Black Monday, Twenty Years Gone

♠ Posted by Emmanuel in at 10/17/2007 03:02:00 PM

It's been nearly twenty years since the events of 19 October 1987, Black Monday, when the Dow[n] Jones Industrial Average dropped by nearly a quarter in a single day. The question is, can a dramatic, Greg Louganis-like plunge happen again, especially in today's turbulent, subprime-laden environment? The Wall Street Journal is relatively sanguine in arguing that the safeguards built into today's market likely preclude a rehash of Black Monday, but you never know. Above is the video and what follows are excerpts from the article entitled "The More Hedges the Better." For the record, I don't buy the argument that hedge funds add stability to the market--quite the contrary--but it's always good to hear another opinion. The WSJ is a tad too Lipsky-esque for my tastes...

Twenty years ago, investors relied on what they considered to be sophisticated strategies to try to avoid big stock-market losses. On "Black Monday," as the stock market plunged 22.6%, they found their safety nets had huge holes.

Today, investors can much more easily and effectively hedge their exposure to the market. "With each successive crisis, the industry gets better and better; it's significantly better prepared than before 1987," says Pavandeep Sethi, global head of volatility trading at Chicago's Citadel Investment Group, a $17 billion hedge fund. "Risk management is more sophisticated, and good managers have a game plan" to prepare for deep jolts to the market.

But some worry that today's improved and sophisticated hedging techniques have created a false sense of security among investors, and that a dramatic market collapse is still possible if issues arise in areas where there is little transparency, such as the world of derivatives.

Although there is a "richer menu" of tools for investors to hedge their portfolios, there remains the possibility of "the same cascading effect as the sellers of the hedge have to move to protect themselves from a falling market, and everyone runs for the door at the same time," says Robert Glauber, a former U.S. Treasury undersecretary for finance who led a probe of the stock-market crash of 1987 and now works as a senior adviser at Peter J. Solomon Co., a New York investment-banking firm.

In 1987, investors had relatively few tools to protect their stock portfolios. They could sell shares, of course. Or they could enter into futures contracts that pay off when stocks fall, or buy "put options," which give investors the right to sell their shares at a lower price. But the market for futures and options was not as big at the time, and the idea of paying upfront to purchase stock-market insurance drew some resistance.

As stocks climbed leading up to the autumn of 1987, a growing number of pension plans turned to a computerized hedging strategy known as portfolio insurance. It usually entailed selling futures contracts on stock indexes when the market tumbled, to try to protect the value of a portfolio by scoring profits from the futures contracts. This strategy is referred to as "dynamic hedging" because it requires portfolio adjustments on-the-go, or rapid selling even as the market falls.

But as the market headed lower in the days before Oct. 19, 1987, traders began to anticipate selling by portfolio insurers, and moved to get out ahead of them, pushing stocks lower. As futures prices collapsed on Black Monday, the futures-selling programs of the portfolio insurers kicked in, accelerating the crash, doing little to help those who relied on this hedge and helping to discredit the value of this insurance.

In many ways, risk management and hedging techniques have improved since 1987, and larger investors have many more-sophisticated tools available, analysts and academics say. For example, credit-default swaps, which essentially are insurance policies that pay off if a company looks more likely to default, give investors a way to hedge their exposure to specific companies and sectors.

But many of the hedging products are new and relatively opaque, raising questions about how they will hold up in a market crisis. For instance, over-the-counter derivatives trades are worked out between two parties and not widely reported, and have been embraced only in recent years. Just as important, consolidation of the banking industry means a few large banks serve as counterparties on many of the new hedging deals, so if a big bank runs into deep trouble, the hedges might not be as solid as some expect.

Deep, sudden losses at some of the most sophisticated hedge funds in August were a reminder that many investors sometimes focus on similar investments, and use heavy dollops of borrowed money to try to boost their returns, both of which can spark a stampede for the sidelines in a crisis. The recent losses also demonstrate that even large investors continue to be caught off guard by market moves, raising questions about their ability to hedge their risks.

The new strategies also have created dangers in often-obscure markets that feature little transparency, usually in the credit markets. For example, recent difficulties in structured investment vehicles, or SIVs, forced a group of big banks to band together this week to try to form a new fund to help avoid potential big losses from a part of the market that remains largely frozen since this summer's debt-market turmoil.

"People have been lulled," says Nassim Nicholas Taleb, a former trader who made big money in 1987 and is the author of "The Black Swan." He argues that investors underestimate the risks of a big crash.

Large investment firms and banks still turn to 1987's big drop, as well as other market collapses, to test their ability to withstand market crashes. Some say that because firms are better prepared for huge drops, market difficulties don't result in the same cascade of selling as it did two decades ago.