Special Report: The Crash, One Year Later

By FELIX G. ROHATYN

A year after Black Monday, the worst day in Wall Street history, an unsettling question lingers: Could it happen again? Yes, answers a senior partner in the Lazard Freres investment banking firm and one of the most respected members of the financial community. The securities markets and the tax system must undergo fundamental reforms, he maintains. Otherwise, inadequate regulation, excessive speculation and overuse of credit could bring on a banking crisis and a stock collapse more damaging than the Crash of '87.

I remember being stunned by the 508-point drop in the Dow Jones industrial average last Oct. 19, but it was not until the morning of Oct. 20 that I became truly frightened. The market, on that day, ceased to exist. One major stock after another was closed and could not be traded. With other markets around the world in a similar state of panic, a major financial crisis was obviously at hand.

What saved the situation, at that time, was not only the self-correction of a free market but also vigorous, direct intervention by Government and business. The U.S. Federal Reserve injected billions of dollars into the banking system and drove down interest rates. Many blue-chip companies announced massive share repurchase programs and drove the market averages back up. The Japanese government urged its securities industry to support the Tokyo market.

In addition to this swift and direct intervention, confidence was maintained by the existence of safety nets and regulatory bodies created during the 1930s, including federal deposit insurance, Social Security and unemployment compensation. There was not a murmur of concern about the banking system since the public assumed, correctly, that the Government was the lender of last resort.

So a financial crisis was avoided. It can even be argued that the actions of the Fed to revive the market, namely pumping huge amounts of liquidity into the economy, provided the stimulus for the strong growth we have seen in 1988. The market has recovered somewhat, and the echoes of the crash are only dimly heard.

But the outward calm is deceptive. The individual investor has been driven away, and a sense of unease is still felt. People are right to feel uneasy: practically nothing has been done to prevent a recurrence of October 1987.

As the dust of the crash is settling, some lessons are emerging. At the same time, an election is upon us. The juncture of these two events provides an occasion to reflect upon what this country wants its financial markets to be. They can be casinos or they can be the lifeblood of future U.S. economic growth. It is a choice that this country can and should make before events make the decision for us.

If we want our markets to be productive instead of self-destructive, fundamental changes must be made. Unfortunately, a year after the near collapse of our financial system, there is virtually no sign of reform. The report on the crash from the presidential commission headed by Nicholas Brady (now Secretary of the Treasury) is a dead letter. The only result appears to be the adoption of "circuit breakers," which would temporarily halt trading during a steep market plunge. That is not a cure for the disease that brought us Oct. 19.

We have yet to address the basic problems: excessive volatility, excessive speculation, excessive use of credit and inadequate regulation. This speculative behavior is not driven by individual manipulators, as was the case in the 1920s and '30s, but by institutions such as pension funds, insurance companies, banks and savings and loan associations backed, in many cases, by state and U.S. Government guarantees. Curbing speculation and promoting investment must be the objectives of reform.

The Brady commission confirmed that heavy trading of speculative "derivative products," like stock-index futures, exacerbated the October crash. It is obvious that futures, options and their kin are securities and should be treated as such. Their trading should be regulated by the Securities and Exchange Commission. The fact that they are now regulated by the Commodity Futures Trading Commission has simply turned the securities markets into commodity markets.

The margin requirements on the use of credit to make investments should be uniform for options, futures and their underlying securities. For any of these instruments, investors should have to put up at least 50% of the purchase price. Current margins range from 50% for stocks to as little as 5% for some types of futures. Speculation will be dampened if speculators have more of their own capital at risk.

Volatility could be curbed with taxes on short-swing profits. We should impose a 50% tax on profits from the sale of securities held for less than one year. At the same time, capital gains on securities held for more than five years could be reduced from a maximum of 33% to 15%, possibly on a sliding scale. The effect of such a tax change would be to inhibit short-term trading activities of large institutional investors by making long-term holdings much more attractive economically.

Since the banking system virtually underwrote the securities industry last October, it is appropriate that the Federal Reserve be given the regulatory power to make sure that the investment firms and the specialists at the exchanges have adequate capital to cope with market swings. The greater and greater assumption of risks by the securities industry requires significantly higher levels of permanent capital to support such risks.

The problems, however, go much deeper than that. The deregulation of the financial markets has helped produce a stunning amount of corporate and personal debt. In particular, almost $200 billion worth of high-yielding junk bonds has been issued over the past few years, a substantial part of which was used in connection with takeovers and restructurings. In certain instances, the use of a reasonable amount of high-yield debt can easily be justified. However, it is questionable whether businesses can service all of this debt while investing for growth. A recession could bring a wave of defaults.

The proliferation of speculative financial instruments is tied to the new role of institutional investors. In fact, the term institutional investor is becoming a contradiction in terms. Too many institutions no longer invest. Instead they speculate -- in every type of financial vehicle from options to junk bonds, from real estate to foreign exchange. They are active players in the takeover game, encouraging corporations either to sell out or to engage in highly leveraged restructurings essentially aimed at maximizing short-term trading profits. But while the managers of institutional funds engage in this speculation, the money is not theirs. They are risking the assets of retirees, depositors and policyholders. Since many of these institutions carry the explicit or implicit guarantee of the states or the Federal Government, they are also putting the taxpayers at risk.

Junk bonds are piling up on top of a huge mountain of existing debt. The world's commercial banks hold almost half of the $1.2 trillion in Third World debt. That debt is choking growth in half the world, and most of it will never get repaid. At the same time, both banks and savings and loan associations have made billions of dollars' worth of bad loans to the real estate and energy industries.

The price that the taxpayers will pay for too rapid financial deregulation and laxness in oversight is murky at this time, but, in the long run, will be staggering. Bank bailouts may well cost the taxpayers billions of dollars. Even though the Federal Deposit Insurance Corporation has a fund of about $15 billion to deal with banks in difficulty, this is not likely to be adequate to deal with the amount of trouble that could arise as a result of a serious recession and Third World-debt defaults. American banks have an exposure of close to $100 billion to Third World borrowers; a 50% loss in the market value of these debts, if it were to be officially acknowledged, would require nearly $50 billion of capital support, more than three times the size of the present FDIC fund. Existing loan-loss reserves would provide part of the capital, but not nearly enough to cover the exposure. Estimates on the ultimate cost of rescuing the S and Ls increase almost daily, with some experts predicting $50 billion to $70 billion as the possible charge to the taxpayers.

To protect the taxpaying public and promote investment instead of speculation, Government regulators should sharply limit the amount of junk bonds and other risky investments held by institutions insured by federal and state agencies. In addition, the federal deposit insurance system should be revamped to ensure that it encourages prudent management at financial institutions. At the moment, regulators bail out mismanaged S and Ls and often turn them over to new owners who commit little or no capital of their own and who get a free ride to continue the institutions' speculative activity at no risk to themselves.

The U.S. should encourage equity investment and discourage excessive debt % through changes in the tax laws. Specifically, the double tax on dividend payments by corporations should be eliminated. In many European countries, companies are taxed only on retained earnings and not on profits distributed as dividends. This is not the case in the U.S., where dividends are taxed first as corporate income and then as personal income. The European method favors dividend payments and makes stocks more attractive to investors; it should be adopted in the U.S. At the same time, we should limit the federal tax subsidies of speculative corporate debt by reducing, to some extent, the deductibility of interest for overleveraged nonfinancial companies.

We were very lucky last October. Lucky not only because decisive steps by various governments stabilized the situation, but also because the bond market and the dollar did not crash along with stocks. One does not have to be a prophet of doom and gloom to sketch a possible downside scenario despite current strong economic statistics. With the trade deficit still high, inflation on the rise, no resolution to Third World debt problems and no decisive action on the federal budget deficit, we could see another steep decline of the dollar, a spurt in interest rates, a break in bond prices and a new plunge in the stock market. Major securities firms could have their capital seriously impaired by portfolio losses in their stock and bond inventories. Ultimately, loan defaults by Third World countries, financial and real estate firms, overleveraged companies and other borrowers could produce a banking crisis.

We have created a gigantic financial house of cards. We have had fair warning about its weakness. It is no coincidence that the explosion in speculation during the past few years has been accompanied by a significant increase in the level of illegal or unethical behavior in the financial community. Charges of insider trading, market manipulation, conflicts of interest and securities fraud are more and more common. The media have made their own contribution to this frenzied climate. They have turned raiders and junk-bond kings into a new economic elite, and takeovers into the highest form of business endeavor. But the combination of highly volatile markets and reports of irresponsible behavior by many in the financial community has undermined public confidence in the fairness of the system.

Confidence in our financial markets has been an enormous national asset. It fueled our economy during the past 40 years. At a time when the need for domestic investment is very great, that confidence must be restored. And it can only be restored through swift and strong action by federal regulators, Congress and the White House.