|Pic from the movie 'Wall Street'|
The next and more interesting hearing was held on April 21, 1988 and covered "program trading" ('Program Trading and Stock Market Volatility'), which was the technical reason why the Dow fell 22% that day. That hearing featured John Bachman, senior partner at Edward Jones and former Chairman of SIFMA; James Higgins, former Chairman and COO of Dean Witter's consumer markets division (now Morgan Stanley Dean Witter); Jeffrey Lane, former Chief Operating Officer of Shearson Lehman Hutton; and William C. Roney Jr., former Senior Partner of brokerage firm Roney & Co (now part of Raymond James).
At the beginning of the first video (2:20), John Galbraith essentially blamed Shearson Lehman Brothers and Drexel Burnham Lambert, investment banks that issued junk bonds for leveraged buyouts (LBOs) in the 80s, for causing the market volatility. At 24:30, the witnesses discussed the rise in corporate leverage and debt-to-equity ratios, and at 28:30, Galbraith said the rise in leverage posed a risk to the financial system. He ended up being right. Junk bonds and commercial real estate loans caused the Savings and Loan crisis, which ended up costing tax payers $124 billion and the thrift industry $29 billion (FDIC). 1,043 thrifts with over $500 billion in assets failed between 1986 and 1995. It's interesting that the same exact thing happened to the financial system in 2008 with mortgage-backed securities and synthetic CDOs, but this time the whole financial system collapsed and was bailed out with trillions of dollars.
Here is a news report on Drexel's involvement in the the Savings and Loan crisis. It featured Jim Grant, editor of the popular 'Interest Rate Observer' newsletter.
During the hearing they talked about an article John Galbraith wrote for the Atlantic Magazine in January 1987, which warned about the parallels between 1987 and 1929. I found it online. Here was the part on leverage.
"The more exciting parallel is in the rediscovery of leverage. Leverage is again working its wonders. Not in utility pyramids: these in their full 1929 manifestation are forbidden by law. And the great investment houses, to be sure, still raise capital for new and expanding enterprises. But that is not where the present interest and excitement lie. These lie in the wave of corporate takeovers, mergers, and acquisitions and the leveraged buy-outs. And in the bank loans and bond issues, not excluding the junk bonds, that are arranged to finance these operations. The common feature of all these activities is the creation of debt. In 1985 alone some $139 billion dollars' worth of mergers and acquisitions was financed, much of it with new borrowing. More, it would appear, was so financed last year. Some $100 billion in admittedly perilous junk bonds (rarely has a name been more of a warning) was issued to more than adequately trusting investors. This debt has a first claim on earnings; in its intractable way, it will absorb all earnings (and claim more) at some astringent time in the future. That time will come. Greatly admired for the energy and ingenuity it now and recently has displayed, this development (the mergers and their resulting debt), to be adequately but not unduly blunt, will eventually be regarded as no less insane than the utility and railroad pyramiding and the investment-trust explosion of the 1920s."
"It is, alas, an illusion. The mergers, acquisitions, takeovers, leveraged buy- outs, their presumed contribution to economic success and market values, and the burden of debt that they incur are the current form of that illusion. They will one day—again, no one can say when—be so recognized. A fall in earnings will render the debt burden insupportable. A minor literature will marvel at the earlier retreat from reality, as is now the case with the Penn Square fiasco and the loans to Latin America."
He was 21 years early on that call, but we still have a decent amount of debt outstanding in the nonfinancial corporate space.
|Source: St. Louis Fed|
The hearing on program trading was more interesting. The 1987 stock market crash was similar to the 2010 flash crash in that they both involved computerized trading, index futures, and were sparked by large institutional trades. Shearson Lehman Hutton's chief operating officer and the heads of retail brokerage firms tackled the issue from an institutional and retail perspective. I also found a Shearson Lehman ad from 1990 on program trading. It seems like program trading was the evil threat to the markets at that time, similar to high frequency trading today. Towards the end of the hearing they talk about market manipulation, insider trading and front running. If you think about it, nothing has changed in 25 years. Most of the credit market still trades over-the-counter, stock market crashes are still caused by automated trades, and orders are still manipulated and now hidden in dark pools (not sure how you can prevent crashes). After 25 years, I still don't understand why all publicly traded bonds don't trade on the NYSE in lower denominations to boost liquidity and transparency. I've been blogging about this since the 2008 financial crisis. Actually more bonds are starting to trade on the NYSE. More transparency and liquidity in the credit market would price risk more efficiently in the financial system. The too-big-to-fail banks still operate the opaque illiquid over-the-counter credit and derivative markets that destroyed the financial system in the first place (see what Greg Smith, ex-Goldman VP, had to say about this - 1, 2). They will do it again, and it won't be because of mark-to-market accounting this time around! (in my opinion).
Want to see Drexel hearings? Here is junk bond king Michael Milken at a hearing but they didn't allow cameras after he swore under oath. However, I found former Drexel CEO Frederick Joseph testifying before congress. Drexel brokers were trading in the bonds they were issuing internally.