Section 7. Reagan's Junk Bond Bubble: Why the 1987 stock market crash? (March 31, 2013)

Prelude to the "Globalization"

The phrase, "Overdose of anything, no matter good or bad, will eventually turn into poison", applies to the fever of the reduction of tariff as well. The rush to protectionism during the Great Depression was considered to have made the depression worse. Thus after The World War II, cutting tariffs has been considered as the panacea to stimulate the global economy. The international trade was regulated by GATT (General Agreement of Tariffs and Trade) until 1995 when it has been replaced by WTO (World Trade Organization). The major role of GATT was to negotiate tariff reductions in the mutually advantageous way. Many rounds of tariff reduction talks were held under GATT. Up to 1970s the rule of "mutually beneficial" was adhered, and The U. S. did not suffer any runaway trade deficit as discussed in Section 6. However, the negotiation from 1973 to 1979, called "Tokyo Round1", was different; that round cut both tariffs and non-tariff barriers substantially, and allowed developing countries to export textiles into the developed world by a substantial amount. The experts engaged in "Tokyo Round" ignored the danger of potential currency market manipulations to create monstrous global trade imbalances that eventually torpedoed the global economy as described in previous sections. "Tokyo Round" itself did not have time to pose ill effect until early 1980s. In this section we will discuss how the tariff reduction fever in couple with Reagan administration's fiscal policy had created the first phase of the runaway U. S. trade deficit. The runaway trade deficit in turn ignited the "junk bond bubble". It was the burst of the "junk bond bubble" that triggered 1987 stock market debacle, and finally ushered in 1991 recession.

The rise of Japan

Japan had played the major role as the counter part of the trade with The U. S. during Reagan era. U. S. trade deficit with Japan had counted more than 90% of total U. S. trade deficit during 1980s. It is important to understand why Japan was able to cause such an impressive trade deficit on The U. S. side, especially considering the lack of explicit currency market manipulation by Japan at that time.

Japan's modernization has started at Meiji Restoration in 1868. Before Meiji Restoration, warriors, called "Samurai", dominated Japan for nearly 700 years. Civilians were suppressed and got a habit to obey the dictatorial powers from above. Japan's path to modernization followed the model of Prussia, the mix of militarism and state capitalism. The militarism created War Lords. On the side of industrialization, Japanese Government nurtured industries, and then turned them over to favored families. That was how Japanese Business Lords (called Zeibatsu2), like Mitsui, Mitsubishi, Sumitomo, Yasuda and so on, were created. With War Lords and Business Lords as two wheels, industrial Japanese pushed ahead, and Japan had become a newly industrialized military power quickly.

Japanese military lords wanted to colonize China. At that time Chinese Nationalists, led by Chang Kai-shek, was about to defeat Chinese Communists led by Chairman Mao, and reunify the whole China. From the fear that once Chang Kai-shek reunified China, the chance for Japan to colonize China would be lost, Japanese War Lords started the full scale invasion of China in 1937. Contrary to the plan of Japanese War Lords to destroy Chang's army in a few months and then force Chang to the negotiation table, Chang fought Japanese invaders vigorously. Though no match to Japan's modernized mechanical force, Chinese Nationalists retreated into mountainous western China and continued to fight with Japanese army. The vast eastern China fell into the hands of Japanese military. But the vastness of China forced four million plus Japanese army to spread thinly. Japanese army lost the ability to reconcentrate and launch effective attacks against Chinese Nationalists. Thus Japanese military stuck in the mud of Chinese Theater. In the meanwhile The U. S. imposed oil embargo against Japan to punish its invasion of China. Starved for oil that drives its military machines, Japanese war lords planned to take Indonesia, the rich oil production region at the time. However, to reach Indonesia, Japanese must go through Philippine, a colony of The U. S.. This means that Japan must neutralize U. S. Pacific fleet that call Perl Harbor at Hawaii as home base. The result is the surprise attack of Perl Harbor and the full scale war with The Allies. The war ended with Japan's surrender in 1945, after attacked by two atomic bombs at Hiroshima and Nagasaki.

At the end of WWII, The Allies had decided to get away from the mode of punishment used against Germany after WWI, since it only helped the emergence of Hitler. The new approach was to rehabilitate Germany and Japan into democracies. On the Japan side, the role of transforming Japan into a peaceful democracy was undertaken by the U. S. occupation force under the command of General MacArthur.

Under the plan to turn Japan into a peaceful democracy, Emperor of Japan has been reclassified as a political symbol without any actual power; Japanese Emperor was regarded as a divine figure by Japanese before and through the war. A peace constitution that bars the regular military has been imposed. Only a self-defense force that lacks the ability to project long range attacks is allowed. On the economic front, Business Lords (Zeibatsu) were also disbanded. Japanese Zeibatsu were constructed around family controlled core banks and many varieties of businesses controlled by those core banks in turn. In other words, a Japanese Zeibatsu is a family controlled huge conglomerate. Though Zeibatsu were disbanded, the necessity of other businesses in a former congrlmerate to rely on the core banks for financing remained. Thus in place of former Zeibatsu, there emerges looser groups of businesses gathered around the former core banks with cross ownership of stocks as the links. Such a newly emerged business group in Japan is called "Keiretsu"3.

The transition from Zeibatsu (Business Lords) to Keiretsu has given businesses substantial autonomy so they have started to compete with the ones in different Keiresu fiercely. The core banks also started to compete with one another to expand their market share. Thus the room was created for new businesses to emerge. The best known example is the emergence of SONY. Through 1950s and 1960s Japanese economy grew rapidly, powered by the fierce competition and dedicated workers very royal to the companies in which they worked. Japan's innovation and productivity improvement based growth was temporarily set back by the first energy crises, since Japan needs to import almost all of its energy needs. However, Japan engaged in a vigorous energy saving mode after the first energy crises, and weathered substantially better the second energy crises than others. At the dawn of 1980s, quite a few categories of made-in-Japan goods had strong competitive power over similar goods made in other developed countries. Thus japan was ready to take advantage of lowered trade barriers and flood the global market with made-in-Japan goods.

The First Phase of the Runaway U. S. Trade deficit and Reagan's Junk Bond Bubble

In a society where there are scant direct foreign investments, like Japan, to have excessive trade surplus is like to give up its own blood to nourish others. To understand this fact, let us assume that the factories of the country manufacture one billion dollar worth of goods and export them to foreign countries. On the account of GDP this one billion dollar is booked as an addition. However, if this one billion dollar worth of goods at the whole sale level is consumed by the domestic consumers, more values are created as the goods move through the chain from whole sale to retail sail, so more than on billion dollars will be added to GDP. At the early part of 1980s, Japan was at such a robust stage, and ready to give its blood away to nourish The U. S.. Of course, with massive giveaway of its blood, Japan's rate of growth had gradually slowed down, though the pain of diminished growth was slow to be felt due to the robust innovation and productivity gain in Japan.

After the end of the second energy crises and the tame of U. S. inflation, the condition for Japan to display its industrial muscle had arrived. Riding on the wave of reduced tariff and non-tariff barriers, the fruit of Tokyo Round of GATT talk, Japan's trade surplus vs. The U. S. had started to rise. However, during the first half of 1980s when the U. S. trade deficit vs. Japan rose sharply, Japanese Yen was oscillating in the range between 200 Yen per Dollar to 250 Yen per Dollar. There was no sigh of currency market manipulation by Japan during that period. So why did the vigilante mechanism of the free currency market failed to push up Japanese Yen and squashed the runaway trade imbalance between two countries? Let us discuss this mystery next.

In Section 2 we have discussed "The Currency Market Manipulation of the Second Kind". It is for the exporting country to lower interest rates unilaterally to suppress its currency to aid its exports. This manipulation is actually a two way street. A country may push up its interest rate unilaterally to boost its own currency and induce its trade deficit, too. That was what Reagan Administration did.

The fiscal policy of Reagan Administration was to cut tax, increase defense spending, but no meaningful curtailment of social spending. The natural result of such policies was the sharply expanded government budget deficit. However, knowing the painful outcome of high inflation in the Carter era, Reagan Administration did not ask The Federal Reserve just to print money to cover the deficit. Instead Reagan Administration sold massive amount of Treasuries into the open market to cover the short fall. As the consequence market interest rates were kept high. On the other hand high inflation of Cater era had been slained by the iron fist monetary policy of Volcker FED, so the market interest rates was substantially higher than the inflation rate as shown in the graph at the right. Under such a condition, called high real interest rate environment, many Japanese financial entities wanted to invest in the lucrative U. S. Dollar denominated instruments. Thus when dollar flooded into the currency market wanting to be changed into Yen due to the runaway Japanese trade surplus, many Japanese financial institutions gleefully scooped up those dollars and brought them back to U. S. money market to be invested in high yielding Dollar denominated instruments. That was the reason why the vigilante mechanism of the free currency market was nullified so Japanese trade surplus and U. S. trade deficit kept running away.

As has been discussed in Section 3, the runaway U. S. trade deficit causes massive amount of foreign owned dollars to flow into the money market. Then in Section 4, it has been pointed out further that those foreign owned dollars in the money market crowd out personal savings to serve as the seed money for the whole economy. It should be noted that the trade deficit generated dollars can speed up the velocity of money circulated through the society compared to the case of personal savings serving as the seed money. Let us consider the following case: Suppose a foreign made product is sold to a consumer for $200, with $100 as the cost of the goods when it passed U. S. custom. This $100 is quickly returned to the foreign exporter, sold in the currency market for the foreign currency, gathered by some foreign institutions or the foreign government, and brought back to U. S. money market to be lent out again. On the other hand what happens if a domestically produced $200 good is sold to a consumer? Through the retailor this $200 is distributed to the employees, the suppliers and stock holders as dividends. The suppliers distribute their share to their employees, their suppliers and their stock holders, and so on. The money went into the hands of employees and stock holders will be spent to buy some thing again. Through this repeated circulation of the original $200, some small amount will be saved at each iteration. We can see that it will take time to save $100 from a $200 purchase. This example shows that the velocit of money induced by the returned dollars generated by trade deficit will be larger than the case of personal saving. Thus with the runaway trade deficit, the economy can grow more explosively than relying on personal saving as the seed money. During Reagan era, the first phase of the runaway trade deficit had generated an economic boom in that manner.

It has also been pointed out in Section 3, Wall Street speculators will be in the front seat to borrow from the money market flushed with the returning dollars generated by the runaway trade deficit. During the Reagan phase of the runaway trade deficit, Wall Street speculators poured the borrowed money into stocks of the companies targeted by corporate raiders. The resulting high yielding junk bonds issued in the process of corporate raiding and leveraged buyouts were in turn bought by yield hungry parties like savings and loans. A raider buys a block of the stocks of the target company and then announces the intention to take over the company by buying up all the remaining stocks of the target company. The raider asks the owners of the remaining stocks to vote for a board appointed by the raider to replaces the existing board to take over the company. If successful, the raider-appointed board will use the rich assets of the target company as collateral to issue a large amount of bonds, and use the money raised to buy back all the stocks with a rich premium to the market price before the announcement of the raiding. Since with such a heavy debt load, the rating of the target cmpany naturally falls to the level of "junk", so those newly issued bonds are called "junk bonds". Junk bonds carry very high interest rates to attract yield hungry investors. However, the existing bonds issued before the raiding still carry low interest rates, but their ratings also fall into "junk" along with the company. Thus the existing bond holders become the biggest losers. Leveraged buyouts are the cases that the management of the target company acts just like a raider to take their own company private in order to prevent the raider to control the company. The boom of junk bonds was aided by the claim that a junk bond issuing company will exit the junk status quickly because it is pushed to undertake its business vigorously and to manage the company efficiently. Therefore, the junk bond boom is a win-win game; a win for the junk bond holders and a win for the whole society via the reinvigorated economy. However, common sense tells us that a company loaded with heavy debts like junk bonds is vulnerable to economic head winds so most likely will not survive an economic down turn. As will be discussed later, the common sense won eventually, proved by the burst of Reagan's junk Bond bubble.

With the proliferation of corporate raiding and leveraged buyouts, many investors got huge windfall profits. Those windfall profits are thrown into the stocks of other potential targets and other ordinary stocks. Thus a huge stock market bubble was formed. we call this Reagan era stock market bubble as "Reagan's Junk Bond Bubble". Money gained from this junk bond bubble enriches many stock holders and then trickled down to the whole society. That was the reason why the wealth gap widened rapidly during 1980s.

The Burst of Reagan's Junk Bond Bubble and the 1987 Stock Market Crash

The first phase of runaway U. S. trade deficit, started at the latter part of 1982, inflicted heavy damage to U. S. manufacturing industry in the hands of massive high quality and reasonably priced made-in-Japan goods, thanks to the high flying U. S. Dollar generated by the interest rate gap resulting from Reaganomics as discussed before. The complaint from the domestic manufacturers rose to the level that could not be ignored by 1985. At the early 1985, an international conference was held at Plaza Hotel of Lake Placid, New York State. In the conference it was decided to let U. S. and Japanese Governments jointly intervene the currency market to bring down the high flying Dollar vs. Japanese Yen. As the result, Dollar fell quickly from the level near 250 Yen per Dollar to 125 Yen per Dollar. In the meanwhile Japanese Government had agreed in the Plaza Accord to stimulate Japan's domestic economy in order to divert Japan's youthful industrial energy away from export and into Japan's domestic consumption. Thus the infamous Japan's land price bubble was formed.

A major change of currency exchange rate trend takes substantial time delay to show its effect on the trade balance. Let us take the exchange rate between Japanese Yen and U. S. Dollar as the example. Japanese exporters will not hastily close their production lines just because of a sudden rise of Japanese Yen vs. U. S. Dollar. Japanese exporters will try to hold on to their market share by cutting their costs and suffer lower profit margins. Only when Yen rises relentlessly vs. Dollar, Japanese exporters will finally not be able to sustain their efforts to keep the market share and let their production and exports wane. Then the trade imbalance will dissipate. In general the goods exported have higher profit magine, longer the time delay from the movement of currency exchange rate to the turning of trade imbalance becomes. In case of made-in-Japan goods, the time delay is about 2.5 years4. Therefore, around the latter half of 1987, U. S. trade deficit vs. Japan, that is, more than 90% of U. S. trade deficit at that time, had started to wane.

The waning trade deficit meant that the influx of foreign owned dollars to the money market had stagnated, too. Thus the speed of the expansion of the junk-bond bubble had slackened. As the rise of stock prices had slowed down, Wall Street speculators, who were incurring substantial borrowing costs, felt pressure to lighten up their stock holdings and to pay back the borrowed money, so the bubble started to unravel. That was the condition led to the fateful October of 1987.

When an investor buys a stock, it is often advised to set a stop loss order. The logic of setting a stop loss order is as follows: When an inevstor buys a stock, it is based on the expectation that the stock will rise. If the price of the stock declines, instead of just holding the stock and waiting for the rebound, it is better to bite the bullet and sell at a pre-determined price, since the stock may race down to nothing. The level to sell is called the level of stop loss. Due to the human nature of second guessing own judgment, it is difficult to actually sell when the stop loss level is reached. The stop loss order is to tell the broker to put the instruction of selling the stock automatically if the stock falls down to the predefined stop loss level. However, stop loss order has a huge draw back. In order to put a stop loss order, the broker must ask either a specialist or a market maker to put the order on their data base so that the stock can be sold automatically when the stop loss price level is reached. This means that the intention of the investor is revealed to other people trading actively in the stock market. Many times on a dull noon time with small trading volume, the price of a stock suddenly drops quite a bit, and then rise rapidly. There always are suspicions that traders who know those stop loss levels are deliberately dropping the prices to clean up those orders and then let the stock shoot up. In other words the ones put in stop loss orders become the biggest fools. Especially large professional money managers will never do such foolish suicidal things like stop loss orders. As computer advances and the trading by computer has become the reality, the stop loss levels are naturally programed in the computer controlled by the investor itself. When the price level is hit, the computer will automatically execute the sell order. Then experts, using the computer power, have pointed out that instead of using the old fashion one stop "stop loss level", it is safer and more efficient to set multi stop loss levels. When the first stop loss level is hit, just sell a portion of the stock. Sell another portion of the stock when the second stop loss level is hit, and so on. All those stop loss levels are all programmed into the computer, and the stop loss levels are calculated by sophisticated computer programs, using the historic trends as the guide. This computer automated multi-stop-loss-level approach is called "dynamic hedging", and was the very popular technology around 1987.

When only a small number of money managers were using "dynamic hedging", it was a very good way to minimize loss in a stock market rout. Unfortunately when many money mangers use "dynamic hedging", it turned into a guarantee that the users of "dynamic hedging" will lose big. This certainty to loss is due to the fact that "dynamic hedging" programs use past stock performance to calculate multi-stop loss levels. That means that various "dynamic hedging" programs used by various money managers all had similar multi-stop loss levels. Let us see how the 1987 crash had unfolded and triggered huge losses for those dynamic hedging model users. The real culprit of the 1987 crash was, of course, the so called "globalization process" that had created the explosive U. S. trade deficit. The exploding trade deficit had induced Reagan's "Junk Bond Bubble". As U. S. Dollar had been engineered to drop big against Japanese Yen from early 1985, U. S. trade deficit had started to wane by the middle of 1987. Thus the pace of rising stock prices slowed down. Some Wall Street speculators had started to dump stock holdings since the profit from stock trading could not cover the borrowing cost any more. The stock prices in general had started to fall. When the first stop loss level was reached, the computers of all dynamic hedging model users started to sell stocks at once. That action forced stock prices down sharply, triggering the second stop loss level, and so on. By this way computers programed for the dynamic hedging models sold more and more stocks, driving down the market sharply. When human had noticed what was going on and pull the plugs of the computers, a huge damage was done already.

The above analyses show that the 1987 crash was not a random event, but bound to happen in 1987. The role of "dynamic hedging model" based computer trading was to condense many weeks of falling stock prices into a few hours. The next question is why the recession did not follow the 1987 crash immediately; the recession had arrived four years later after the 1987 crash.

The Belated Recession

U. S. manufacturers were hit hard during the first phase of runaway trade deficit in Reagan era, but were not destroyed since the era of the runaway trade deficit was still young. As U. S. Dollar devalued down sharply against Japanese Yen from 1985 and the runaway trade deficit waned in 1987, U. S. manufacturers had rebounded. On the other side Japan had kept the promise made at Plaza Accord at early 1985 and had loosened monetary policy to usher in the infamous Japan's land price bubble. The rampant boom in Japan also induced more exports from the newly revitalized U. S. manufacturers. Thus, in spite of the 1987 crash of the stock market, the growth rate of the real economy of The U. S. declined very slowly as can be seen from the above graph. Seeing the resilience of the real economy, investors soon returned to the stock market and the damage done by the 1987 crash was repaired gradually. In the meanwhile, helped by the vastly depreciated U. S. Dollar and the bubble in Japan, U. S. trade deficit kept falling. However, as 1990 approached, the momentum carried by the revitalized manufacturing sector had run its course. At that time Japanese Government had also started to rein in the runaway land price based bubble. Thus the growth of U. S. economy started to stagnate. Finally the junk bond issuing junk rated companies fell like autumn leaves and had pushed the economy into a recession.

The corporate raiding and the leveraged buy out boom had ended in 1987 and the issuance of new junk bonds had also ceased. Junk bonds typically carry a maturity of 5 years, so the existing junk bonds did not need to be refinanced for quite a while. The influx of new money into the money market, though dminished, were still enough for the normal business borrowing. This fact in couple with loosened monetary policy after the 1987 crash sustained the expansion of the real economy in the period from 1988 to 1990. However, as time went on, more and more existing junk bonds needed to be refinanced, but the shrinking money market due to the falling trade deficit could not support the refinancing of those junk bonds. Thus many junk rated businesses that had issued junk bonds crashed down, inflicting heavy losses on the junk bond holders. Quite a few savings and loans were among the big losers by holding those defaulted junk bonds.

Some venturesome savings and loans borrowed from the money market to invest in junk bonds and to make risky loans. The borrowing from the money market were short-term borrowing so required continuous refinancing. As the trade deficit waned and the supply of liquidity from the money market became scarce, those speculative savings and loans issued higher and higher yielding CDs to cover their refinancing. Under such condition the default of many junk bonds pushed quite a few savings and loans into insolvency. Some bankrupted savings and loans were state chartered. Their down fall had revealed the fact that state sponsored deposit insurance funds did not have enough money to honor the deposit insurances. Naturally depositors started to run on those state chartered savings and loans. The Federal Government was forced to step in, using tax payer's money to bail those savings and loans out and converted all of them to federal chartered status so FDIC can be used to pay the defaulted depositors. That was the well known "savings and loans crises". In such an environment, consumer confidence and spending fell. That in turn created hardship on many businesses, forcing them to restructure, meaning laying off a large number of workers. High unemployment depressed consumer confidence and spending further, forming a vicious cycle to push the economy into a recession in 1991. During the recession the natural trend of trade balance took over, and U. S. trade deficit fell further to near zero. The 1991 to 1992 recession marked the end of Reagan's junk bond bubble. After the recession, the second phase of runaway trade deficit had started. In the next section how the second phase evolved will be the main focal point.

1. From the link from Wikipedia and more references contained there.
2. From the link from Wikipedia and more references contained there.
3. From the link from Wikipedia and more references contained there.

4. article 2 and article 2A on our website

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