Wall Street Crash

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Though analysts have been warning about a mortgage-related shock for months, the contours of the coming decline are nonetheless bracing. Trouble started by America’s least affluent—a group that rarely sets our economic course—has begun to grow and spread, slowly affecting every corner of the financial world. Cleaning up the mess will take months, if not longer, and investors who thrived on the cheap credit and private-money deals that have defined this financial era may take years to recover.

While it’s not clear what caused the decline in 1987, we do know what exacerbated it. The in-vogue product that year was portfolio insurance: People who owned stocks sold futures contracts tied to the Standard & Poor’s 500-stock index as a hedge. If shares fell, the futures would rise in value, cushioning investors’ losses. The hedge was “dynamic,” automatically updated by computer-driven models.

The strategy was sound, provided only a few used it at once. But by midsummer 1987, portfolio insurance had become as ubiquitous as hair-metal music. Many people, driven by the same computer models, were placing almost identical bets. Rob Arnott, a well-known value investor who, in 1986, wrote a seminal article for Pensions & Investment Age that warned against the technique, says the amount of money invested with the strategy hit about $90 billion, or as much as 10 percent of all pension assets, that year. By comparison, the value of volume traded daily on the stock market was about $4 billion.

On the morning of Monday, October 19, after several rocky weeks, money managers using portfolio insurance came into the office needing to sell stocks. Because everyone was moving in the same direction, the New York Stock Exchange’s clunky trading system locked up. As stocks fell, more futures needed to be sold, pushing the stock market down and creating a ­vicious cycle. Mix in a dash of panic, and a strategy intended to be anodyne ended up causing searing pain.

Old Wall Street guys love talking about the 1987 crash—from this distance. Jeremy Grantham, chairman of the Boston money-management firm GMO, describes the period as “the most exciting days of my professional life.” Grantham, a value-investing icon and noted bear, told me he was in an investment meeting the Friday before the crash, urging a college endowment to hedge against a potential drop in the market and to do so right away. For technical reasons, the hedge was never put in place, and the crash hit the endowment much harder for the lack of it.

By the standards of today’s credit-default-swap and collateralized-debt-obligation-filled marketplace, portfolio insurance was almost laughably crude. Unlike current complex investment strategies, portfolio insurance, which was limited to stocks, was unusually concentrated. Investors now are “less focused on a single type of strategy that trades in a specific way,” says Arnott. But the lessons of that debacle remain pertinent. “While the kind of portfolio insurance practiced in 1987 is extinct, today there is portfolio insurance in disguise,” he says.

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