How those in trenches would avoid a rerun of Oct. 19
What could be done to prevent another Black Monday? Paul Camilleri, assistant manager of the Southfield, Mich. office of E.F. Hutton, recently-acquired by Shearson Lehman Brothers, paused for a split second. Then:
``We could start every week on Tuesday.''
Ah, were it so simple. Analyzing the causes of - much less the solutions to - the 508-point drop on the stock market on Monday, Oct. 19 has occupied thousands of column inches and several official investigations.
On Friday, the commission headed by Nicholas Brady, a former United States senator and current chairman of Dillon, Read & Co., gave its long-awaited report to the President. It makes some startling, already controversial recommendations (see story below).
In light of this and other recommendations by other commissions, the Monitor asked some of those in the financial trenches - brokers, individual investors, securities lawyers, politicians, and academics - to answer the question that supersedes all others: How can another Black Monday be prevented?
Austin Kiplinger, The Kiplinger Letter. ``In commodities markets, you have daily limits,'' says the publisher of this financial newsletter. If the price of soybeans swings more than 30 cents, for example, soybean trading stops for the day. ``I've often thought something like that would be useful for stocks.''
Apparently, the Brady Commission held a similar view. In intentionally vague language, it recommended creating a ``circuit breaker'' mechanism that would halt trading if the selling pressure became too great.
Richard Baldwin, Columbia Business School. By October, the stock market had become a ``speculative bubble'' - overvalued and just waiting to be popped, Professor Baldwin observes. ``If someone in, say, June or July had sold a lot of stocks and bought bonds, that might have burst the bubble sooner, and the crash would not have been as great,'' he says.
Perhaps in the future, the government should have that role, he suggests, as it does in the foreign exchange markets. Governments hold a portfolio of currencies, such as yen, dollars, and francs. (In the United States, this is done by the Federal Reserve.) When one currency - most recently, the dollar - falls too much in value to their liking, the governments buy that currency to prop it up.
``A similar intervention might keep the stock market closer to the fundamentals,'' Baldwin says. An agency, such as the Securities and Exchange Commission, could keep a portfolio of stocks and bonds. If, on a day like Black Monday, stock prices began to plummet, the SEC could sell their bonds and buy stocks. Once the crisis is over, the government could gradually sell back the stocks to even out its portfolio.
Asher Edelman, corporate takeover artist. Not a long-winded sort, Mr. Edelman offered this advice: ``Eliminate program trading.''
The corporate raider, who was somewhat burned on Black Monday, echoes the feeling of many others, who believe program trading accelerated the decline.
In program trading, computers spot mismatches between the stock index futures (a bet about how a group of stocks will be priced in the future) and the underlying stocks. The computers automatically buy the less expensive instrument and sell the more expensive one. On Black Monday, critics of program trading claim, the computers swamped the market with orders and sent stock prices into a free fall.
Clayton Sauers, West Point-Pepperell. Mr. Sauers, the chief financial officer at this Georgia-based consumer products company, sees trouble in the ``specialist'' system. These dealers are expected to buy up stocks that are being sold, and thus keep the market orderly. ``One of the more serious problems that came out of Oct. 19 was that specialists ran out of money'' because there was such a flood of sell orders, he says.
He notes that bank regulators require banks to keep a certain level of reserves to ensure they don't run out of money. In like manner, he says, ``Maybe we have to tighten the standards on the minimum capital base that specialists have to have.''
Bevis Longstreth, former commissioner of the SEC. Mr. Longstreth, now a New York-based securities lawyer, would change and effectively eliminate the specialist system through computer technology.
``We should have a better system to enable buyers and sellers to find each other,'' he says. When sell orders began flooding in on Oct. 19, Some ``dealers just disappeared, so there was no one to make the trade,'' he says. If buyers and sellers could interface automatically by computer, ``someone would be there to execute the buy orders,'' he says, and that would help buoy prices and stop the free fall.
Perrin Long, Lipper Analytical Services. ``Nothing'' should be done to prevent another Black Monday, says this veteran observer of Wall Street. ``The 500-point drop is one of the best things that ever happened to us,'' he says, ``because it wakes people up to the fact that we've got to do something about our trade and budget deficits.''
Stephen Goodale, individual investor. This semi-retired businessman from Ocean Ridge, Fla. echoes many (including the Brady Commission) in calling for uniform margin requirements in trading futures, options, and stock indexes.
Investors must pay at least 50 cents for every dollar of stock they buy, or a 50 percent margin. However, investors can still buy on, say, a 20 percent margin in the futures and other risky markets.
On Black Monday, ``You had so many sellers - and they were leveraged sellers'' involved with futures and index trading, Mr. Goodale observes. ``They had to sell when the margin calls went out, and that exacerbated the selling.''
John Markese, American Association of Individual Investors. Mr. Markese, the association's director of research in Chicago, says something should be done to reduce the ``wild discrepencies'' between stock prices and the prices of stock index futures.
Generally, the prices of stock index futures and the underlying stocks track pretty closely. But on Black Monday, the prices of the futures were falling faster than the stocks. Logically, arbitrageurs would step in and buy futures (they were a better bargain). They would sell stocks ``short'' - that is, sell stocks they don't really own, and agree to buy them later at a specified price.
That way, the price of the futures would rise (remember, the ``arbs'' were buying them) and the price of stocks would fall (arbs were selling them) until the two came into line.
However, arbs could not do that. Under a post-1929 law, stocks cannot be sold short in a falling market; investors must wait for an uptick. That meant stocks and futures got even more out of line, accelerating the downward spiral.
Markese's solution, which he notes is controversial: ``I'd take off the downtick rule on stocks.''
Sen. Donald Riegle (D) of Michigan. If there ever was a doubt that stock markets have gone global, Oct. 19 put that to rest. In the following days, one market after another - New York, London, Tokyo, Sydney - spurred each other to record losses.
Given this cascading effect, Senator Riegle, who heads the Subcommittee on Securities, would like to see ``an international SEC.'' It would set up uniform standards on things like margin requirements, reporting requirements, and accounting procedures.
He concedes that foreign markets, which compete against each other, would balk at such coordination. But eventually, he says, ``we've got to have a structure that works in the whole rather than just through the various separate pieces.''
`Circuit breakers' and other Brady recommendations
When Nicholas Brady strolled into the White House on Friday, all of Wall Street was watching him. After all, the stock market's fate could hinge on what Mr. Brady and his commission said in their report.
The commission concluded that program trading was a major culprit in the Dow's 508-point drop on Oct. 19. To prevent a repeat performance, the commission recommended:
Creating a ``circuit breaker'' mechanism to halt trading of stocks and limit price swings of futures if the selling pressure gets too intense. Brady backed away from definitively suggesting there be limits to price changes in stocks, as had been rumored.
Empowering one body, such as the Federal Reserve, to oversee both the stocks and the futures markets. Currently, the Securities and Exchange Commission (SEC) regulates the stock and bond markets and the Commodities Futures Trading Commission (CFTC) regulates futures.
Making uniform margin (down payment) requirements to trade all types of financial instruments. Today, an investor buy stocks if he pays for half in cash; if he wants to buy riskier investments like commodities, however, he only has to put down, say, 20 percent of the investment in cash and borrow the other 80 percent.
Creating a unified system to clear and settle trades.
The Brady report is the third in a series of reports on Black Monday. The Chicago Mercantile Exchange and the New York Stock Exchange issued their analyses in December. In the next month, the SEC, CFTC, and General Accounting Office will come out with reports of their own. In late January, the House will hold hearings on the market, as will the Senate in early February.