By Ron Cooper
The events on Black Monday had traders, bankers and average Americans alike shaking their heads in wonder. In a wonderfully mangled metaphor, one electrician said to another on the New York subway: "That’s the price of voodoo economics coming home to roost."
Wall Streeters have since offered their own perspectives, all of which sound a little like Richard Huber's. "It's a different world than it was on October 15," said Huber, head of investment banking at Citicorp. Indeed, the way Washington views the US securities industry, and the way that Wall Street sees itself, may never be the same.
Some of this, of course, has been exhaustively reported in the media. Not quite all. Our investigators noticed the following:
- surprisingly, commercial banks may get limited underwriting powers despite the market crash
- foreign acquirers, especially European, have for the moment deserted US M&A markets
- the woes in junk bonds spell big trouble for bridge loans
- swaps emerged a clear winner from the market turmoil.
There were many other legacies of Black Monday. One of the most important is the Washington perception of events.
In a sense, Washington likes to think of itself as a hero of the market crash. "From the Washington standpoint, the only reason the market didn't fall apart even more was the intervention of Washington and the Fed to save the Street from itself," said Donald Coxe, chief portfolio strategist at Wertheim Schroder. And, in truth, liquidity was helped enormously by the Fed's lowering key rates and pumping money into the system, not to mention unofficial Washington arm-twisting to get a host of stock buybacks off the ground.
Yet others on Wall Street remain convinced that Washington – aside from a few key individuals – still knows nothing of what makes the Street tick. "There is a combination of distrust and lack of understanding between Washington and our industry that will persist," said Peter Cohen, chairman of Shearson Lehman Brothers. Cohen isn’t particularly worried about any new regulations that will emerge from Washington. Rather he is concerned with Washington's ignorance of "what capital markets are all about, how they reflect psychology and sentiment" in the general economy. President Reagan's October speech – in which he said the economy was strong and had little to do with Wall Street – did nothing to mitigate Cohen's concern.
From the regulatory point of view, Black Monday raised so many issues that regulators don’t know which to tackle first. David Ruder, Securities and Exchange Commission chairman, hinted at some interesting possibilities in Senate testimony. In prepared remarks, Ruder said possible changes could include lowering merger barriers, and increasing capital and margin requirements for market-makers. The SEC will "study" a host of other issues, ranging from program trading and who should regulate futures markets on through to volatility itself.
The view from the Street has changed radically, too. The securities industry now has a sense of fragility that wasn't there before. “There's a sort of growing sense of vulnerability, that we could be bought up so cheaply from abroad, now that the dollar is so much lower," said Wertheim's Coxe. "It's a sense of: Who are we going to be working for two years from now?"
Others are more philosophical. John Heiman, vice chairman of Merrill Lynch Capital Markets, saw Black Monday as the latest in a series of "rolling tests" that are probing the weaknesses in the global marketplace. The crash, he said, was preceded by a series of other disparate tests – the closing of the Singapore Stock Exchange, the tin crisis in London, the perpetual floating rate note disaster, the fixed-income trading losses in New York in April.
Some tests may come sooner than expected. The Glass-Steagall issue, for instance, is not nearly as moribund as some would like to think. The popular conception is that Black Monday buried any tinkering with Glass-Steagall in the near future.
Tell that to Senator William Proxmire. By November 9, Proxmire – the darling of the commercial banks for his opposition to Glass-Steagall – had met top Fed and Treasury officials. He was lobbying for support, with some success, to get portions of Glass-Steagall repealed.
Said Herman Greene, an attorney at Mayer, Brown & Platt who specialises in Glass-Steagall: '"The banks want power in three areas: insurance, real estate, and underwriting. The lobbies may be too powerful in the first two, especially during an election year. Securities houses have less popular support. The key is that banks are far better mobilised now than in the past, and for the first time banks have the clear support of all federal regulators. Banks just may get something limited in the underwriting arena. "
Naturally, investment banks and commercial banks view the effect of Black Monday on Glass-Steagall quite differently. "The firms who went out of business as a result of the events of October 19 are the small firms, the specialist firms, those who had high concentrations," said Douglas Ebert, head of investment banking at Manufacturers Hanover. "I think this supports our argument that a stronger, more diversified financial services industry – including commercial banks – is a critical element in minimising systemic risk."
One senior investment banker saw this line of thinking as self-serving hogwash. "I could make the argument that during a period of financial unrest it was comforting to know that there was a certain part of the financial system that was protected from some of what went on," he sniped anonymously. "When the going gets tough, there are very few firms that will stand up and provide liquidity, whether they are empowered to or not."
Glass-Steagall aside, other issues face Wall Street today. One is the effect of recent events on mergers and acquisitions. Most see M&A in general continuing at a brisk pace.
"The notion of buying and selling and restructuring could change," said Thomas Strauss, president of Salomon Brothers. “Surely the valuation process could change significantly. But they are still very much a part of the financial landscape."
Ebert of Manufacturers Hanover even saw some positive effects, looking out into 1988 and 1989. "We see more deals and better quality deals. We think the whole M&A business should be more attractive." One reason: acquisitions that were being done at 12 or 13 times earnings before the crash could now be done at eight or so, he noted,
One of the two Wunderkinds at First Boston's vaunted M&A team, co-head Joseph Perella, saw at least temporary difficulties. “What you've got now," Perella said, "is a big crisis in confidence in the US on the part of Europeans in particular, more so than the Japanese. I sense a lack of commitment in terms of doing anything here.” For M&A in general, Perella predicted a two-month period of what he termed "intense uncertainty and shakeout" before things returned to normal.
It may take a while longer for the junk bond market, which has gone from one unhealthy extreme to another. Said Perella: “There was a time when almost any [junk bond] deal could get done. Now almost no deal can get done."
Perella made that comment two days before Southland Corp delivered what may be a knockout blow to junk bonds. Beset by tax and other uncertainties, the junk bond market was merely dismal before Southland had to postpone a $1.5 billion offering on November 10. It cited "current market conditions" for the delay. In reality, underwriters Goldman Sachs and Salomon couldn’t find takers.
To compound the misery, both Goldman and Salomon were left holding $100 million in "bridge loans" to Southland. Each had syndicated $200 million or so more apiece to an unidentified group of banks. That fiasco certainly won't kill off bridge loans, but it will give pause to other merchant bankers. In mid-November, Kidder, Shearson and others reportedly still held loans that weren’t refinanced into junk bonds before the market crash.
"Once you make these loans," noted Perella, “there are two ways out. One is a divestiture; the other is a financing. If the financing shuts down, people are going to be more reluctant to make bridge loans."
Same investment banks were fortunate enough to have refinanced bridge loans just before Black Monday. Those bond prices have plummeted, and investors question whether asset sales will bring in sufficient cash to repay the bonds. A Burlington Holdings issue done by Morgan Stanley sold at 100 on September 23; by early November, it traded at 88 bid.
All this raises the question how corporate treasurers will fund themselves in the post-crash environment. Many commercial bankers claim that treasurers may revert to plain vanilla bank loans instead of "trying to be a hero and squeeze an extra two or three basis points out of some exotic source of funding," said Citi's Huber.
Traditional loans would be sought especially by lesser credits, Huber said. But triple-A-rated companies "will continue to have a broad array of opportunities" in debt and equity markets. Shearson chairman Peter Cohen noted: "There will be plenty of money around. Whether it's through the banking system or commercial paper activities, the short- and long-term end of debt financing capacity will be great."
For all the woes and heartache caused by the market crash, there are none the less a few silver linings. "Aberrant hiring practices" and inordinate bonuses will go out of the window, Cohen said. He suggested that a 50% cut in some bonuses might be in order,
"It'll also get margins back in certain businesses where rampant competition has just destroyed them," he said,
At Manufacturers Hanover, investment banking chief Ebert saw some acquisition opportunities. Manny Hanny stayed on the sidelines when American firms were snapping up British securities houses during Big Bang. It had planned a UK securities acquisition for 1988-1989, but the market crash may accelerate its plans. "There have got to be some opportunities over there," Ebert said. It may also "selectively expand" its commercial paper business.
Some sectors of the financial industry even – gulp – made money out of the crash. The swaps industry, for one, made out quite nicely, thank you.
Swaps was one of the few businesses to emerge from the rubble of October 19 a clear winner.
"October was one of our best months ever, said Robert Schwartz, head of global swaps for Chase Manhattan. In some weeks, volume exceeded $1 billion, said Schwartz. Manufacturers Hanover had a volume increase of 15% to 18% for September-October over March-April, usually its peak volume season for the year. "In times of extremis," admitted one senior investment banker, "the strong swaps houses do a lot more business."
The driving forces were volatility and uncertainty about interest rates. The action was in dollar interest-rate swaps. "What the volatility did was galvanise a lot of people into action," said Schwartz. "Every corporate that was thinking about fixing a rate for the next six months wanted to get in."
Liquidity virtually disappeared during the week of October 19. Almost every user wanted to pay fixed. The following week, the pendulum swung all the way to the other end: all users wanted to receive fixed as interest rates began to ratchet down in earnest. By the third week, a measure of normality had returned.
Still, the week of Black Monday provided its thrills. "The first few days were crazy," Schwartz recalled. "It was awfully hard to get a firm Treasury price." An understatement, according to other observers. In that single week, US Treasury rates – the benchmark against which interest rate swaps spreads are measured – dropped 150bp. In the three-year-and-under market, "you saw swaps spreads changing 20 basis points within an hour," said Michael Rulle, head of swaps at Shearson Lehman. “At some points there was hardly a market." This market mirrored the Eurodollar futures market, which was extremely volatile and thin.
The disappearance of two-way markets was worrying, and there is no guarantee that it won’t happen again in a big market swing. What do swaps houses do when all their clients want to jump in one direction? "About all you can do is hope you're weighted on the other side," said Rulle. "Then you try to move it out and hope. You can't walk away from clients. You might try to broker things in certain situations. You might try to put in prices that you think are too high to be hit. You just try to manage it."
Worried that it couldn’t lay off some deals, Chase reverted to an old stand-by: matched trades. Matching has lost cachet as big swaps houses have moved aggressively into exotica like portfolio hedging. "We found a payer on one side and a receiver on the other," said Schwartz. "We locked in the spreads and didn’t even have to trade the Treasuries."
Apparently, no swaps houses got into trouble in the market turbulence. In fact, the industry came through relatively unscathed, and isn't above patting itself on the back. "In a time of stress you usually find the imperfections in a market," Schwartz said. "Everyone behaved professionally – and there were no blow-ups. I don't think any flaws were uncovered in the swaps business."
All that may be true, but there is a nagging thought beyond the illiquidity worry: what if a couple of big swaps began to come unravelled at a most inopportune time?
"Assuming that institutions can withstand losses by a particular counterparty going under, it should not have a flow-through effect," said Shearson's Rulle. "I would be more concerned about that happening in the repo market."
None the less, there are those who believe that swaps and other exotica in financial markets have yet to face their sternest tests. They see Black Monday as the latest in a series of tests that will probe the corners of the global marketplace. And they see this as inevitable, and probably good.