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THE TRUTH ABOUT THE CRASH OF 1987  

Now it can be told! Twenty years after the great stock market crash of October 19, 1987, when the Dow Jones Industrial Average fell by more than 22% in a single day, the truth about why it happened can now be revealed.

And believe me, I know what really happened. Because I caused the crash myself. Yep, it was me. With a little help from some market manipulation, a lot of bad judgment and some colossal mistakes.

Back then I ran portfolio management and trading for Wells Fargo Investment Advisors. With $69 billion under management, we were then the world's largest institutional investment manager. The company is now called Barclays Global Investors, and with almost $2 trillion under management, it's still the world's largest.

In 1987 Wells Fargo was by far the largest player in the two strategies that caused the crash. One was "program trading," the simultaneous execution of hundreds of stock trades with a single electronic order. The other was "portfolio insurance," a hedging strategy that used program trading and stock index futures to hedge the downside risk in institutional stock portfolios.

According to official government reports issued in the aftermath of the crash, program trading and portfolio insurance combined to cause the crash. The portfolio insurance strategy required that Wells Fargo execute program trades, selling all 500 stocks in the S&P 500, over and over as the market declined. With every execution, the market declined even more. And that triggered the next execution.

Wells managed portfolio insurance strategies for America's largest pension plans. But other giant pension plans just used us to manage their S&P 500 index funds, managing the portfolio insurance part themselves. On the day of the crash, we were executing plenty of sell programs for our own portfolio insurance strategies all day. At the same time, clients called to say, "Sell a billion S&P, right now" -- and we did. Then they called again. And we sold again. And again.

That's why I say I caused the crash. It was my team's finger that was on the sell button. It was our job to push it, and we pushed it.

Our execution of portfolio insurance and program trading strategies were blamed for the crash in the official government reports. But here's what got left out of the official story: the whole thing was triggered by a massive market manipulation by a major Wall Street investment bank. Lest I end up in litigation about this, that firm will remain nameless.

Here's how it happened.

Before the crash, it was widely discussed among professional investors that the combination of portfolio insurance and program trading could cause a cascading market decline, as each step downward caused portfolio insurance strategies to do more program selling, which in turn would cause a steeper decline, and more selling, and so on.

One especially aggressive head trader on the proprietary trading desk of one particularly aggressive investment bank had followed that discussion, and it gave him an evil idea. What would happen, he wondered, if he started massively short-selling stock index futures, driving the stock market down single-handedly as long as he dared to sell enough contracts -- thus setting off the cascade. Once the cascade was set in motion, he could keep selling, knowing that the portfolio insurers would drive the market lower and lower. Eventually he'd cover his shorts at a huge profit.

It worked. And this man was in a great position to know that it would. His firm acted as broker for all the largest portfolio insurers, including Wells Fargo. So he knew exactly how much the market would have to decline to set off the portfolio insurers' sell programs. In other words, he had inside information. All he had to do to make a fortune was use that information, betray his own clients' trust in his firm, and threaten the world financial system by causing the biggest stock market crash in history.

So the crash of Monday, October 19, 1987, was started as a crime. But it ended as a comedy of errors the next morning, Tuesday, October 20.

Monday night after the market closed, hedge fund mega-manager George Soros became convinced that the world stood on the brink of a global depression. He felt sure that the downward spiral begun on Monday would continue, and he resolved to get out of stocks as quickly as possible.

An hour or so after the market opened on Tuesday morning, he placed an order to sell about $1.6 billion in stock index futures. It was a market order, which means he didn't specify a price -- just sell, no matter what.

By today's standards, $1.6 billion may not sound like much. But in 1987, that was about as big as a trade could get. But then, something astonishing happened that made the trade even bigger.

Somehow, in all the pandemonium on the trading floor in Chicago where the stock index futures were traded, Soros's order got doubled. The ticket got printed twice. So instead of a sell order for $1.6 billion, it was $3.2 billion. All at once. At the market.

His order hit the futures market like a boulder dropped in a shallow pond. Over the next hour, the futures fell almost 27%, an even larger drop than the market had sustained in the previous day's historic crash. The drop in the futures market caused renewed panic in the stock market, and for much of the day it looked like Soros was going to be right -- the meltdown appeared to be continuing.

But he was right for the wrong reason. It was a mistake. A mistake of judgment to sell so much in the first place (Soros must remember that as one of the worst trades he ever made) and another mistake on top of that for his broker to sell twice as many contracts than Soros had ordered. By the end of the day, the stock market and the futures market found their footing, and the foundation for a sustainable recovery was in place.

The crash, then, was an artificial creation -- the product of error and manipulation. It wasn't a actual investor expectations about earnings, the economy, or anything else. So it caused no lasting harm to investors -- stocks actually showed a positive return in calendar 1987, all told. And it did no lasting damage to the economy.

Maybe some day the true story will be told about the panic that markets have been through the last three months. This time around I didn't have a front-row seat like I did in 1987, so I'm not in a position to know that story. But I'll bet there's one out there, waiting to be told.

Like the 1987 crash, I'll bet the sub-prime meltdown will enter the history book as little more than a curiosity -- no lasting harm to investors, and Like the 1987 crash, I'll bet the sub-prime meltdown will enter the history book as little more than a curiosity -- no lasting harm to investors, and no lasting damage to the economy.

Posted by Donald L. Luskin
October 19, 2007

http://www.poorandstupid.com/2007_10_14_chronArchive.asp

THE BLOW UP-----

The quants behind Wall Street's summer of scary numbers.
by Bryan Urstadt 

Full article at http://www.technologyreview.com/Biztech/19529/?a=f

Excerpts:

"On Wednesday, August 8, not long after the markets closed, 200 of the smartest people on Wall Street gathered in a conference room at Four World Financial Center, the 34-story headquarters of ­Merrill Lynch.

August is usually a slow month, but the rows of chairs were full, and highly paid financial engineers were standing by the windows at the back, which looked out over black Town Cars below and the Hudson River beyond. They didn't look like Masters of the Universe; they looked like members of a chess club. They were 'quants,' and they had a lot to talk about, for their work was at the heart of one of the most worrisome summer markets in decades."

"[T]he word 'quant' refers to any practitioner of quantitative finance, a wide-ranging discipline that includes, among other things, the pricing of financial instruments, the evaluation of risk, and the search for exploitable patterns in market data".

"One common method that quants use to identify market opportunities is pairs trading. Pairs trading involves trying to find securities that rise in tandem, or that tend to go in opposite directions. If that relationship falters--if, say, the values of two stocks that travel together suddenly diverge--it's likely to indicate that one stock is undervalued or overvalued. Which stock is which is irrelevant: a trader who simultaneously bets that one will go up and the other one down will probably make money."

"In what's called nondiscretionary trading, computers both find the inefficiencies and execute the trades. The Aite Group, a financial-services research firm, estimates that roughly 38 percent of all equities may be traded automatically, a number it expects to increase to 53 percent in three years."

"One trader I spoke with at a $10 billion hedge fund based in New York said that his computer executed 1,000 to 1,500 trades daily (although he noted that they were not what he called 'intra-day' trades). His inch-thick employment contract precluded my using his name, but he did talk a little bit about his approach. 'Our system has a touch of genetic theory and a touch of physics,' he said. By genetic theory, he meant that his computer generates algorithms randomly, in the same way that genes randomly mutate. He then tests the algorithms against historical data to see if they work. He loves the challenge of cracking the behavior of something as complex as a market; as he put it, 'It's like I'm trying to compute the universe.' Like most quants, the trader professed disdain for the 'sixth sense' of the traditional trader, as well as for old-fashioned analysts who spent time interviewing executives and evaluating a company's 'story.'

High-frequency trading is likely to become more common as the New York Stock Exchange gets closer and closer to a fully automated system.

Already, 1,500 trades a day is conservative; the computers of some high-frequency traders execute hundreds of thousands of trades every day.

Linked with high-frequency trading is the developing science of event processing, in which the computer reads, interprets, and acts upon the news. A trade in response to an FDA announcement, for example, could be made in milliseconds. Capitalizing on this trend, Reuters recently introduced a service called Reuters NewsScope Archive, which tags Reuters-issued articles with digital IDs so that an article can be downloaded, analyzed for useful information, and acted upon almost instantly.

All this works great, until it doesn't. 'Everything falls apart when you're dealing with an outlier event,' says the trader at the $10 billion fund, using a statistician's term for those events that exist at the farthest reaches of proba­bility. 'It's easy to misjudge your results when you're successful. Those one-in-a-hundred events can easily happen twice a year.'

The events of August were outliers, and they were of the quants' own  making. 

"The damage quickly spread beyond the market for low-quality debt instruments. It was almost as if the financial world had become a market for nothing so much as standard deviations, the mathematical term for the spread of values straying from a mean. In fact, the summer might be described as a time when too many investors had purchased standard deviations that were too high for their means.

Among the lessons that August taught is that there may be a finite number of viable investing strategies--a suspicion borne out by the oddly synchronous decline of many quant funds this summer, including [James] Simons's Renaissance Technologies. August's bizarre market behavior, according to [Lehman Brothers quantitative analyst Matthew] Rothman and others, was probably the product of some large hedge funds' seeking cash to meet their debt obligations, as the value of their CDOs declined, by selling those securities that were easiest to shed, chiefly stocks. (And which funds? In another example of the secrecy of fund managers, no one really seems to know, or wants to say.)

According to most of those to whom I spoke, something like the following occurred this summer. Quants had, in the ordinary nature of their jobs, 'shorted' many stocks. ... CDOs had functioned as the collateral on the quants' short positions. When the subprime crunch squeezed the financial markets, the value of those CDOs declined, forcing quants to increase the collateral in margin accounts, buy back the shorted stocks, or both. But in either case, in order to supplement their shrinking collateral, quant funds were forced to sell strong blue-chip stocks, whose prices consequently fell. At the same time, as quants bought back shorted stocks, the prices of those stocks increased, demanding the posting of yet more collateral to margin accounts at the very time that the value of CDOs was suffering. That the quants were, apparently, long on the same strong stocks and short on the same weak stocks was a result of a number of strategies, pairs trading among them 

Another related explanation for the August downturn was that the quants' models simply ceased to reflect ­reality as market conditions abruptly changed. After all, a trading algorithm is only as good as its model. Unfortunately for quants, the life span of an algorithm is getting shorter. Before he was at RiskMetrics, Gregg Berman created commodity­-trading systems at the Mint Investment Management Group. In the mid-1990s, he says, a good algorithm might trade successfully for three or four years. But the half-life of an algorithm's viability, he says, has been coming down, as more quants join the markets, as computers get faster and able to crunch more data, and as more data becomes available. Berman thinks two or three months might be the limit now, and he expects it to drop."

"[Richard] Bookstaber is a quiet, thoughtful man, with sharp brown eyes and an attentive look. He studied with [Robert] Merton in the 1970s at MIT, where he got his doctorate in economics. Today, he is very worried about the tools and the methods of the quants. In particular, he frets about complexity and what he calls 'tight coupling,' an engineer's term for systems in which small errors can compound quickly, as they do in nuclear plants. The quants' tools, he feels, have became so complicated that they have escaped their creators. 'We have gotten to the point where even professionals may not understand the instruments,' he says. This, to Bookstaber, was perfectly demonstrated this summer, when the subprime troubles touched off a reactionary wave of selling in equities that would nominally seem unrelated, or, as Wall Street puts it, 'uncorrelated.'"

"Linkage is one of Bookstaber's favorite topics. He believes that quants' instruments have 'linked markets together that wouldn't normally be linked,' and that such linkages are dangerous because they are unforeseen.