Important Moments in Market History
5 Financial Market Crises and the Lessons Learned
From 1980 to 2009, we examine the context and causes, along with the insights learned.
Black Monday | 1987
Following sharp declines in the previous week, the Dow fell a record 508 points, or 22.8%, on October 19, 1987.
CAUSES: A general fear that stocks had risen too far too fast, the market had gone up by 230% in the course of 5 years.
OUTCOME: The Fed responded with open market operations which cut the federal funds rate from 7.5% to 7.0%. Credit markets were largely unaffected and the economy continued to grow. The stock market fully recovered within less than two years.
LESSONS: A bear market does not have to lead to a recession. Stock market declines that are not validated by economic weakness, should be revered (provided there is not a valuation issue).
Orange County Bankruptcy | 1994
In December 1994, Orange County declared bankruptcy leading 3,000 public employees to be discharged.
CAUSES: The OC Investment Pool, run by Robert Citron, generated strong returns in the early 1990s, betting on falling interest rates. OC municipalities piled into the fund. In less than a year, the Fed raised the federal funds rate from 3% to 6%.
OUTCOME: Citron’s fund lost $1.5 billion, causing them to claim bankruptcy pushing Orange County to declare bankruptcy too.
LESSONS: It really exemplified the problem when the Federal Reserve raises interest rates very rapidly. It taught us a little bit about not being too overleveraged or too committed to one view of the world, as the Citron fund depended upon interest rates staying low. If returns look too good to be true, they probably are.
Long-Term Capital Management | 1998
Hedge fund LTCM, used strategies to exploit small pricing discrepancies in the market, following a Russian default LTCM collapsed.
CAUSES: The fund had $4.7 billion but debt of $125 B. Following a Russian default, LTCM bets went sour and their debts to banks caused financial stability fears.
OUTCOME: The NY Fed organized a bailout of LTCM. The Fed cut rates three times in 1998, stabilizing markets but fueling a stock-market bubble that burst in 2000.
LESSONS: The financial system was vulnerable to big mistakes made by small players. In dealing with one problem, policy makers can sow the seeds of others: the bailout may have encouraged leverage by limiting pain to both principals and creditors.
The Dot-Com Bubble | 2000
Easy money, a booming economy and investor optimism about the internet fueled huge stock market gains.
CAUSES: Wild over-valuation of tech stocks, and capital spending pulled back after Y2K. Vendor financing of capital spending contributed to a recession, amplifying stock market losses.
OUTCOME: A recession and then the shock of 9/11 prolonged the downturn, with the market only hitting a trough in October 2002 with the S&P500 down 49% and NASDAQ down 77%.
LESSONS: Valuations matter. Know what you own, investors unknowingly had many overlapping growth funds. Diversification is key, portfolios that had bonds and commodities fared far better in the early 2000s than the S&P500.
Global Financial Crisis | 2008 - 2009
The bursting of the housing bubble led to the collapse of Lehman Brothers and AIG, triggering a major global recession.
CAUSES: Lax mortgage standards fueled a real estate bubble. Ratings agencies were too cozy with issuers. There was too much leverage among investment banks, and a widespread use of complex derivatives.
OUTCOME: Markets began to recover in March 2009, when the government made it clear that it would not let another major financial institution fail.
LESSONS: With enough leverage and counterparties, even small players can cause financial havoc. Moral hazard is only a useful consideration before a crisis erupts and all financial institutions need higher capital standards.
Recessions and Market Crises since 1980