The day Wall Street collapsed

The book review of 'A First-Class Catastrophe'

A First-Class Catastrophe 

The Road to Black Monday, the Worst Day in Wall Street History

By Diana B Henriques 

Henry Holt & Company

393 pp; $32

Diana B Henriques is an award-winning financial journalist and a best-selling chronicler of the Bernie Madoff Ponzi scheme. Her new book focuses on a 30-years-ago crisis — the Black Monday debacle of 1987 when the stock market turned in a one-day loss that, on a percentage basis, was almost twice as large as the steepest drop in 1929. In making her case for the importance of the 1987 crash, Ms Henriques has produced a valuable and unfailingly interesting account of a crucial two-decade period in Wall Street history — when markets made a full-bore transition from serving individual investors to a system dominated by giant corporations, mostly trading for themselves, and competing by means of arcane computer algorithms and spectacular processing speeds.

A critical factor in her tale is the “financial future.” Futures are an old instrument used in trading commodities, like wheat. At spring planting, farmers and wholesale buyers could execute future contracts to lock in prices at harvest. Futures regulation, however, wasn’t fully formalised until the creation of the Commodity Futures Trading Commission (CFTC) in 1974.

A portentous milestone was passed when the Chicago Board of Trade and the Chicago Mercantile Exchange, or “the Merc,” started trading financial futures on a host of instruments — Treasury note interest rates, government-issued mortgage bonds, foreign currencies and various stock index futures, like Value Line and the S & P 500 stock indexes. After a jurisdictional catfight between the CFTC and the Securities Exchange Commission (SEC), the regulators settled into an uneasy truce, although the Chicago institutions consistently outgunned the SEC and the New York Stock Exchange in creativity and aggressiveness.

It took only about a decade for futures and related instruments like options to dominate Wall Street trading. The intellectual motivation came from new axioms of “efficient markets” and “rational agents” that held that untrammelled markets were always self-correcting. Portfolio mathematics superseded fundamental business analysis. Computers and new cadres of “quants” reigned.

In the 1970s, two young professors at Berkeley’s business school, Hayne E Leland and Mark Rubinstein, conceived the idea of “portfolio insurance,” a technical method for protecting the value of a large institutional portfolio. They joined with John O’Brien, a highly sophisticated trader and a master salesman, to form a company, Leland O’Brien Rubinstein Associates (LOR), that soon was racking up stunning sales.

LOR’s product was a set of algorithms that clicked in during a market downturn to limit losses. When the insurance algorithms were triggered, computers would sell futures to lock in a pricing floor, and then reverse the process as markets recovered. The concept was simple, but its execution requirements were formidable.

Sceptical customers asked what would happen if the markets didn’t step up and buy futures at “rational” prices. That was easily waved off. Yes, in panicky markets, the futures clearing prices might be lower than the rational price, but canny traders would soon recognise the bargains on offer. That glibly danced by a scarier issue, however — the sheer scale of portfolios that were protected by insurance. A truly serious downturn could trigger huge robotic futures sales that could overwhelm the capacities of the traders.

And that duly happened on Black Monday, October 19, 1987. After several weeks of slipping markets, floods of computer-driven futures orders hit the Chicago markets, overwhelming their systems and driving a steep plunge in futures prices, many all the way to zero, which signalled no bids at all. As futures prices collapsed, the implacable insurance algorithms accelerated the selling. Ms Henriques gives us a gripping, almost minute-by-minute account of the weeks that followed, including the posturings, the denials and the panics, as well as the “web of trust, pluck and improvisation” that pulled the markets through.

Summing up the crisis, Ms Henriques places blame on “disparate, blindly competitive and increasingly automated markets … gigantic and increasingly like-minded institutional investors” and “a regulatory community that was poorly equipped, ridiculously fragmented, technologically naïve and fatally focused on protecting turf.”

Ms Henriques overstates her case, however, when she writes that “more than a trillion dollars in wealth had been lost.” And she cites a comment from President Reagan at an impromptu news conference during the worst days of the crisis that “all the business indices are up. There is nothing wrong with the economy,” which she compares to Herbert Hoover’s complacency in 1930.

Actually, Reagan was right. The economy was fine. From 1986 through 1989, real (inflation-adjusted) growth was 3.5 per cent, 3.5 per cent, 4.2 per cent and 3.7 per cent. The 1980s stock market was a roller coaster. It opened with historically low price-earnings ratios, which allowed canny leveraged buyout investors to snap up solid companies at bargain prices. As copycat investors flooded into the buyout markets, the quality of deals deteriorated — laughably, one major acquisition was insolvent on the day the deal closed. The trillion-dollar drop in market values was just a recognition of reality. The saps who took the losses were counterbalanced by the lucky investors who got their money out in time.

That said, Ms Henriques is quite right that the quant-driven market complexities of the 1980s finally caused a real crash in 2007-8. Sadly, the deregulatory crusaders of the current administration seem to have paid no attention.
 

© 2017 The New York Times News Service