Plunge Protection Team
By Brett D. Fromson
Washington Post Staff Writer
Sunday, February 23, 1997; Page H01
The Washington Post
It is 2 o'clock on a hypothetical Monday afternoon, and the
Dow Jones industrial average has plummeted 664 points, on
top of a 847-point slide the previous week.
The chairman of the New York Stock Exchange has called the
White House chief of staff and asked permission to close the
world's most important stock market. By law, only the
president can authorize a shutdown of U.S. financial markets.
In the Oval Office, the president confers with the members of
his Working Group on Financial Markets -- the secretary of
the treasury and the chairmen of the Federal Reserve Board,
the Securities and Exchange Commission and the Commodity
Futures Trading Commission.
The officials conclude that a presidential order to close the
NYSE would only add to the market's panic, so they decide to
ride out the storm. The Working Group struggles to keep
financial markets open so that trading can continue. By the
closing bell, a modest rally is underway.
This is one of the nightmare scenarios that Washington's top
financial policymakers have reviewed since Oct. 19, 1987,
when the Dow Jones industrial average dropped 508 points, or
22.6 percent, in the biggest one-day loss in history. Like
defense planners in the Cold War period, central bankers and
financial regulators have been thinking carefully about how they
would respond to the unthinkable.
An outline of the government's plans emerges in interviews with
more than a dozen current and former officials who have
participated in meetings of the Working Group. The group,
established after the 1987 stock drop, is the government's
high-level forum for discussion of financial policy.
Just last Tuesday afternoon, for example, Working Group
officials gathered in a conference room at the Treasury
Building. They discussed, among other topics, the risks of a
stock market decline in the wake of the Dow's sudden surge
past 7000, according to sources familiar with the meeting. The
officials pondered whether prices in the stock market reflect a
greater appetite for risk-taking by investors. Some expressed
concern that the higher the stock market goes, the closer it
could be to a correction, according to the sources.
These quiet meetings of the Working Group are the financial
world's equivalent of the war room. The officials gather
regularly to discuss options and review crisis scenarios because
they know that the government's reaction to a crumbling stock
market would have a critical impact on investor confidence
around the world.
"The government has a real role to play to make a 1987-style
sudden market break less likely. That is an issue we all spent a
lot of time thinking about and planning for," said a former
government official who attended Working Group meetings.
"You go through lots of fire drills and scenarios. You make
sure you have thought ahead of time of what kind of
information you will need and what you have the legal authority
to do."
In the event of a financial crisis, each federal agency with a seat
at the table of the Working Group has a confidential plan. At
the SEC, for example, the plan is called the "red book"
because of the color of its cover. It is officially known as the
Executive Directory for Market Contingencies. The major U.S.
stock markets have copies of the commission's plan as well as
the CFTC's.
Going to Plan A
The red book is intended to make sure that no matter what the
time of day, SEC officials can reach their opposite numbers at
other agencies of the U.S. government, with foreign
governments, at the various stock, bond and commodity
futures and options exchanges, as well as executives of the
many payment and settlement systems underlying the financial
markets.
"We all have everybody's home and weekend numbers," said a
former Working Group staff member.
The Working Group's main goal, officials say, would be to
keep the markets operating in the event of a sudden,
stomach-churning plunge in stock prices -- and to prevent a
panicky run on banks, brokerage firms and mutual funds.
Officials worry that if investors all tried to head for the exit at
the same time, there wouldn't be enough room -- or in financial
terms, liquidity -- for them all to get through. In that event, the
smoothly running global financial machine would begin to lock
up.
This sort of liquidity crisis could imperil even healthy financial
institutions that are temporarily short of cash or tradable assets
such as U.S. Treasury securities. And worries about the
financial strength of a major trader could cascade and cause
other players to stop making payments to one another, in which
case the system would seize up like an engine without oil. Even
a temporary loss of liquidity would intensify financial pressure
on already stressed institutions. In the 1987 crash, government
officials worked feverishly -- and, ultimately, successfully -- to
avoid precisely that bleak scenario.
Officials say they are confident that the conditions that led to
the slide a decade ago are not present today. They cite low
interest rates and a healthy economy as key differences
between now and 1987. Officials also point to SEC-approved
"circuit breakers" that were introduced after 1987 to give
investors timeouts to calm down.
Under the SEC's rules, a drop of 350 points in the Dow would
bring a 30-minute halt in NYSE trading. If the Dow declined
another 200 points, trading would cease for one hour. No
additional circuit breakers would operate that day, but a new
set would apply the next trading day.
Despite these precautions, today's high stock market worries
officials such as Fed Chairman Alan Greenspan, who in a
speech in early December raised questions about "irrational
exuberance" in the markets. Because the market declined
following Greenspan's speech, government officials have
become even more reluctant to comment on these issues for
fear of triggering the very event they wish to forestall, according
to policymakers.
A Brewing Concern
Greenspan had expressed similar thoughts a year ago at a
confidential meeting of the Working Group. Treasury Secretary
Robert E. Rubin and SEC Chairman Arthur Levitt Jr. also are
concerned about the stock market's vulnerability, according to
sources familiar with their views.
The four principals of the group -- Rubin, Greenspan, Levitt
and CFTC Chairwoman Brooksley Born -- meet every few
months, and senior staff get together more often to work on
specific agenda items.
In addition to the permanent members, the head of the
President's National Economic Council, the chairman of his
Council of Economic Advisers, the comptroller of the currency
and the president of the New York Federal Reserve Bank
frequently attend Working Group sessions.
The Working Group has studied a variety of possible threats to
the financial system that could ensue if stock prices go into free
fall. They include: a panicky flight by mutual fund shareholders;
chaos in the global payment, settlement and clearance systems;
and a breakdown in international coordination among central
banks, finance ministries and securities regulators, the sources
said.
As chairman of the Working Group, Rubin would have overall
responsibility for the U.S. response, but Greenspan probably
would be the government's most important player.
"In a crisis, a lot of deference is paid to the Fed," a former
member of the Working Group said. "They are the only ones
with any money."
"The first and most important question for the central bank is
always, 'Do you have credit problems?' " said E. Gerald
Corrigan, former president of the New York Federal Reserve
Bank and now an executive at Goldman Sachs & Co. "The
minute some bank or investment firm says, 'Hey, maybe I'm not
going to get paid -- maybe I ought to wait before I transfer
these securities or make that payment,' then things get tricky.
The central bank has to sense that before it happens and take
steps to prevent it."
1987: A Case Study
The Fed's reaction to the 1987 market slide, which Corrigan
helped oversee, is a case study in how to do it right. The Fed
kept the markets going by flooding the banking system with
reserves and stating publicly that it was ready to extend loans
to important financial institutions, if needed.
The Fed's actions in October 1987 read like a financial war
story.
The morning after the 508-point drop on Black Monday, the
market began another sickening slide. Corrigan and other Fed
officials strongly discouraged New York Stock Exchange
Chairman John Phelan from requesting government permission
to close the market. Phelan was concerned that if the market
continued to erode, the capital of the NYSE member firms
would disappear. Corrigan feared a shutdown would cause
more panic.
"It was extraordinarily difficult around 11 o'clock," Corrigan
recalled. "The market was at one point down another 250
points, and that's when the debate with Phelan took place."
Simultaneously, Corrigan and other central bank officials spoke
privately with the big banks and urged them not to call loans
they had made to Wall Street houses, which were collateralized
by securities that could no longer be traded and whose value
was in question.
A final critical moment came that day when the Fed decided
not to shut down a subsidiary of the Continental Illinois Bank
that was the largest lender to the commodity futures and
options trading houses in Chicago. The subsidiary had run out
of capital to provide financing to that market.
"Closing it would have drained all the liquidity out of the futures
and options markets," said one former top Fed official involved
in the decision. Investors use stock futures and options to
hedge positions in the underlying stock market.
Recognizing the crucial role of banks if another financial crisis
should strike, the Office of the Comptroller recently conducted
an internal study of what damage a market decline would inflict
on U.S. banks. The OCC declined to discuss the study or its
conclusions.
At the SEC, one big worry is how to cope with an international
financial crisis that begins abroad but quickly rolls into U.S.
markets.
"We worry about a U.S. brokerage firm that is dealing with a
Japanese insurance company, where we don't know how they
are run or regulated," a SEC source said. To improve its ability
to react in a crisis, the SEC and the Fed have begun joint
inspections with their British counterparts of U.S. and British
financial institutions with global reach.
The most drastic -- and probably unlikely -- move the SEC
could take in a crisis would be to propose a market shutdown
to the president. That would require a majority vote of the
commission. If a quorum couldn't be mustered, the chairman
could designate himself "duty officer" and go to the president or
his staff.
"Closing the market is, of course, the last thing the commission
wants to do," said a source familiar with the SEC's planning.
"During a time when people are extremely worried about their
investments, you are cutting them off from taking any action. . .
. The philosophy of the commission is that markets should stay
open."
Just the Facts
Gathering accurate information would be the first order of
business for federal regulators.
"Intelligence gathering is critical," Corrigan said. "It depends on
the willingness of major market participants to volunteer
problems when they see them and to respond honestly to
central bank questions."
The SEC, CFTC and Treasury have market surveillance units.
They monitor not only the overall markets, but also the cash
positions of all the major stock and commodity brokerages and
large traders.
The regulators also are hooked into the "hoot-and-holler"
system used to notify participants in all financial markets of
trading halts. The hoot-and-holler system alerts traders and
regulators when a halt is coming.
Relying on Quick Action
In the event of a sharp market decline, the SEC and CFTC
would be in constant contact with brokerage and commodity
firms to spot early signs of financial failure. If they concluded
that a firm was going down, they would try to move customer
positions from that firm to solvent institutions.
At least this team of crisis managers already has been through
the Wall Street wars. Greenspan was Fed chairman in October
1987. Rubin has served as the co-head of investment bank
Goldman Sachs & Co. Levitt has been both a Wall Street
executive and president of the American Stock Exchange.
"I think the government is in good shape to handle a crisis,"
said Scott Pardee, senior adviser to Yamaichi International
(America) Inc., a Japanese brokerage subsidiary, and former
senior vice president at the New York Fed. "A lot depends on
personal relationships. You have a number of seasoned people
who have gone through a number of crises. So if something
happens, things can be handled quickly on the phone without
having to introduce people to each other."
Consider what happened at 11:30 p.m. Dec. 5, when
Greenspan made his comments about irrational exuberance.
Alton Harvey, head of the SEC's Market Watch unit, was
called at home by officials of Globex, a futures trading system
owned by the Chicago Mercantile Exchange. U.S. stock
futures trading in Asia had fallen to their 12-point limit, they
said.
Harvey immediately alerted his direct superior as well as his
opposite number at the CFTC. More senior SEC and CFTC
officials were informed as well. But there wasn't much to be
done until the morning. So Harvey went back to sleep.
REACTING TO A PLUNGE
After the market crashed on Oct. 29, 1929:
* The Federal Reserve provided loans and credit to financial
systems.
* President Hoover met with business, labor and farm
organizations to encourage capital spending and discourage
layoffs; he also promised higher tariffs.
* Federal income taxes were reduced by 1 percent by the end
of the year.
After the market dropped 22.6 percent on Oct. 19, 1987, the
Federal Reserve:
* Encouraged the New York Stock Exchange to stay open.
* Encouraged big commercial banks not to pull loans to major
Wall Street houses.
* Kept open a subsidiary of Continental Illinois Bank that was
the largest lender to the commodity trading houses in Chicago.
* Flooded the banking system with money to meet financial
obligations.
* Announced it was ready to extend loans to important
financial institutions.
What would happen today during a stock drop would depend
on the particulars. Here are current guidelines:
* If the Dow Jones industrial average falls 350 points within a
trading day, NYSE trading would be halted for 30 minutes.
* If the DJIA falls another 200 points that day, trading would
stop for one hour.
* If the market declines more than 550 points in a day, no
further restrictions would be applied.
SOURCE: The New York Stock Exchange, "The Crash and
the Aftermath" by Barrie A. Wigmore
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