The Sorcerer’s Apprentice
On October 19, 1987, the very day of the
crash that brought stocks down by 22%, I was flying to Colorado Springs to
present a paper at the annual Q Group conference. Many of those in attendance
were in up to their eyeballs in the quantitative finance that was putting the
market decline into overdrive. New York Times reporter Diana Henriques has
written an intriguing story about the plumbing of the financial markets where
conflicting regulators, the rivalry between the cash market in New York and
futures market in Chicago, and the emergence of quantitative finance in the
form of portfolio insurance/dynamic hedging forced the stock market to turn in
on itself much like the sorcerer in the Hall of the Mountain King.
She tells a very good story about the
personalities that fueled the rivalry between the SEC and the Commodity Futures
Trading Commission and its parallel rivalry between the New York Stock Exchange
and the two Chicago futures exchanges, the “Merc” and the Board of Trade. The
upshot driving the controversies was that, contrary to what most people
expected, the futures market drove the cash market, a phenomenon that the
regulators were not ready for.
She also is very good describing the
academic and business origins of portfolio insurance where the theories of two
Berkeley business school professors, Hayne Leland and Mark Rubinstein merged
with the business smarts of John O’Brien to form Leland O’Brien Rubinstein
& Associates (LOR) to market their new product. By the way, I overlapped
with Rubinstein in the UCLA finance Ph.D. program in the early 1970’s. At its
core the problem with portfolio insurance is that it required a continuous trading
in the cash, futures and options markets. A breakdown in anyone of these
markets would trigger a massive dislocation. None of this mattered when only a
few investors were engaging in the dynamic hedging necessary to insure a stock
portfolio, but once it became popular among pension managers the assumption of
continuous markets became questionable. By way of example when all is calm,
fire insurance is readily obtainable, but when the whole city is burning down,
there are very few sellers of fire insurance. That is precisely what happened
on October 19th.
Henriques rightly notes that the real risk
to the system occurred a day later when trading halts in both the cash and
futures markets occurred. The markets were rescued by the newly installed Fed
Chairman Alan Greenspan acting as lender of last resort and the timely buying
of an obscure index product by traders Stanley Shopkorn (a friend) of Salomon
Brothers and Bob Mnuchin of Goldman Sachs.
Although Henriques is very good at
describing the drama of the minute by minute trading on the exchanges she
glosses over the big macroeconomic causes of the crash. It was part and parcel of the great 1980s bull
market that took the Dow Jones Industrial Average up from 776 in August 1982 to
2722 just five years later.
In fact the Dow Stood at 1890 as 1986 drew to a close and then skyrocketed to 2722 in less than eight months, a gain of 44%. So no one should be surprised that a correction occurred. Indeed if you were in a coma for most of the year and you woke and saw that the market closed at 1739 on October 19th it would have been logical to surmise that not a whole lot happened in 1987.
In fact the Dow Stood at 1890 as 1986 drew to a close and then skyrocketed to 2722 in less than eight months, a gain of 44%. So no one should be surprised that a correction occurred. Indeed if you were in a coma for most of the year and you woke and saw that the market closed at 1739 on October 19th it would have been logical to surmise that not a whole lot happened in 1987.
The mid-1980’s bull market was fueled by
the 1985 Plaza Accord that was designed to lower the value of the dollars by
dramatically increasing global liquidity, a Fed easing cycle in 1986 caused by
a collapse in the price of oil, and the emergence of leveraged buyouts. By
October of 1987 all three of these factors were called into question as the Fed
began a tightening cycle in early 1987, a very public currency dispute between
the U.S. and Germany broke out into the open thereby questioning the Plaza
Accord and Congress was considering proposals to limit the tax deductibility of
interest deductions associated with leveraged buyouts. Thus the stock market
had every reason to go down. What portfolio insurance and the regulatory
cacophony did was put the decline into overdrive.
Thus I wish Henriques would have devoted
her writing talents to place what happened in 1987 into a broader macroeconomic
context. But make no mistake much of the regulatory issues she discussed remain
with us today and were partially responsible for the 2008 meltdown.
The Full Amazon URL appears at: https://www.amazon.com/review/R3QEZXTEFCWZQ0/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv
No comments:
Post a Comment