Wall Street: From Free Fall to Fail-Safe

THE problems that attacked the world's financial markets in October 1987 are still threatening, and market defense systems are too weak to prevent another crash. Even without economic disaster, stock and related markets can collapse again. Surprisingly, the public ignored the most frightening lesson of 1987: that markets reacted in a disastrous manner to non-disastrous events. The true crash was not the collapse in prices, but the failure of the financial system to cope in an orderly fashion with a cluster of negative, but not out of the ordinary, economic and political events.

What went wrong? The trading mechanism collapsed, and specialists in major exchanges and marketmakers in over-the-counter markets were unable to maintain orderly and continuous trading. Malfunctioning systems created extreme price volatility, delays in openings, trading halts, unexecuted orders, mistakes, and general confusion. At several points, officials considered closing the exchanges.

The most disastrous thing that can happen to financial markets is an information blackout. Because of computer failures, delays in openings, trading halts, unreliable indexes, and loss of trust in the information system, it was often impossible to determine trade prices or even to know in what direction markets were moving.

Somehow the pricing mechanism righted itself, chaos faded, and some analysts called the crash ``smart.'' But ``Black Monday'' delivered a clear warning: Market defenses are critically weak.

Regulations and procedures that were adapted after the 1929 crash to protect Wall Street from disaster functioned reasonably well for half a century. Why did they fail in 1987?

The answer is simple. Market mechanisms promulgated early in Franklin D. Roosevelt's administration are inadequate to cope with today's complex financial products and systems. Despite the advent of the computer age and the internationalization of financial markets, the rules that control Wall Street remain almost unchanged since they were designed in the 1930s during the New Deal.

FDR wouldn't recognize today's markets:

Computers permit millions of dollars' worth of securities to be traded in seconds.

Market volatility has increased substantially. Until a few years ago, a 30-point swing in the Dow Jones industrial average in one trading day was unheard of.

Simple trading of stocks and bonds has been overshadowed by highly complex, creative financial devices such as index trading, futures, complicated market timing and asset allocation models, hedging transactions, program trading, arbitrage, portfolio insurance, junk bonds, and complex tender offers relating to takeover and leveraged buyouts.

The level of debt has increased throughout the economy, resulting in higher sensitivity to crisis situations.

The market has become institutionalized. Most trading is conducted by a few large financial institutions, and many transactions are inspired by insiders, the legality of which is at best unclear.

International financial boundaries have fallen. The existence of one interdependent global megamarket increases the risk of a cross-market snowball effect. When funds can move easily from nation to nation, control and regulations in any one country become less effective.

In recent years, more and more transactions are made for short-term profits rather than long-term investment.

Stock markets are interacting with futures and index markets, creating in the price-searching process complex relationships that are sensitive to extreme situations and difficult to control.

Brokerage houses that originally served as agents for individual investors have become big traders for their own accounts, large portfolio managers, investment bankers, and dealmakers in the takeover game, creating possible conflicts of interest.

Financial institutions, pension funds, banks (including savings-and-loans), and insurance companies that should be averting risks have become speculators.

New regulatory agencies have been created, resulting in an uncoordinated policing system.

No single factor triggered the 1987 crash, which occurred during the nation's longest period of prosperity. Storm signals were flying, but none of the economic problems were new when Black Monday dawned, nor were they catastrophic, even when considered in combination. They had been around for years, and they are still with us today. The market was actually more overpriced in August 1987 than in October. Economics and politics alone did not pull the trigger in 1987.

The old mechanisms created in FDR's days simply could not tolerate the pressures. Wall Street's defense system is hopelessly out of date. Factors that in a bygone era would have resulted in a normal, gradual market correction created a crash in 1987.

The warning of 1987 should not be ignored. In its post-crash study, the General Accounting Office reported to Congress: ``Had the precipitous decline continued for even another day, massive disruptions to the United States financial system might have occurred.''

Unless the system is strengthened, another massive crash may occur again, even in response to a random combination of non-catastrophic events.

What can be done to remedy the situation? While the experts do not all agree on the details, one conclusion is clear: Critical problems exist in the way the financial systems work, and these problems should be dealt with promptly.

This conclusion was ignored in 1988 by politicians who shied away from such a Pandora box during an election year. Control agencies that cannot agree on who should control what and large investment houses with vested interest in maintaining the status quo are also disregarding the warnings.

Explanations on what went wrong and a detailed list of options on what to do are buried in thousands of pages of professional reports. Courageous, farsighted leadership is required to evaluate this well of information and come up with immediate policy measures to solve the problems. Similar steps should have been undertaken a few years ago on the S&L problem.