Thursday, 20 September 2012

7 Biggest Crashes of All Time, III.

Many people believe that the 1929 Crash was the biggest of all time in terms of percentage change – and while that has been the case for decades after 1929, the winner of the dubious glory of being the biggest percentile fall in the DJIA belongs to another crisis – the relatively unknown, yet still very real and consequential Black Monday of 1987.

Brokers of Drexel Burnham in panic after the collapse of the 1987 bubble.
Source: Media.Nowlive.net


5.
The Black Monday (The crash of 1987)
Date: October 19th 1987
Location: USA
Causes: shady IPOs, junk bonds, program trading
Duration of panic: 1 day
Biggest percentage change of market index: -22.61% (DJIA)
Length of recession: none
Results: a temporary halt in the 18-year long bear market of 1982

 

Background


The 1980's were a decade of economic prosperity. While the Nixon Shock and the subsequent troubles in the world economy made growth in the 1970's rocky at best, but all became well by 1982, with US inflation brought down again to acceptable levels and low interest rates fuelling the economy. This started a long bear market, where previously unknown forms of investment emerged.
Market-wise, the biggest trend of the decade was the emergence of junk bonds-backed company takeovers. This means that a company issues junk bonds – hence taking loans which it might not take back – to buy the shares of other, often bigger companies, with the aim of merging with the target company, and adding it's productivity to the company's own – at least in theory. IPOs (Initial Public Offering, the first day of a stock's public trade) of new, unknown companies were also becoming more common, further adding to the emerging speculative bubble.
Theory-wise, the biggest invention of the decade were trade programs – computer algorithms designed to conduct trade with no or minimal human intervention, buying and selling at the split of a second, and conducting complex market manoeuvres such as shorting (You lend a share, sell it, then re-buy it at a lower price and give it back, hence gaining a profit) or arbitrage (You buy a share sold on multiple markets at the place it's price is lower, and sell it where it is higher).
The decades of intellectual effort culminating in the creation of these programmes is the main subject of Peter. L. Bernstein's book 'Capital Ideas', and was an inspiration for thrillers like Robert Harris's 'The Fear Index'. The opacity of computer trades was also a major factor in the coming crash.

Immediate causes


The controversy of the 1980's growth was evident for the SEC (Securities and Exchange Commission, the US market regulator), who conducted a series of inside trade enquiries starting from early 1987. This made investors alert – yet at the same time, inflation was increasing, to which the FED responded by raising interest rates. Instead of only curbing inflation, however, the move caused a massive panic. 
 

The crash


While prices already began to fell on 16th October, previous Friday, the real shock and bust came next Monday, on October 19th – which has gained the name of Black Monday in international financial history. Amid the panic, the DJIA fell 508 points – it's biggest single-day fall ever! – and many investors were forced to declare bankruptcy. The biggest loser was Drexel Burnham, a major Wall Street player – it's investment banking department, headed by the infamous Michael Milken, invested heavily in both junk-bonds backed companies and portfolio insurance (meaning that the insurer pays when stock prices fall below a pre-set level or percentage), and the company was forced to declare bankruptcy in 1990.
Markets then all around the world responded to the grim American news – New Zealand fell 60%, Hong Kong fell 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.45%, Canada 22.5%. It was the biggest – and quickest – stock market fall since 1929.

Aftermath


With such a huge crash in a single day, many people were predicting that a 1930's like worldwide economic disaster would follow. Luckily for all, this was not the case – the FED immediately lowered interest rates, and the markets – emboldened by the untouched economic boom of Japan – quickly continued their growth. The Japanese bubble also soon burst, however – but this didn't stop the rest of the world markets from continuing to grow – surviving a stagnation in 1994, they did so until 2000, the burst of the dot-com bubble.

The crisis was the first 'modern' financial crisis in the age of computers, and had all the characteristics the future crises would have. The markets however didn't learn from it's lessons – that only came much later, during the 2008 financial crisis. Or did it? Tell us your opinion in comments.

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