. Stocks aren't cheap, but they are not at the peak multiple, compared with prior cycles.
That's valuations. So, factor two, demographics. We have a boom-bust demographic cycle going back to Ben Franklin's time. You can correlate virtually every boom market demographic as it enters the household-formation years.
Q Aren't we headed into a demographic bust, with the Baby Boomers retiring, and immigration down?
A (He laughs) Not necessarily. There are maybe 90 million Millennial children of the Baby Boomers, vs. 80 million Baby Boomers. It's a little larger, on an absolute basis… The pressures have started to ease. This group is getting integrated into the workforce. They are more likely to work (than middle-aged people.) This will drive household formation to new highs. They will be consumers, investors, savers. It will create upheaval and disruption. And organic growth in economic activity. A new generation looking for work, building houses, trying to buy cars. Disruptive. Very bullish. Stocks tend to thrive off that.
And three, private credit markets contracted in 2007-09. They never really expanded again, until recently. Lending standards are still tight. I like the accumulation (of lending capital) I am seeing in the banks.