Free Bailout Nation by Barry Ritholtz Page B

the markets. By August, the S&P 500 had gained about 40 percent year-to-date. September was a bit rocky, sliding 10 percent from the highs—but that was to be expected. Nothing goes up in a straight line forever, right?
    But then came October. Things took a turn for the worse, as the Dow Jones Industrial Average slid 3.8 percent on Wednesday, October 14. On Friday, October 16, the blue chips lost another 4.6 percent. The crash occurred on Black Monday (October 19)—when the Dow plummeted a harrowing 22.6 percent.
    We can spend many hours going over all of the conditions precedent to the crash, but that is another book entirely (the interested should read Black Monday , by Tim Metz). While there is still academic debate over the causes of the crash, for our purposes, let’s note as sufficient causal elements the combination of portfolio insurance—a derivatives product that utterly failed to work as advertised ( let’s hear it for innovation! )—a creaky New York Stock Exchange (NYSE) infrastructure, and Treasury Secretary Baker’s remarks over the weekend implying we were no longer supporting the dollar.
    The actual crash is a fascinating part of stock market history. Those of you who wish to become serious students of the market must familiarize yourself with what occurred. Panics may vary from generation to generation, but we learn that human nature is immutable.
    It is not the crash itself, however, but rather the actions of various parts of the government that are of particular interest to us.
    The response from the Federal Reserve was swift. Before the market’s opening on Tuesday, October 20, the Fed issued the following statement: “The Federal Reserve System, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.”
    Note that the address is to the system, threatened by the large movement downward of asset prices . The central bank then added substantially to reserves through open market operations. Over the next two weeks, the federal funds rate fell to 6.5 percent from 7.5 percent just prior to the crash.
    But the Fed’s pledge was not sufficient to halt the sell-off. According to Tim Metz, author of Black Monday (Beard Books, 2003), there was a slight problem prior to the opening of the markets the next day: Most of the NYSE floor specialists were technically insolvent. Not only had they absorbed enormous losses during the crash, but the various bank lines of credit they used each day had disappeared. It looked like the crash was going to continue Tuesday, with the Dow off 6 percent in the morning. It wasn’t until New York Federal Reserve President Gerry Corrigan jawboned banks into restoring credit lines—and somehow turned off futures information between New York and Chicago—that the mother of all Turnaround Tuesdays took place.
    It is a classic example of the authority of the Fed being used to avoid what looked like a full-blown liquidity crisis.
    â€œ . . . the Fed’s responsibilities to serve as lender of last resort was intended to reverse the crisis psychology and to guarantee the safety and soundness of the banking system” was how Robert T. Parry, president of the Federal Reserve Bank of San Francisco, described the Fed’s actions at a University of California at Davis conference 10 years later. 2 He affirmed what the Fed saw as its proper role.
    Now, it’s at precisely this point in our narrative that we must stop for a moment to point out something you may not have taken the trouble to consider before. Exactly why did the Fed become in charge of psychology? The central bank was originally established to bring financial order to the early Wild West days of banking. Somehow, resolving fiat currency issues and supervising credit morphed into a far more subjective role. Michael Panzner, author of the prescient