In the 1970s, two young professors at Berkeley’s business school, Hayne E. Leland and Tag Rubinstein, conceived the thought of “portfolio insurance,” a specialized method for protecting the worthiness of a large institutional portfolio. They became a member of with John O’Brien, an extremely superior trader and a master salesman, to create a business, Leland O’Brien Rubinstein Associates (LOR), that shortly was racking up stunning sales.
LOR’s item was a couple of algorithms that clicked in during a industry downturn to limit losses. When the insurance algorithms had been triggered, computers would promote futures to secure a pricing ground, and then reverse the process as marketplaces recovered. The concept was simple, but its execution requirements had been formidable.
Skeptical customers asked what would happen if the markets didn’t step up and buy futures at “rational” prices. That was very easily waved off. Yes, in panicky marketplaces, the futures clearing prices might be less than the rational value, but canny traders would shortly recognize the bargains available. That glibly danced by a scarier issue, however – the sheer scale of portfolios which were shielded by insurance. A truly serious downturn could result in huge robotic futures product sales that could overwhelm the capacities of the investors.
And that duly occurred on Black Mon, Oct. 19, 1987. After weeks of slipping marketplaces, floods of computer-influenced futures orders hit the Chicago marketplaces, 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 providing. Henriques gives us a gripping, almost minute-by-minute account of the weeks that used, like the posturings, the denials and the panics, in addition to the “net of trust, pluck and improvisation” that pulled the marketplaces through.
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Summing up the crisis, Henriques places blame about “disparate, blindly competitive and more and more automated market segments … gigantic and more and more like-minded institutional investors” and “a regulatory community that was poorly prepared, ridiculously fragmented, technologically naïve and fatally focused on protecting turf.”
Henriques overstates her case, however, when she writes that “greater than a trillion dollars in wealth have been lost.” And she cites a comment from President Reagan at an impromptu media conference during the worst days of the crisis that “all the organization indices will be up. There is normally nothing wrong with the overall economy,” which she compares to Herbert Hoover’s complacency in 1930.
Actually, Reagan was best suited. The economy was good. From 1986 through 1989, real (inflation-adjusted) progress was 3.5 percent, 3.5 percent, 4.2 percent and 3.7 percent. The 1980s currency markets was a roller coaster. It opened up with historically low price-revenue ratios, which allowed canny leveraged buyout investors to snap up stable companies at bargain prices. As copycat investors flooded into the buyout markets, the quality of discounts deteriorated – laughably, one main acquisition was insolvent on the day the offer closed. The trillion-dollar drop in industry values was simply a recognition of fact. The saps who got the losses had been counterbalanced by the lucky investors who got their money out in time.
Having said that, Henriques has produced an extremely intelligent and perceptive evaluation of an essential transitional era in modern finance. She is quite correct that the quant-driven industry complexities of the 1980s finally induced a real crash in 2007-8. Unfortunately, the deregulatory crusaders of the current administration appear to have paid no attention.