(Bloomberg) -- On Wall Street, when things decline, you tend to remember. When things decline a lot, you remember the date. Oct. 19, 1987, is one such example. The biggest single-day stock market collapse in history—a 23 percent drop—rendered once-trusted ideas useless and redefined the financial landscape for market professionals.
One of them was a rising Salomon Brothers bond salesman named Michael Lewis, who had yet to pen Liar’s Poker. “The markets in a panic are like a country during a coup, and seen in retrospect that is how they were that day,” he would later write of the chaos he witnessed. “One small group of people with its old, established way of looking at the world is hustled from its seat of power.”
Black Monday, as the day became known, is part of financial history’s fossil record, a divide between old and new markets. It was the first significant instance of computer-driven trading run amok. The nascent equity options market saw assumptions based on the Black-Scholes model overturned and replaced by a more complex world of volatility skews. And Federal Reserve Chairman Alan Greenspan, just two months on the job, got to glimpse a market panic and sell his first “Greenspan Put” under the U.S. equity market.
To mark Black Monday’s 30th anniversary, Bloomberg Markets asked players throughout the marketplace to reflect on the day and its lasting impact. While everyone remembers the 31.25 percent decline in IBM (NYSE:IBM), the real Black Monday story is less about the carnage in equities than what happened elsewhere—in options, futures, and fixed income. There’s also the story of Tuesday, with all its trading and never fully explained (until now!) rally. Most of the people willing to share their memories count themselves as winners who seized the moment as an opportunity not only to make money, but also to insert themselves in the new financial order—Paul Tudor Jones, Stanley Druckenmiller, Nassim Nicholas Taleb. Their story, and the story of Black Monday, is the birth story of modern financial markets—a wild ride of shock, angst, and, for some, glory.
In the weeks before Black Monday, a few investors spotted patterns that gave them pause. The most confident were Paul Tudor Jones and Peter Borish, young partners at a small hedge fund in Lower Manhattan. In a prescient Sept. 24 note to investors, Jones even signed off with “caveat emptor”—buyer beware.
PETER BORISH, head of research at Tudor Investment Corp. and Paul Tudor Jones’s No. 2:
We were tracking exponential moves in the equity market. The main one was the equity move in the 1920s, and the market in 1987 looked almost identical. The week before Black Monday, the technical and fundamentals aligned, and so we thought Monday would be the day.
ALLAN ROGERS, head of government bond trading at Bankers Trust Co.:
In the first half of 1987, the bond and stock markets diverged for seven months. Bonds went straight down, equities straight up. These sorts of divergences always get my attention. In August and September, I persuaded management to cover all of our hedged short positions in sovereign fixed income, and we built up a long position in notes and bonds.
MICHAEL LEWIS, bond salesman at Salomon Brothers:
A week or two before Black Monday, Salomon announced job cuts. They chopped a few departments, including the municipal and money-market groups. It felt ill-considered and rushed. Nobody completely understood why. [Ed. note: Lewis is a Bloomberg View columnist.]
ROGERS:
Nippon Tel, the Japanese telephone company, was going to do an IPO in mid-August. I thought that would pull money from other segments of the equity market. In early October there was another IPO, which I think was a very large British company. These IPOs were a big deal to me, because the main thing I pay attention to is changes in global money flow.
NASSIM NICHOLAS TALEB, FX options trader at First Boston who later wrote The Black Swan, a book about the impact of unpredictable events:
Currency options were very inexpensive during that period for some reason, especially OTM [out-of-the-money] options, so I had accumulated a few of these. I had accumulated a lot of OTM options in Treasuries and eurodollars, for no other reason than that they were cheaper than I had seen in a long time. [Ed. note: Eurodollars are U.S. dollars deposited in commercial banks outside the United States and futures tied to the interest rates paid on them are among the most-traded contracts in the world.]
ERIC ROSENFELD, vice president in the U.S. fixed-income arbitrage group at Salomon Brothers:
On Friday night, Oct. 16, the Dow was down 4 percent on the day and 10 percent on the week. I remember going to dinner with my wife, and the couple next to us were a young guy and gal out on a date. He was telling her how he was going to make a killing, because he’d put all of his money into the market on the close. And I’m thinking to myself, “I’m not so sure she should want to date this guy …”
BORISH:
Many people thought that Japan would crash before the U.S., because Japan was more extended on fundamentals; they would be long U.S. and short Japan. We looked at the 1920s, and it was Britain, the older bull market, that went first. So we said, “No, the old goes first, because people have more hope on the new.” By the way, Japan didn’t go until 1989.
STANLEY DRUCKENMILLER, founder of Duquesne Capital Management, who was also running several funds for Jack Dreyfus’s mutual fund company:
On Friday I placed a bet that U.S. stocks would rally, on the thinking that the week’s 9 percent decline in the Dow had been overdone. Over the weekend, after studying trading charts and talking to Jack, I knew I was wrong.
While Druckenmiller considered his options that weekend, U.S. Secretary of the Treasury James Baker III told his German counterparts: “Either inflate the mark or we’ll devalue the dollar.”
PAUL TUDOR JONES, founder of Tudor Investment Corp.:
When Baker threatened a devaluation of the dollar over the weekend, it was apparent the Acapulco cliff dive was on for Monday.
The equity selloff from Friday continued in the Asian and European markets. U.S. markets opened lower as well.
ROSENFELD:
On Monday morning, my wife and I had an ultrasound appointment to look at our first child. I used the phone in the doctor’s office to call our office. It was down pretty good that morning. I go into the ultrasound feeling a little queasy from the call, and the doctor figured it was from the ultrasound and said, “You better sit down, buddy.”
JONES:
My prior going into the day was that it was going to close on the lows. I had to stay short and take the pain of gain no matter what.
BORISH:
That Monday morning was probably the greatest demonstration of trading skill that I have ever seen in my life. Even though we had this model saying Monday was the day, Paul was willing to add to the position.
LEWIS:
We were in One New York Plaza still, and everything seemed off from the time I arrived. I wasn’t exactly working. I was based in London at the time, and they’d asked me to come to New York to give a talk at the Salomon Brothers training program. I had free run of the place, so I was almost like a reporter who was wandering around the firm watching and talking to people.
DRUCKENMILLER:
On Monday morning, I took advantage of a very brief rally to sell the equities that I had bought on Friday.
JIM LEITNER, Bankers Trust FX trader:
During the day, the noise level in the trading room got quite ferocious. The chairman of the bank, who at one point had been a trader, walked onto the trading floor and stood behind my chair, which was a first.
LEWIS:
I remember walking from the 41st floor down to the 40th floor. The 41st floor was this cathedral of bonds, and then you walked down to 40 and were in this cramped, low-ceiled, dark place that was the equity department, with a lot of guys who were named Vinny and Tommy and Donny. They’d been around forever, and they had Brylcreem in their hair and big guts and they smoked too much and they were lovable. And they were all going through this visceral animal experience. People were screaming and going absolutely crazy in ways I’d never seen before. It was the first time in my career at Salomon Brothers where I was actually interested in standing beside the equity department and watching these people do their job.
EDWARD THORP, managing partner at Princeton Newport Partners:
We didn’t use Black-Scholes for option prices; we had our own model. And we didn’t model prices using a lognormal distribution—instead we had found a distribution that better fit the historical stock price data. We were trading off of those models. So even though I was surprised by the drop, I wasn’t nearly as shocked as most.
JIM CHANOS, founder and CIO of Kynikos Associates:
I had scheduled a marketing trip to Texas and flew from New York to Dallas on Monday morning. When the plane landed I called my brother, who was a stockbroker in Wisconsin. He mentioned a conflict with Iran in the Persian Gulf involving some oil platforms. “That’s making this whole thing worse,” he said.
ROGERS:
At 10 or 11 o’clock in the morning, we had a fire drill. Mandatory evacuation. So we had to leave the trading floor. We all gathered outside, champing at the bit to get back upstairs because we had no other place to go to trade. We didn’t have cell phones or internet or anything, so we had no idea what was happening.
JONES:
There was red everywhere, and all I could think about was how cornered the portfolio insurers were.
HOWARD MARKS, head of the high‑yield bond department at Trust Company of the West:
Portfolio insurance convinced people that they could somehow own more stocks without increased risk, which is fanciful. And like all silver bullets, it didn’t work.
“That fire drill saved us a fortune”
Portfolio insurance was a hedging technique that systematically sold stock index futures as the equity market declined. The equity market decline on Oct. 19 forced portfolio insurers to sell futures, which drove the market even lower in a vicious feedback cycle that continued throughout the day.
LEITNER:
The biggest risk for us that day—and I don’t mean in terms of money, but in terms of an unknown—was a position in Hong Kong. We had found a way to lend Hong Kong dollars at an interest rate that was significantly higher than the prevailing interest rate in the market by purchasing a portfolio of Hong Kong stocks and hedging them with Hang Seng futures. A rumor went around that the Hong Kong Futures Exchange would not open the next day, which would have left us long all these Hong Kong equities, but not short the futures.
ROSENFELD:
I thought we needed to remember that day, so at noon I called Delmonico’s and ordered steaks for the entire desk. I think that was a serious mistake, because there we were, chowing down on these steaks when we should have been focused on what these moves in the stock market meant for the bond market.
HARLEY BASSMAN, mortgage trader at Merrill Lynch & Co.:
As a mortgage trader, I was watching stocks in what seemed like an out-of-body experience—and yes, I was thinking 1929.
ROGERS:
A few dealers began reducing exposures to some of the middle-tier firms midday. I remembered the Hunt brothers’ failure in 1981 and the problems that caused for Merrill Lynch and Paine Webber. But I didn’t think we should be reducing our exposure at that moment, as the market couldn’t stand to lose more liquidity.
LEWIS:
I’ll give you insight into how it was at Salomon Brothers that day. I sat next to [Chief Executive Officer] John Gutfreund for maybe 45 minutes. He was up and around a lot and energized by the whole thing. But the fact that I could wander in, two-and-a-half years into my job at Salomon Brothers, plop myself down next to the CEO during the greatest crisis in a decade or more, and nobody even noticed tells you something about the chaos and turmoil of the place.
JONES:
The friends and counterparties I was speaking with were gripped with complete fear.
BLAIR HULL, managing partner of Hull Trading Co., a Chicago-based market-making firm specializing in options:
The 1987 crash is the only time I’ve ever seen the market makers scared to death.
DAVID SHIELDS, president of Shields & Co., a broker-dealer and Registered Investment Advisor, who was on the New York Stock Exchange’s board of directors:
As luck would have it, Greenspan was on a plane to Texas that Monday, so he was out of touch with what was happening.
CHANOS:
I canceled my meetings and went to a friend’s office. The few times I tried to enter orders, I couldn’t get through. The structure of the market was dependent on these technologies that were voluntary. I was trying to cover my shorts and a buyer is what they were looking for, but people were not picking up the phones. So basically I sat on my hands, which turned out to be the right thing to do.
ROGERS:
We hadn’t been able to sell our long Treasury position or make markets because of the fire drill. So we came back up and I think by the end of the day, 3 o’clock or whatever, we finally sold our long bond position. That fire drill saved us a fortune.
LEITNER:
In the afternoon, I went out and I bought a bunch of Japanese bonds, which were still yielding 6 percent. And I said, “If the world is really going to hell in a handbasket, interest rates will collapse and at some point I’ll be able to sell those bonds at a higher price.”
LEWIS: It was right around then that I was selling my book, which would become Liar’s Poker, and I was absolutely aware that this was literary material. I remember grabbing scraps of paper and writing down notes, so I had it if I needed it.
ROSENFELD:
I remember talking to Mike Halem, the proprietary equity trader. I was urging him to do these basis trades. It was tough to do futures vs. stocks, because you couldn’t execute the trades simultaneously. So I was telling him to do futures vs. the most liquid stocks and not worry about the fact that he wasn’t doing exact arbitrage. I was talking to him about futures vs. IBM or futures vs. GE, and forget about anything else.
THORP:
By the time I left the office in Newport Beach, Calif., for lunch with my wife, the market was off 7 percent. I remember noting that was about half the decline of the two largest previous ones—Oct. 28 and 29, 1929, which signaled the start of the Great Depression. I then got a call at the restaurant that the market was down 18 percent. My wife thought maybe I should go back to the office, but I stayed and finished my lunch. There was nothing I could do.
SHIELDS:
There was one big pension fund that had 10 pieces of $100 million sales that came in the last hour and that just kept pressure on the market, so it closed at the bottom.
BORISH:
I think that Paul’s greatest skill was realizing that people were going to drive to the place of most liquidity, and that was going to be fixed income.
JONES:
I decided to get very long fixed income on the close on Black Monday, as I knew the Fed would react.
BORISH:
We were concerned about a lot of the counterparties and their liquidity, so the best place to be was in fixed-income futures, because if worse came to worst, we could always take delivery of the bonds.
“The Fed chief and his staff had basically subverted the hotel switchboard”
The equity market took one final dive at the close, which pushed the S&P 500 to its record decline; the DJIA fell 508 points and roughly 600 million shares were traded, both records.
LEITNER:
My group had been up about $9 million for the month, and by the end of the day we were only up $1 million.
SHIELDS:
Greenspan lands in Dallas, and the story is that when he got off the plane he asked where the market ended up. The response was “Five oh eight” and Greenspan replied: “Oh, good, it had a nice rally.” He thought it was 5.08. He had only been in office since August, so I think he was a bit of a deer in the headlights.
CHANOS:
I check into my hotel, and there’s all kinds of security. I asked what was going on: Alan Greenspan and Margaret Thatcher were both checked in as guests. I get to my room and I’m trying to call New York, but I can’t get through. I had to go to another friend’s office, because the Fed chief and his staff had basically subverted the hotel switchboard.
SANDOR STRAUS, partner at Axcom, which Renaissance Technologies founder Jim Simons would merge into Renaissance and create the Medallion Fund:
We were a typical CTA [commodity trading adviser]. It was a volatile day for most trenders, who were short fixed income. Some were trying to buy eurodollar options to hedge themselves, but that was next to impossible. Our biggest loser on the day was actually a long copper position, because the pit-traded futures had already closed when the fixed-income products started soaring.
TALEB:
At the end of the day, I remember a terrified woman came up to my friend and me. “Do you know what’s happening?” she asked. When I looked at her, I saw panic—and that’s when it hit me that something was going on. I had been in a state of hyperconcentration during the day.
ROGERS:
I was so scared that I got $10,000 out of the bank, took it home, and stored it in the rafters. When I moved out, I forgot that I’d stashed the money. I think it’s still there.
JONES:
I was feeling guilty about our success. I thought we were going into the Great Depression.
BORISH:
I had 1929 on my mind. Paul and I were concerned about our friends and people who were struggling that day.
ROSENFELD:
That night, [Salomon Brothers Vice Chairman] John Meriwether and I had dinner at Il Mulino in Little Italy with Vinny Mattone, the head of repo at Bear Stearns. For us, a key element to these longer-term convergence trades is making sure that you can hold the trade until convergence. Our worry was that clients were getting so skittish that they would pull their repo lines. The outlook from Vinny was dismal. It reinforced that we had to rethink the portfolio.
TALEB:
I started calling my friends to see if they were OK. I couldn’t leave the apartment, because Hong Kong might call, so I was calling anyone to chat. My cousin called and said the police were outside. It turned out a guy had committed suicide at 72nd Street and First Avenue, so it hit close to home.
THORP:
I went home and thought about what had happened. There was a huge difference between S&P futures, which were trading at 185 to 190, and the corresponding price of the S&P index, which was at 220. This difference was previously unheard of. Arbitrageurs usually kept it in line.
Marketwrap episode from October 19, 1987:
https://www.youtube.com/watch?v=YXfUM6H_jeE
As bad as the decline on Monday was, Tuesday turned out to be the day of reckoning. Specialists on the New York Stock Exchange were sitting on losses and facing margin calls; some were rumored to be insolvent. Making matters worse, bankers were reluctant to extend credit to the specialists.
LEITNER:
We were in very early on Tuesday morning, and no one was quite sure what to expect.
STRAUS:
We knew we were going to lose a lot of money on Tuesday. We were short Treasuries and eurodollars and long copper, which had all hit their limits. So we could predict where those markets would trade on Tuesday, and it looked bad.
TALEB:
It wasn’t the day of the crash that was the big trading day. It was the next day. Eurodollar futures rallied by something like 375 basis points on the open.
Around 9 a.m., Greenspan issued a one-sentence statement from his Dallas hotel: “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” The fixed-income markets rallied on the Greenspan news, but specialists were still reluctant to make markets, leaving equities in limbo.
ROSENFELD:
There was this delayed open to the equity market, and many equities were not really trading on Tuesday morning. Rumor had it that the exchange had not been able to obtain complete margin payments.
THORP:
On Tuesday, I told our head trader to buy $5 million worth of S&P 500 Index futures at around 190 and sell short stocks around 220—not for $5 million worth of assorted stocks, which was the optimal amount to best hedge the futures, but for $10 million. I chose twice as much because I figured only half would get done.
HULL:
Although the Fed cut rates and agreed to provide liquidity, they also came out and said they were hiking margin requirements. That forced market makers to cut positions and effectively become liquidity takers.
BORISH:
On Tuesday, interest rates declined dramatically after Greenspan came out. The 10-year was around 9 percent, so it had a lot of room to move.
TALEB:
The largest move in statistical terms—the largest outlier relative to what models would predict—was actually in eurodollars.
HULL:
At 9:30, I left the CBOE [Chicago Board Options Exchange] and walked across the street to the CBOT [Chicago Board of Trade] to try to cover our short position in the MMI [Major Market Index].
The Major Market Index was a futures contract launched by the Chicago Board of Trade in 1984. It consisted of 20 blue-chip stocks, 17 of which were also part of the Dow, making it something of a proxy, yet one that typically traded less than 10 percent of the volume of the DJIA.
HULL:
I was the only member of the firm who had the full CBOT seat and could trade. I’d taken the test but had forgotten the language, so I was a foreigner in that pit.
THORP:
Our head trader was frozen with fear and at first refused to execute the trades. We got two rounds off and roughly half of our shorts for a near-optimal hedge. We had about $9 million of futures long and $10 million of stocks short, locking in a $1 million profit.
BASSMAN:
There was a limit on Treasury futures, but not on Treasury cash bonds. If cash Treasuries were up 5 points, Treasury futures could only be up 3, and the futures options were constrained to a limit of 3 points as well. To cover a short Treasury position, people were buying any option they could find that was not up to its limit. All of a sudden people were paying 2.5 points for an option that was 10 points out of the money. These were almost random prices. It was crazy.
HULL:
At about 10:30, a rumor emerges that there might be a trading halt on the Chicago Mercantile [Exchange]. If we closed, I thought we might be closed for a few days; it wasn’t going to be a few hours. So I said, “Send somebody to the library and find out what’s happened on trading halts.” Which was kind of a ridiculous request that everybody smartly ignored.
SHIELDS:
Around 11:15, John Phelan, the CEO of the NYSE, came to the floor and said, “I’m getting calls from everybody, they want to close this place.” All the major firms had called him—Merrill and Salomon and Goldman—which put a lot more pressure on him. I said, “John, you can’t close this place. If you close it, you’ll lose control.”
BASSMAN:
I had bought 100 bps out-of-the-money call options for a tick [1/32nd of a point] a month prior for a thrill. They had a few weeks to expiry. As the bond market exploded higher, my options started moving into the money. I ran over to the Treasury desk to sell some Treasuries to hedge my position, and in the time it took me to run over to the desk the market had rallied another point. That’s how fast the Treasury market was moving.
TALEB:
I had a huge delta in eurodollars. I remember vividly offering eurodollars at a price and selling them for much higher—it was like in Trading Places. We spent the day liquidating our positions and selling above our offers all morning. Currencies went wild and the USD collapsed.
BASSMAN:
I could use the Treasury basis—the relationship between cash and futures—to figure out where futures should be trading and, by extension, where options on futures should be priced. So I started trading futures options vs. cash, which the locals on the exchange couldn’t do. The spread was huge, and it was quite profitable.
SHIELDS:
Finally, Howard Baker [President Ronald Reagan’s chief of staff] called and said he’d just seen the president. And this is a direct quote, he said, “I’ve just been to see the president, and the president understands that you have to do what you have to do to protect your people. However, the president of the United States would very much prefer if the New York Stock Exchange could see its way clear to remain open.”
HULL:
At 11:28 [Central time], the Chicago Mercantile halts trading on the S&P contract. At the same time, the CBOT held a meeting and decided that they would stay open. Three minutes later, at 11:31, the market for the MMI was 290 at 295. Normally this market would be 5¢ wide, now it’s $5 wide. I had been a buyer of small lots, 5 and 10 contracts, trying to cover our short position in the MMI and reduce exposure.
SHIELDS:
I think there was something that came out of either the Fed or Treasury that the New York Stock Exchange was not closing. And at that point, I think someone called somebody. My guess is it would have been one of the monetary people that would have done it; they would have known where to go. And the MMI started rallying, carrying everything along with it.
HULL:
“What will you buy 100 at?” a trader from Drexel [Burnham Lambert] asked. “285,” I said. And the Drexel trader said, “You own them.” I swallowed hard; it trades 287, 288. A few minutes later he asks, “Will you buy another 50 at 285?” And I said, “Yes.”
STRAUS:
On Tuesday, we were all watching, and it looked like the decline would continue—and then someone bought the MMI, the small index in Chicago, and that started to stabilize the whole market.
HULL:
These trades with me were really whisper trades—in other words, he sold them to me knowing that I was the only buyer. He didn’t want to hold an auction because there would have been a mass panic. I ended up buying 150 contracts at 285.
When the MMI started moving up, it was one factor that helped begin pulling up the Dow and other equity indexes. This gave New York market makers confidence to start trading the underlying stocks. The Dow closed the day with a record gain of 102.27 points. Over the course of Monday and Tuesday, 2-year interest rates rallied by 100 bps and 10-year notes rallied by 73 bps.
BORISH:
The big question we thought about was, if this was going to be a big deflationary event, should we be long gold and short silver, or buy more bonds?
LEWIS:
This crash happens, and there’s this flight to money markets—and because of these recent layoffs, we don’t have a money-market department anymore. They should have been having a boom moment; instead there were empty chairs. That seemed crazy and had to be going through Gutfreund’s mind.
“I made an entire year’s profit in one day because of those options”
HULL:
Typically when there was a huge panic, the population of the pits would double. It was the only time that I saw the pits empty. The population of the pits was 50 percent of a normal day later in the week.
ROSENFELD:
From Oct. 20 to 21, we lost our entire year’s worth of profit. We went from having a really good year to breakeven in those two days. On Wednesday morning, Meriwether put us all in a room and systematically went through our portfolio. We took off the trades that were least viable and focused on the most attractive ones. The next year, 1988, ended up being our best ever, based in large part on the trades we did that week.
CHANOS:
Tuesday the 20th and Wednesday the 21st were two of the scariest days I’ve experienced in the market—not because of the market action itself, but because of the concern about the system. There was a lot of suspicion that brokers were insolvent and that they might not be able to clear trades later in the week. People were on pins and needles come Wednesday for trades from the previous week and Monday to see if the trades would clear.
BORISH:
The irony is everyone thinks Paul made all this money being short stocks. But there wasn’t that much liquidity in stock index futures. A lot of the opportunity to be made was in bond futures, on the assumption that the Fed would supply a lot of liquidity. Paul didn’t make as much in 10-year futures per contract as he did on S&P futures, but he did make more in the aggregate.
DRUCKENMILLER:
The Dow lost more than 22 percent that day [Black Monday] and 13 percent for the week. I finished the week with a profit due to those early Monday morning trades.
BORISH:
For the year of 1987, the Tudor Futures Fund made 200 percent. For the month of October, we made 62 percent.
THORP:
We ended October flat for the month, whereas the S&P index was down 22 percent. During the surrounding five-month period, from August through December, the index fell 22 percent, whereas Princeton Newport Partners gained 9 percent.
BASSMAN:
I made an entire year’s profit in one day because of those options. I bought my first Manhattan apartment with the bonus from that year.
TALEB:
Everybody talks about what happened to IBM on Black Monday. People don’t talk about the moves in eurodollar futures or currency options, because it’s a professional market. Tuesday was the big day for me.
HULL:
We started the month with $19 million in firm capital and ended with $26 million.
Author Diana B. Henriques is a George Polk Award-winning journalist and a Pulitzer Prize finalist whose latest book is A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History (Henry Holt and Co.). We asked her to identify a few of the most noteworthy Black Monday casualties.
1. A.B. Tompane & Co.: The NYSE specialist sold itself to Merrill Lynch at 4:00 am on Tuesday morning.
2. Nasdaq: The “Market of the Future” took a reputational hit—markets were crossed, machines were locked—and suffered the worst performance of all the exchanges.
3. Leland O’Brien Rubinstein Associates: The portfolio insurance pioneers lost 80 percent of their business following Black Monday and eventually folded.
Black Monday had enormous influence on investors, regulators, and exchanges. President Reagan called on former Treasury Secretary Nicholas Brady to set up a commission to study the crisis. Portfolio insurance was fingered as the primary cause of the crash and relegated to the dustbin of financial innovation. A U.S. Securities and Exchange Commission white paper titled “The October 1987 Market Break” suggested a stock basket exchange mechanism to improve market liquidity, which ultimately gave birth to the exchange-traded fund industry. Exchanges adopted new regulations on equity futures, and traders started to incorporate black swan events into risk management models and trading strategies.
THORP:
Portfolio insurance was designed to protect investors from large market declines. Ironically, the cure became the cause.
BORISH:
The early part of Black Monday was probably due to portfolio insurance, but the second part of the day was due to fear.
Oct. 19, 1987 remains the biggest one-day stock market drop in history.
ROSENFELD:
The need for dynamic trading from portfolio insurers exceeded the liquidity. The standby capital that usually comes in during these times was slow to come in. In that sense, circuit breakers do help. It allows the standby capital to assemble.
LEWIS:
It makes everybody uncomfortable when something dramatic happens with prices, and no drama in the world could explain such movement. It makes the market seem absurd. And so that was the feeling. To me it was like, Corporate America is not worth whatever percent less today than yesterday.
MARKS:
People think that if stocks went down 20 percent in a day, it must be the end of the world. That is, they impute intelligence to the market—and that’s a mistake.
“They learned the hard way that markets, left to their own devices, can and will break down into panic and chaos”
TALEB:
I had no idea about market conditions and didn’t predict the crash. All I was saying is that events of even half the size of Black Monday were vastly more likely than what the normal distribution would tell you.
CHANOS:
What everyone forgets about 1987 is that the week of Black Monday was the end of the move, not the beginning of the move. The market peaked in the last part of August. After the Black Monday week, the market stabilized and ended flat on the year.
LEWIS:
I knew everybody was making a big deal of it, and it was of course big headlines and all the rest. But I had no sense that anything had fundamentally shifted in the world.
JONES:
Black Monday’s 33 percent decline in S&P 500 futures taught newly baptized regulators what old-school commodity traders had known for a hundred years: Limits on trading of stock futures were obligatory. They learned the hard way that markets, left to their own devices, can and will break down into panic and chaos.
LEITNER:
It was the first time we gave a lot of thought to counterparty risk. Had the Hong Kong Futures Exchange [which was closed for nearly a week and subsequently bailed out by the Chinese government] gone belly-up and those futures contracts not been honored, I probably would have been fired.
BORISH:
Afterward, Paul seconded me to the New York Fed to help with the Brady commission. To Paul’s credit, he put a lot of resources into getting data and computers. We’d be in there on weekends with screwdrivers taking out floppy drives and putting in hard drives. We hired summer interns to type data into spreadsheets, which only had 3,000 rows at the time. We provided all of our data to the Brady commission; Goldman didn’t have it, J.P. Morgan didn’t have it. The chapter on the market break mostly came from Tudor.
ROSENFELD:
There wasn’t this global perspective that you see today with correlations being so high, and I think that’s what saved the marketplace that day. It wasn’t the circuit breakers that saved the day; it was that the markets were siloed. If that were to happen today, who knows what would happen.
BORISH:
If you look at Greenspan’s behavior during the Long-Term Capital Management crisis 10 years later, he moved quickly to provide liquidity to the system. So like every good trader, he learned from his prior mistakes. He thought, “We’re going to get out there, we’re going to get in front of it, and we’re going to provide liquidity to the system.”
TALEB:
If the Fed hadn’t stepped in on Tuesday morning, we would have a lot cleaner financial system today, but it would have been a complete bloodbath then.
In the days after Black Monday, out-of-the-money put options became more expensive relative to other options, a feature of the market that persists today.
ROSENFELD:
I thought the volatility smirk was an arbitrage opportunity; later I came to see it as a part of the marketplace.
HULL:
I was late to realizing that the equity skew would be a permanent feature of markets. We did try to fit the curve, to try to trade around the skew that existed at that time.
TALEB:
After the event, I knew that I was right and that people would take me seriously. And I made a lot of money. I also knew that all of this modeling they teach in school, the Black-Scholes model and whatnot, is nonsense. I felt vindicated. I knew it was nonsense, and it turned out to be nonsense.
THORP:
Academics described stock price movements using a lognormal distribution, but those underestimated the likelihood of very large changes. In the short-term version of our price model for individual stocks, Black Monday was an outlier, but not anywhere near the impossible extreme of the lognormal model. There were several features of our model which each said such a move was much more likely than people thought.
ROSENFELD:
The Wednesday morning meeting is what sticks with me. We had just lost the entire year’s profit, but we sat there in a reasoned way and systematically went through the portfolio. It reinforced my view that avoiding panic and clear, analytic thinking win the day.
BASSMAN:
The key takeaway was to never sell an option for less than one-eighth of a point. The most you can make is an eighth, and the potential loss is unlimited. I learned not to leave myself exposed to tail risk like that. For me, it helped crystallize the point that successful investing is not about your entry level; rather, it’s about position sizing.
CHANOS:
Black Monday made a huge difference in how I manage my fund. It was my lesson that as a short seller, I was an unsecured lender to a prime broker. It forced me to understand my back-office operations, and that really helped in 1990 when Drexel failed, in 1998 during LTCM, and again in 2008. I understood how to hold collateral in the form of Treasuries. It was an immensely important learning experience, and luckily I didn’t have to pay financially for it.
LEITNER:
Black Monday woke me up to the fact that black swans happen much more frequently than a normal distribution would imply. I became more of an options buyer than a seller and put the onus of the risk management on the other guy. I started thinking about when it made sense to pay the extra premium to be long options.
MARKS:
It really reinforced the idea that anything can happen in a market, and it doesn’t require a rational process.
TALEB:
The first lesson I learned was that these things happen. The second lesson I learned was that when they happen, what you make everywhere else disappears. Unless you’re hedged for events like Black Monday, whatever alpha you think you’re going to get, you’re not going to get. —With assistance from Max Abelson, Katherine Burton, and Erik Schatzker
Dewey is a freelance contributor. The founder of Entropic, a hedge fund in New York, he’s worked for Elm Partners and Pimco and interned on the global macro desk at Tudor Investment Corp.
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