Terrible Tuesday: How the Stock Market Almost Disintegrated A Day After the Crash

A version of this article appeared November 20, 1987, on page 1 in the U.S. edition of The Wall Street Journal.

NEW YORK -- A month ago today, the New York Stock Exchange died. But within an hour or two, it was raised from the dead.

The previous day, Oct. 19, when the Dow Jones Industrial Average plunged 508 points in history's largest one-day loss, has been dubbed Black Monday. But it was on Tuesday, Oct. 20, that the stock market -- and by extension all the world's financial markets -- faced one of their gravest crises.

Full details of what happened that fateful week are only now emerging and are the subject of major inquiries by a presidential commission, congressional committees and others. But minute-by-minute scrutiny of the events of that Tuesday, plus scores of interviews with key stock, commodities and futures market participants, the Federal Reserve, and investment and commercial bankers, reveals that:

-- Stock, options and futures trading all but stopped during a crucial interval on Tuesday. Many major stocks, such as International Business Machines Corp. and Merck & Co., couldn't be traded. Investors large and small couldn't sell their stock; there were no buyers. The industrial average was meaningless because many of its component stocks weren't trading. The Big Board's market makers, or specialists, were overwhelmed by unfilled sell orders, and their capital was devastated.

-- Many banks, frightened by the collapse in prices of stocks that were collateral for loans to securities dealers, refused to extend sorely pressed dealers any more credit. They also called in major loans, imperiling some securities firms.

-- Some big investment-banking firms, facing catastrophic losses if the market panic continued, urged the New York Stock Exchange to close.

-- Only the intervention of the Federal Reserve, the concerted announcement of corporate stock-buy-back programs, and the mysterious movement -- and possible manipulation -- of a little-used stock-index futures contract saved the markets from total meltdown.

The story of that Tuesday discloses major weaknesses in the U.S. financial system and raises the specter that such a crisis could strike again. "Tuesday was the most dangerous day we had in 50 years," says Felix Rohatyn, a general partner in Lazard Freres & Co. "I think we came within an hour" of a disintegration of the stock market, he says. "The fact we didn't have a meltdown doesn't mean we didn't have a breakdown. Chernobyl didn't end the world, but it sure made a terrible mess."

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Monday, Oct. 19, 11 p.m. This day was the worst in Wall Street's history -- and worst of all for the Big Board's specialists. The specialists, more than 50 little-known but powerful firms, are required by Big Board rules to buy and sell assigned stocks during volatile times to keep prices as orderly as possible. They usually profit handsomely by shrewd trading -- a franchise that has long been the envy of large, publicly oriented securities firms prevented by Big Board rules from becoming specialists themselves. Specialists are supposed to provide the last bastion of liquidity; in normal times, they are the reason an investor can buy or sell a stock when no other investors are in the market. On this day, at least, they were clearly not up to the task.

As the market plunged on Monday, the specialists bore the brunt of the fall. "From 2 p.m. on, there was total despair," says James Maguire, the chairman of Henderson Brothers Inc., a big specialist firm that makes markets in about 70 stocks. "The entire investment community fled the market. We were left alone on the field." Forced to buy stock himself when there were no other buyers, Mr. Maguire ended the day with $60 million in stock -- three times his normal inventory. Like other specialists, he had to pay for this stock five business days later, the following Monday. To do so, he would have to borrow.

Mr. Maguire phoned his bank, Bankers Trust Co., one of New York's biggest and an important lender to Wall Street. He asked for a $30 million loan, even though Henderson is one of Wall Street's best-capitalized specialist firms. He was stunned by the response. "They stated they were in no position to make commitments," Mr. Maguire says.

Mr. Maguire phoned the bank five times between 11 p.m. and 12:30 a.m. It wouldn't budge.

Other specialists report similar experiences. One, A.B. Tompane & Co., similarly turned down by Bankers Trust, was hurriedly forced into the arms of well-capitalized Merrill Lynch & Co. The two firms shook hands on the merger at 3 a.m. By dawn, nevertheless, the worst was yet to come for the markets.

Tuesday, 6:30 a.m. Big Board Chairman John J. Phelan met a neighbor going down in the elevator of his Manhattan apartment building. The neighbor was concerned not about Monday's 508-point plunge but about rumors that the Big Board might close. "He said, 'My God, if things were bad enough to close the market, things were really bad,'" Mr. Phelan recalls.

Tuesday, 8 a.m. Bank credit is the lifeline of Wall Street securities firms, and specialists weren't the only ones rushing to arrange more of it Tuesday morning. Large securities firms had swollen stock inventories, accumulated to accommodate major clients who wanted to sell, or in some cases held as part of the firms' holdings of stocks they expected to be involved in takeovers. Demand for credit was further fueled by an explosion of trading in the government-securities market. Trading by big government-securities dealers surged by $58 billion to a daily average of $173 billion that week. In addition, arbitragers, who had accumulated billions of dollars of takeover stocks, were also getting squeezed by margin calls.

The big firms fared little better. Phone calls started pouring into officials at the Big Board and the Federal Reserve Bank of New York. Angry securities dealers reported that foreign and U.S. regional banks were cutting back credit to the securities industry. Bankers Trust told Wall Street firms that it would stop extending unsecured credit-loans not collateralized by assets.

Executives at one big Wall Street securities firm were shocked when another U.S. bank Tuesday refused to deliver promptly $70 million in West German marks that it had sold to the firm in a foreign-exchange trade. Apparently, the bank feared that it might not be paid promptly -- if at all -- for the marks. Securities firms "were beginning to have trouble getting extended credit," Big Board Chairman Phelan says. "Japanese banks threatened to stop" lending, adds the head of one of Wall Street's largest securities firms.

Tuesday, 9 a.m. As the credit markets came to life in the U.S., Federal Reserve officials were swinging into action. In the early-morning hours, from a hotel room in Dallas, Chairman Alan Greenspan had decided to issue a one-sentence statement that in effect would reverse the course of policies that he had set into motion upon taking office two months before. He canceled a speech and headed back to his Washington office.

Meanwhile, E. Gerald Corrigan, the beefy president of the Federal Reserve Bank of New York and a protege of Mr. Greenspan's predecessor, Paul Volcker, was in close touch with the stock exchanges -- due to open in half an hour -- the banks and the bond market. As the head of the Federal Reserve's key operating unit, which daily buys or sells huge amounts of government securities and international currencies, he is the Fed official most closely in touch with Wall Street. He was to become the agency's point man in dealing with the developing crisis.

After learning of the credit squeeze facing Wall Street, Messrs. Greenspan and Corrigan feared that something far worse than a stock-market panic might be in the offing. If credit dried up, securities firms could start to collapse, much as the banks did after the 1929 crash. Fed officials saw a real threat of gridlock developing in the markets: Even the simplest financial transaction might have become impossible.

To avert that risk, Mr. Greenspan agreed to suspend, at least temporarily, the tightening grip the Fed had imposed on credit in order to head off inflation fears that he had seen building up in the economy. Signaling clearly its determination to prevent a market disaster, the Fed issued its extraordinary statement affirming its "readiness to serve as a source of liquidity to support the economic and financial system."

Even that was an understatement. Acting as the ultimate supplier of funds, the Fed flooded the banking system with dollars by buying government securities and thus quickly driving down short-term interest rates. "The Fed opened the floodgates of liquidity," says David Jones, the chief economist of Aubrey G. Lanston & Co., a major government-securities dealer.

Alerted by calls about the developing credit crisis from Mr. Phelan and others, the Fed leaned heavily on the big New York banks to meet Wall Street's soaring demand for credit. Mr. Corrigan and key aides personally telephoned top bankers to get the message across.

"Right from the beginning, Corrigan understood there was a major problem in the system," says Mr. Phelan, who spoke repeatedly to the New York Fed chief. Mr. Phelan sums up the Fed's strategy as he saw it: "The banks would be kept liquid; the banks would make sure everyone else in the system would stay liquid."

The banks were told to keep an eye on the big picture -- the global financial system on which all their business ultimately depends. A senior New York banker says the Fed's message was, "We're here. Whatever you need, we'll give you."

Tuesday, 9:30 a.m. The New York Stock Exchange opened. But many important sectors were at a standstill. Two-thirds of the specialists' total $3 billion of buying power had been wiped out on Monday. Some specialists refused to open trading in stocks until they had enough buy orders to enable the shares to trade at higher prices. Many stocks took more than an hour to open. When they did, they were mostly up from Monday's close. The Dow opened about 200 points higher, an extraordinary gain.

But the euphoria was short-lived. Specialists and major firms quickly unloaded some of their huge inventories, and buyers evaporated. Stock-index futures began to plunge on several exchanges. Program traders and portfolio insurers, whose computer-generated trading had accelerated Monday's fall, were largely absent from the market. Program traders switch money between stock-index futures and the underlying stocks, depending on which is cheaper. Portfolio insurance is a method of hedging a stock portfolio, usually by selling futures contracts on stock indexes when the market falls.

Ordinarily, the huge discount of the futures contracts to the cash value of the underlying stocks would encourage selling of the stocks and buying of the futures. That, in turn, theoretically could trigger some buying of stocks at bargain prices. But as the morning continued, everything was being sold -- stocks and futures alike.

Tuesday, 11:25 a.m. Of all securities linked to stock-market indexes, the Major Market Index has been the most secure, even in turbulent markets. It is pure blue chip: 17 of the 20 stocks in the index also are in the Dow Jones Industrial Average. Indeed, the MMI was created to mirror that average.

On Monday night, after the market turmoil that day, Ronald Shear, the American Stock Exchange's likable, balding senior specialist for the MMI, couldn't sleep. At 4 a.m., he gave up trying, and he went to the Brasserie, a 24-hour French restaurant in midtown Manhattan. Later, as the markets opened, he could hardly believe what he saw. One after another, major stocks broke down and couldn't be traded. By 11:30 a.m., when IBM stopped trading, the pace of closings was so fast Mr. Shear had trouble keeping track.

Big Board printouts of the morning's trading paint a harrowing picture of a market in disarray. By 11:25, even Du Pont hadn't opened. Merck opened at 9:46, was overwhelmed by sell orders and closed eight minutes later. Sears closed at 11:12; Eastman Kodak at 11:28; Philip Morris at 11:30; 3M a minute later. Dow Chemical shut at 11:43; USX at 12:51. Many other major stocks also weren't trading. Those that were did so only sporadically, in small numbers of shares or on regional exchanges. Over-the-counter market makers stopped answering their phones.

Specialists didn't have any buy orders, and many simply stopped making markets. Many believed that their capital, much of it in stock that looked as though it couldn't be sold, was gone or nearly gone. The specialists had run out of buying power. "The specialist system just let {stocks} go. People just stood aside," says Leslie Quick Jr., the chairman of Quick & Reilly Group Inc., a big discount brokerage firm.

Suddenly, Mr. Shear heard rumors coursing across the Amex floor. One turned out to be true: Tompane, the USX specialist on the Big Board, was about to be taken over by Merrill Lynch. Another later proved to be false: SEC Chairman David Ruder was about to announce the closing of the exchanges.

Sensing a similar imbalance in the options trading, Mr. Shear called a floor supervisor to check the rules for index-options trading on the Amex. The supervisor confirmed that if stocks representing more than 20% of the underlying capitalization of the index aren't trading, then options trading should stop. From what Mr. Shear saw, well over half the stocks in the index had stopped trading.

Mr. Shear got on the loudspeaker and halted trading in the MMI options.

Tuesday, 12:15 p.m. Leo Melamed, the short, dark-haired, kinetic chairman of the Chicago Mercantile Exchange, was on the phone to Mr. Phelan in New York. The Merc trades the Standard & Poor's 500, the principal futures contract used by program traders and portfolio insurers. Mr. Melamed was alarmed by the unprecedented breakdown in trading of the stocks making up the S&P 500. The Chicago Board Options Exchange, which trades options, had already closed because so many stocks weren't trading. "I was told there were no buyers," Mr. Melamed says. Then, he received a jolt: Mr. Phelan told him that Big Board directors were convening to decide whether to close the stock exchange. Mr. Phelan told him that "a decision was close," Mr. Melamed recalls.

Mr. Melamed suddenly envisioned a selling onslaught of the futures that could exhaust every bit of liquidity on the Merc floor. "We were exposed in a very dangerous way. We couldn't bear the brunt of any panic," he says. At 12:15 p.m., the Merc ordered a halt in trading of S&P 500 futures contracts.

A few blocks away at the Chicago Board of Trade, Chairman Karsten Mahlmann, known by his nickname, "Cash," also was on the phone to the Big Board. His exchange was still trading futures contracts on the MMI. But the situation was worsening: The MMI futures, already trading at the deepest discount to the underlying cash value of the index in its history, plunged further on the news that Mr. Shear had halted options trading on the Amex.

Mr. Mahlmann also was told that the Big Board was thinking of closing. But the Board of Trade was a little better off than the Merc. Trading of the relatively little-used MMI futures contracts had almost ground to a nervous standstill; MMI traders didn't seem to face a flood of orders.

Moreover, Mr. Mahlmann calculated that 17 of the MMI's 20 stocks still were trading, albeit sporadically, on some regional stock exchanges. Just the day before, Mr. Mahlmann had received a phone call from Beryl Sprinkel; the chairman of the President's Council of Economic Advisers urged him to keep the Board of Trade open. And there was the fierce longstanding rivalry between the Board of Trade and the New York exchange, a rivalry that has given rise to a generally defiant attitude at the Board of Trade toward any action adopted by the Big Board.

"We felt we had to stay open to do our job, to provide liquidity," Mr. Mahlmann recalls. Then he and his executives made what turned out to be one of the most critical decisions of the day: They kept the Board of Trade open and continued to trade the MMI futures contract.

Tuesday, 12:30 p.m. Mr. Phelan, Big Board President Robert Birnbaum, other top exchange officials and floor directors representing shellshocked specialists had gathered in Mr. Phelan's office to consider an extraordinary step: closing the New York Stock Exchange. The mood was grim. Mr. Phelan recalls that during the morning the market "was off 100 points and looked like it had potential to drop another 200 or 300. It looked like it would go again; it would be faster and heavier than the day before because there would be panic in the system." Exchange officials feared that selling would cascade as investors were hit with margin calls and big mutual funds dumped stock in the face of huge shareholder redemptions.

Behind the scenes, other pressures on Mr. Phelan to close the Big Board were multiplying. Several big securities firms "called the SEC and asked them to tell us to close," says Mr. Phelan (only the U.S. president and a stock exchange -- but not the SEC -- can order a closing). Mr. Phelan won't name the firms, but market sources say Salomon Brothers Inc. and Goldman, Sachs & Co., major firms with huge inventories of securities that were being rapidly devalued, were among those pushing to shut the exchange.

A Goldman official says the firm did discuss the possibility of a temporary closing with SEC Chairman Ruder but didn't recommend it. A Salomon spokesman didn't return a phone call.

"There were pressures from all firms that day to cut hours -- to close," Mr. Phelan says. Donald Stone, a Big Board director, says there was also a discussion of a plan -- broached on Black Monday -- for big Wall Street firms to raise a $1 billion fund to keep specialist firms from going broke.

Mr. Phelan denies suggestions by Mr. Melamed and Mr. Mahlmann that he or other officials gave any indication the Big Board was on the brink of closing. He says he had talked during the morning to White House Chief of Staff Howard Baker. "They said if you can do it {stay open}, do it," he relates.

Mr. Phelan says he shared White House fears over the impact of a Big Board closing. Shutting the biggest U.S. securities exchange not only would loudly trumpet the gravity of the stock-market crisis, "but the strain on the country . . . would be taken as an extremely bad sign," he adds. And reopening hundreds of stocks at once could later prove impossible. "If we close it, we would never open it," Mr. Phelan says bluntly.

Despite the intensifying pressures to close, the market was still officially open at 12:30.

Tuesday, 12:38 p.m. With the closing of the Big Board seemingly imminent and the market in disarray, with virtually all options and futures trading halted, something happened that some later described as a miracle: In the space of about five or six minutes, the Major Market Index futures contract, the only viable surrogate for the Dow Jones Industrial Average and the only major index still trading, staged the most powerful rally in its history. The MMI rose on the Chicago Board of Trade from a discount of nearly 60 points to a premium of about 12 points. Because each point represents about five in the industrial average, the rally was the equivalent of a lightning-like 360-point rise in the Dow. Some believe that this extraordinary move set the stage for the salvation of the world's markets.

How it happened is a matter of much conjecture on Wall Street. Some attribute it to a mysterious burst of bullish sentiment that suddenly swept the markets. Some knowledgeable traders have a different interpretation: They think that the MMI futures contract was deliberately manipulated by a few major firms as part of a desperate attempt to boost the Dow and save the markets.

According to this theory, the rally in the MMI futures contract was caused by a relatively small amount of concerted buying by one or more major firms at a time when it was so thinly traded that the orders had an enormous and disproportionate upward thrust. By forcing the futures contract to a premium to the underlying cash value of the index, the buyers of the futures could trigger immediate buying of the stocks in the index and selling of the futures by index arbitragers. Because so many of the MMI stocks are in the Dow, this would enable the NYSE to reopen many of these stocks at higher prices, leading to an upturn in this psychologically important index. At the very least, the buyers could flash a powerful bullish signal to the markets.

Mr. Mahlmann says he doesn't know whether this is what happened, but he says it is possible. "The market was extremely thin at that point," he recalls.

Statistics supplied by the Board of Trade lend circumstantial support to the thesis that the index was driven upward by a small number of sophisticated buyers. During the half hour -- 12:30 to 1 p.m. in the East, 11:30 to noon in Chicago -- that encompassed the extraordinary rally, only 808 contracts traded, representing an underlying cash value of the index of about $60 million. The actual cost to someone buying those contracts can't be precisely determined, but it would have been a small fraction of the cash value.

Of the 808 contracts traded, about 70% were purchased at low commission rates. That indicates that the buying came from major Wall Street firms with their own traders on the floor. Only 30% of the buying came from so-called locals -- smaller, independent traders who trade for their own and customers' accounts. The Board of Trade's statistician says this is an abnormally low percentage of local buying. Which firms were doing the buying couldn't be determined. Major firms contacted, including Morgan Stanley & Co., Kidder Peabody & Co., PaineWebber Inc., Goldman Sachs and Salomon Brothers, all either denied that they were responsible for the buying or declined comment.

As news of the rally in MMI futures reached the New York Stock Exchange (major firms maintain open lines both to their traders in Chicago and to specialists in New York), the market got another important psychological boost: the announcement of stock buybacks by major corporations. This, too, appears to have been encouraged by major investment banks, many of which spent Tuesday morning frantically calling chief executives of major clients urging them to buy back their stock. First Boston, for example, called about 200 clients.

"It looks like there's almost a get-together on the part of corporate America to prop up the market," Stanley Abel, a consultant specializing in buy-backs, observed that day. Among the companies announcing buy-backs were Shearson Lehman Brothers Holdings Inc., Merrill Lynch, Citicorp, Honeywell , ITT, Allegis, four regional Bell companies and USX.

The precise timing of those announcements and any accompanying purchases are difficult to pinpoint, but some occurred during the crucial hour between 12:30 and 1:30. The USX specialist, for example, says trading in USX was halted at 12:43 p.m. because of a sudden influx of buy orders following the company's buyback announcement.

Floor traders at the Chicago Board of Trade say the major securities firms that maintain direct contact with specialists in New York were the first to learn of such buy orders, which in turn led to further buying by those firms of the MMI futures whenever the contract traded at a discount to the underlying cash index. (Indeed, the locals in Chicago have long complained that because the MMI consists of only 20 stocks, it can be manipulated by the major firms with access to Big Board specialists.)

A graph of Tuesday's movement in the MMI futures contract is consistent with such observations. At 12:45, the MMI contract had moved to a sharp premium to the underlying cash value of the index (so many of the stocks weren't trading that the underlying cash value was calculated using recent trades that probably overstated its true value at the time). The graph shows that the contract immediately turned downward, as traders presumably sold the futures and began to buy the underlying stocks, thereby locking in a profit.

One index arbitrager admits using such a strategy. "I did it very, very cautiously," he says. "I was terrified of the market. But it was a very profitable move."

If the goal of those buying the MMI futures beginning at 12:38 was to drive up the Dow, it succeeded brilliantly.

Tuesday, 1 p.m. Like water on parched earth, buy orders began flowing into securities firms and into the stock exchange.

Banks, including the recalcitrant Bankers Trust, had finally pledged their support after receiving reassurances from the Fed, giving specialists and other firms the financial confidence to execute orders. The Fed told the banks that they were free to increase their borrowings at the Fed's discount window. New York's Chemical Bank increased its loans to securities firms for that week by $400 million above normal, a bank official says.

All told, the 10 biggest New York banks nearly doubled their lending to securities firms that week to $12 billion, pumping in an extra $5.5 billion.

A spokesperson for Bankers Trust says, "We were able to accommodate routinely the financing requirements of our major customers in an environment characterized by great uncertainty. The requirements of most others were met after greater than usual consideration."

As the buy orders reappeared, large capitalization stocks -- especially those in the MMI -- began coming back to life. Merck reopened at 1:15, albeit 21 points lower, and IBM reopened at 1:26 at 112, unchanged from two hours earlier. By 2 p.m., when USX reopened, up 62 1/2 cents, all the MMI stocks were trading.

Mr. Phelan told his counterparts at the other exchanges in New York and Chicago that the day's threat of closing had passed, that the immediate crisis was over. At the Amex, Mr. Shear got on the loudspeaker to announce that MMI options would resume trading in 15 minutes. Mr. Melamed ordered the resumption of futures trading on the Merc, and the Board of Trade's Mr. Mahlmann breathed a great sigh of relief. "We were immensely pleased that the market came back and that we were the ones who stayed open," he says.

Tuesday, 4 p.m. The stock market ended its tumultuous day with a record -- and psychologically crucial -- gain of 102.27 points in the Dow. Volume was also a record 608,120,000 shares, a little higher than on Black Monday. On the Big Board overall, 1,398 stocks declined. Only 537 gained.

The Dow's rise partly reflected the strong peformance of the stocks that make up the MMI. Throughout the afternoon, the MMI futures traded several times at a premium to the cash index, apparently triggering buying of the underlying stocks. The performance of the MMI futures diverged significantly from that of the S&P 500, which remained at a deep discount to the index even after it reopened.

Because of the Fed's aggressive move to drive down interest rates by flooding the system with liquidity, the bond market, too, rallied strongly, providing crucial support for the broader financial system. "If the bond market had been going the same direction as the stock market -- down -- that would have been the straw that broke the camel's back," Mr. Phelan says.

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On Wednesday, Americans woke to newspaper headlines proclaiming the largest rise in the Dow's history. A wave of optimism washed over the exchanges. The stock market that day was to have a real rally -- 186.84 points on the Dow, with 1,749 stocks gaining.

In the end, the stock market and financial system didn't collapse on Tuesday. Although trading losses -- mainly in takeover-related stocks -- ran into hundreds of millions of dollars, no major securities firm defaulted on its obligations to customers or was rendered insolvent. A few specialist firms merged or were forced to find new infusions of capital; most survived. But privately, key participants say they were deeply shaken by how close to catastrophe the system came.

And the crisis in the financial system revealed glaring weaknesses that are being closely examined in Congress. The New York Stock Exchange specialist system -- despite some heroic efforts -- proved inadequate to meet the demands of huge international flows of capital, nearly triggering a shutdown of the exchange and a public crisis of confidence. Though there is little to suggest that program trading or portfolio insurance caused the crisis, both contributed to a degree of volatility that the system couldn't handle.

"The markets will be nothing but an open casino if you let this continue," Mr. Phelan says.

More worrisome, many officials note, is that the crisis occurred in the absence of any true calamity. What might happen to the markets in a major political or economic crisis? Could a real meltdown happen?

"I won't even get into that," the Merc's Mr. Melamed says.