Thursday marks the 30th anniversary of Black Monday, and I remember the day vividly. I was on the trading desk at Salomon Brothers, and the milestone has me thinking of the root causes of the crash, when the Dow Jones industrial average plunged nearly 23 percent on Oct. 19, 1987.
In the fall of 1987, I was coming to the end of my fifth year (of 15) at Salomon. I was a vice president and sales trader covering the trading desks of institutions like Harvard Management, MFS, State Street Bank (the forerunner of State Street Global) and Loomis Sayles. Younger people may not know this, but Salomon, along with Goldman Sachs, was the most important trading desk on Wall Street at that time.
As I will explain, the crash of 1987 was largely a trading event, not a fundamental or economic one. I don't mean to sound overly boastful, and I certainly do not pretend to be the foremost expert on the crash of 1987, but I do think my vantage point was quite unique for this momentous event in history.
Some might say you could blame the whole crash on Dan Rostenkowski. OK, before you get all worked up, I don't really blame the crash on Rostenkowski, who chaired the House Ways and Means Committee at the time and had spent many years on the tax-writing committee. But Rostenkowski and his committee played a very, very important role in the crash of 1987.
In fact, it was that committee's "trial balloon" regarding a takeover-tax bill, sent around several days before the crash to see how the measure would be received, that was a main catalyst — or at least the straw that broke the camel's back — in an environment that was already appearing to be a perfect storm for some kind of tumble for months, if not years.
Many accounts of what took place on Oct. 19, or what led up to that trading session, involve rising interest rates that year and the rise of so-called portfolio insurance. While rising rates played a key role, they did not play as core a role as many people believe. The same can be said for portfolio insurance.
Taking a step back for a moment, it's important to consider the backdrop in 1987, and the conditions under which investors lived during that time. Back then, everybody in the investment community had lived through the bear market of 1973 through 1974, which was a grueling time, and the post-1974 recovery was a slow one. It was not until 1982 that the market was able to break out, and reclaim its title as a bull market once again. Wall Street did not begin hiring meaningfully again until 1982; by that time, most of Wall Street was more senior, and remembered both that bear market in the '70s, as well as the Great Depression. Those who didn't remember it were raised by people who lived through it. Furthermore, many also remembered World War II, and understood the fragility of life to a degree few of us understand today.
Portfolio insurance became quite popular that year with some institutional investors; the market had rallied strongly in the 4½ years prior to 1987, and that year itself was quite good. As money managers from mutual funds, insurance companies, pension funds and others looked at the landscape, they began to worry that their gains would not last through the rest of the year. Again, given what had taken place in the 1930s and the 1970s, who could blame them? And thus, the "hedge" was popularized. In a nutshell, institutions who bought the product engaged in an agreement to sell short S&P 500 futures if the stock market fell by a certain amount; this would allow them to offset any losses that a meaningful decline would inflict on a portfolio.
This was a very new idea. Before 1987, if investors began selling aggressively "into a falling market," it's because they had no choice. They were getting margin calls and they had to sell. With portfolio insurance, these people did not have to "sell" to raise money. They were simply contractually obligated to "sell into a falling market" due to their portfolio insurance agreements. Basically, the program was set with a mathematical formula, in which a certain amount of futures would be sold short after the market had fallen by a specific amount. If the market continued to fall, they would short more futures as the broke below other certain levels. The problem came when investors from several other different areas "had to sell" at the same time, with each obligation further exacerbating the situation.
Another important feature of this market, which played a role in the crash of 1987 along with the bill introduced by the House Ways and Means Committee, was the risk arbitrage and mergers and acquisitions environment of the time. They are immediately connected to one another. This strategy, risk arbitrage, is the effort to simultaneously buy the stock of a company that is being acquired, and shorting the stock of the acquiring company. The speculative method tries to take advantage of the spread between the time the deal is announced, until the deal closes.
In the 1980s, many of the deals were hostile takeovers, so there was quite a bit of risk involved. These deals were usually financed by high-yield debt, so there was also a high amount of leverage involved. Furthermore, many investors were betting heavily on rumors and chatter around the Street about potential deals both hostile and friendly. Some of this chatter was around specific deals that might be in danger of getting called off due to rising interest rates; in theory, either the acquirer wouldn't be able to get the financing (in other words, they would not be able to sell the bonds needed) or the rates would be too high to make the deal make sense.
However, it was not until the week of Oct. 12 that a new issue was brought up into the marketplace; Rostenkowski and his committee, on the evening of Oct. 13, introduced a takeover-tax bill that would have placed restrictions on takeovers and other corporate restructurings that is so core to mergers and acquisitions. In other words, this bill would have repealed many tax breaks related to M&A activity.
This, and not the concern of what higher rates would do to the economy and stock market, was the real reason that higher interest rates were important to the crash of 1987.
On Oct. 14, I distinctly remember getting a call from one of the traders from Harvard Management asking about what was going on with all the takeover stocks. "Why were they all down so much," was the question. Well, the answer was this bill out of Rostenkowski's committee. This is what finally led all of these leveraged risk arbitrage traders unwinding some of their positions. Stocks of announced deals, as well as rumored deals, fell out of bed that day. Remember, these investors were already nervous about the impact higher rates would have on these deals, and now this news led them to start dumping some of their leveraged positions.
Things did not calm down much on Thursday, but the S&P 500 did not decline meaningfully. Then Friday came. When nothing had come from Washington that indicated they would hold off on the committee's bill, selling accelerated. Many of the takeover stocks again fell sharply on Friday, and there were few, if any, bids in them. Liquidity was diminishing, so risk arbitrage firms could not meet their margin calls by only selling the takeover stocks. Therefore, these firms had to sell what they could sell.
Then came Monday.
Overseas markets were in a panic, as they saw what happened on Friday. By the time U.S. investors went to work on Monday, global markets were in very bad shape. Liquidity continued to wither, and players in the risk arbitrage space had to continue selling "what they could." The problem is that when mutual fund redemptions hit the markets in a major way, they cause the same kind of "forced" selling. Two sources of forced selling hit the market, but this new one, mutual fund redemptions, was much larger in terms of dollar amount.
As we all know, it didn't end there. The portfolio insurance players hadn't even gotten started. As the "forced selling" from the margins calls of risk arbitrage players (and from the redemptions from mutual funds) accelerated, the stock market plunged dramatically.
This took it down to the "trigger levels" for the portfolio insurance holders. Once their magic levels were broken, the portfolio insurance players began selling futures (short) in a meaningful way, which, of course, exacerbated the sell-off. As the market sold off further, individual investors (who were watching the market very closely that day), called their mutual funds and redeemed even more shares.
So, that's why the stock market crashed on Oct. 19, 1987. It was a "perfect storm." You had leveraged risk arbitrage investors who were "forced" to sell to meet margin calls. You had mutual fund who were "forced" to sell to meet mutual fund redemptions. Finally, you had holders of portfolio insurance who were contractually "forced" to sell to protect (or "insure") their portfolios.
These players were all put at risk by the rise in interest rates, but it was the bill out of Rostenkowski's committee that was the catalyst that sparked the crash. That bill was what "Mrs. O'Leary's Cow" was to the Chicago fire.
All in all, the crash was ignited by a measly trial balloon, but the foundation of leverage had been laid. Luckily, two-thirds of the "forced selling" that took place was not due to margin calls, and the percentage of the money that was engaged in this "forced selling" was much bigger than that. Therefore, since the mutual fund sellers and portfolio insurance players were not unwinding leverage, it did not turn into an economic event like it did during such grievous times like 1929 and 2008.
Remember one thing. Crashes are never caused by poor earnings or lower economic growth. Those things cause recessions, but they do not cause crashes. One thing, and one thing only, can cause a crash: forced selling.