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.
Skeptical 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 recognize 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, Oct. 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 signaled no bids at all. As futures prices collapsed, the implacable insurance algorithms accelerated the selling. 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, 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.”
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 percent, 3.5 percent, 4.2 percent and 3.7 percent. 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, Henriques has produced a highly intelligent and perceptive analysis of an important transitional era in modern finance. She 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.