The Federal Reserve’s Response to the 1987 Market Crash

The following statement was issued before markets opened on Tuesday, October 20, 1987:

“The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system” (Carlson 2006).

On Monday, October 19, 1987, Chair Greenspan traveled to Dallas to deliver a prescheduled speech at the American Bankers Association. The Federal Reserve Vice Chair, Manuel Johnson, gathered a group at the Board of Governors’ office in Washington, DC. The group included: Donald Kohn, the director of the division of monetary affairs; Edwin Truman, the staff director of the division for international finance; William Taylor, the staff director for bank regulation and supervision; and General Counsel Michael Bradfield. The group monitored international markets overnight and drafted a statement on liquidity. Before being published on Tuesday morning, the statement was reviewed by Greenspan and Gerald Corrigan, president of the Federal Reserve Bank of New York (Murray 1987).

The demand for US Treasury securities with certain maturities increased sharply as investors exited equity markets. To alleviate some of the pressures in the Treasury market, the Federal Open Market Committee members agreed to temporarily suspend:

1. The size limits imposed on loans of securities to individual dealers
2. The requirement that such loans not be related to short sales (FOMC 1987).

In order to provide more of the Treasury securities with in-high-demand maturities into the market, the Federal Reserve effectively entered into reverse repurchase agreements with the primary dealers. The Federal Reserve would lend Treasury securities with maturities that were in high demand to the primary dealers. As collateral for the loan, the primary dealers would give the Federal Reserve Treasury securities with maturities that were not in high demand (FOMC 1987b).

“The federal funds rate dropped from above 7-1/2 percent just before October 19 to 7 percent and below immediately following the stock market collapse” (FOMC 1987a).

The prevailing monetary policy regime focused on influencing the money supply; short-term interest rates were a secondary focus. As seen in the following quote, the FOMC tracked the federal funds rate, but the amount of fluctuation the committee would tolerate was much greater than it would later be when the policy regime shifted to influencing the short-term interest rates directly. Notes from the next scheduled FOMC meeting following the market crash read, “The members agreed that the intermeeting range for the federal funds rate, which provides a mechanism for initiating consultation of the Committee when its boundaries are persistently exceeded, should be reduced from 5 to 9 percent to 4 to 8 percent.” (FOMC 1987a).

Continental Illinois (the bank that had been bailed out in 1984 and gave rise to the term “too big to fail”) subsidiary First Options of Chicago Inc. was hit with substantial losses on Black Monday. First Options looked to Continental Illinois for emergency funding; however, when First Options was purchased by Continental Illinois, regulators placed lending caps on the amount of funding Continental Illinois could provide to First Options. It is reported that “Greenspan acted quickly to enable Continental Illinois Corp., the bank’s holding company, to inject funds into the options subsidiary. Without that action, one official says, ‘the options exchange would have shut down’” (Chicago Tribune 1987; Cohen 1987; Murray 1987).