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Black Monday for Greenspan: A Race to Forestall a Liquidity Crisis

By John M. Berry
Washington Post Staff Writer
Sunday, October 19, 1997; Page H01
The Washington Post

When the stock market crashed 10 years ago, Federal Reserve Chairman Alan Greenspan and other central bank officials understood that a huge wave of fear and uncertainty had been set loose that, if not quickly countered, could bring the U.S. financial system to its knees.

Greenspan was so concerned about the looming possibility of a major financial rupture that on the Friday before Black Monday, he convened the first of a series of daily telephone conference calls with other members of the Fed board and officials at the 12 regional Federal Reserve banks. The calls, which continued every workday for two weeks, were intended to keep tabs on what was happening and to decide how to respond.

The fire-fighting atmosphere at the Fed during those tense days is clear from partial transcripts of a conference call around noon the day after the crash.

"I think we're playing it on a day-to-day basis," Greenspan told his colleagues. "And in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos."

E. Gerald Corrigan, president of the New York Federal Reserve Bank, who took the lead role in persuading the executives of many banks and securities firms to continue to extend credit and settle trades when their instincts told them to pull back, underscored the uncertainty.

"It's quite clear that a lot of people are not entirely sure where they are," said Corrigan, who had spent much of that Tuesday morning cajoling and twisting arms in an effort to keep the nation's financial network from crashing as the stock market had the day before.

The biggest weapon in the Fed's arsenal was an unlimited bankroll of cash, which early on Tuesday the central bank committed: "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," said an announcement issued in Washington in Greenspan's name.

The Fed chairman himself had flown to Dallas the day before to make a speech to the American Bankers Association, leaving in early afternoon when the stock market was down but not disastrously so. Met by a senior officer from the Dallas Fed, Greenspan asked how the market had closed and was told its was down "five oh eight." He thought that meant the Dow was off only 5.08 points and relaxed.

His relaxation was brief, for on the way to his hotel he heard radio reports of what had actually happened. In his room, he began a nonstop series of phone calls to Corrigan, Fed officials in Washington, the Treasury, stock and commodity exchange officials and others that lasted until about 11 p.m. During that period, the announcement for the next morning was set. He canceled his planned speech and flew back to Washington the next day on a Gulfstream jet sent by the White House.

Beginning with that morning's announcement, the Fed "maintained a highly visible presence" in financial markets by pumping cash into the banking system every day. The infusions continued through Oct. 30, with the cash going out early each morning, "underscoring our intent to keep markets liquid," Greenspan told Congress a few months later.

From the Fed's point of view, maintaining liquidity was the key to containing the damage from the crash. For instance, investors and securities firms needed to borrow huge amounts to meet obligations, such as margin calls and capital requirements. Corrigan, in his calls, assured the banks and financial firms that the Fed would supply enough cash to make sure there was no liquidity squeeze.

Greenspan later likened this added demand for cash as "similar in some respects to a run on a bank that is fundamentally sound. In the days before deposit insurance, banks attempted to fend off such runs by putting cash in the front window. . . . In a sense, the Federal Reserve adopted a similar strategy following Oct. 19."

Making all that cash available required the Fed to change its daily operating procedures and begin directly targeting the level of overnight interest rates, an approach it has used ever since. In the end, it was able to head off what likely would otherwise have been a disastrous rise in interest rates. Instead of shooting upward, as rates often had done in the wake of earlier financial crises, they quickly fell by about three-quarters of a percentage point.

Meanwhile, the Fed took a series of other steps to head off potential trouble. It placed examiners in the nation's major banks to monitor developments -- such as requests for currency shipments that might signal potential bank runs. And it kept close track of the banking industry's exposure to possible problems in the securities industry while stressing the need to continue to extend credit to firms in the industry. Finally, the Fed also relaxed a series of rules covering the government securities market to keep it functioning relatively smoothly.

Two weeks after the crash, Greenspan was pretty sure -- but not positive -- the Fed's aggressive approach had worked. Financial markets were still unstable, and there was still some risk that foreign investors might decide to pull their money out of the United States, which could have driven down the value of the dollar and put upward pressure on interest rates.

At a Nov. 3 meeting of the Federal Open Market Committee, which includes the Fed board and the reserve bank presidents, Greenspan noted that the stock market was no longer at an unjustifiably high level, while the value of dollar had stabilized and inflation fears had abated. The latter could have forced the Fed to raise interest rates.

"It is conceivable . . . that in retrospect this whole thing could turn out to have been a remarkable blessing. I must tell you that the odds of it coming out that way cannot be very large, but they are not zero either."

The New York Fed's Corrigan thought the financial markets might "settle in," but he was fearful that they might not.

"The other scenario . . . isn't so pretty," he told the FOMC. "And that's a scenario in which for whatever reason . . . there's a sudden hit to the system.

Who knows what the exact trigger might be, but we could find ourselves confronted with another very, very difficult and turbulent set of conditions in the financial markets."

As late as the following January, Greenspan was still sufficiently worried about the possibility of another "sudden hit" to the markets that he reduced the Fed's target for overnight interest rates one more time, a reminder that the central bank stood ready to supply the cash the economy needed. That move annoyed a number of other Fed officials, who felt it was a mistake.

Today many economists believe that the stock market crash was indeed "a remarkable blessing," scary as it was at the time. It relieved a great many pressures that had built up in the U.S. economy that might have forced the Fed to raise interest rates so high that it would have caused an economic slump.

© Copyright 1997 The Washington Post Company

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