The Brady commission a story (by Andy Constan)
The Brady commission a story (by Andy Constan)

The Brady commission a story (by Andy Constan)

Original post on May 19th, 2022.

In 1987 on October 19th the stock market crashed. I was 23 years old and had been working at Salomon as a corporate finance analyst. The job was a two year stint where at the end you left to go to business school. It was a thrilling job. My specific role was as a quant explaining more complicated securities to our corporate clients. Of course this was 1987 and index options were only 6 years old. Convertible bonds were exotic and rights offerings were uncommon. Because of this I was also a resource for all the bankers and some of the trading floor to help them sell corporate clients and then the capital markets clients on the products we dreamed up. I was a busy guy. I had a couple of really really nerdy superiors but somehow the rest of the firm was more comfortable with me.

It might be because at the time I was extremely connected in the NY club scene and my analyst class, and many of the associates and VP’s came to the parties I hosted at Area, Limelight, The Tunnel and other super hot clubs of the day. Anyhow I was well known.

The stock market crashed and Nicholas Brady who was the CEO of Dillon Read and later the secretary of the treasury was appointed by President Reagan to put a task force together to study what had happened and to suggest ways to prevent such a crash from happening again. Brady gave the chief of staff job to a guy who had just joined Salomon in banking named Chas Phillips. The staff was to be composed of some academics and a few Wall Street guys. Salomon chose me. I have no clue why. Goldman chose Michael Coors who was running Equity capital markets, Morgan Stanley picked Scott Lenowitz who ran Program trading, JP Morgan chose Peter Bernard who ran Fixed income derivatives and Lehman picked Phil Jones who ran equity derivatives structure products. PTJ chose Peter Borish a partner and head of research. All were much more senior than me. We met at the Federal Reserve on Maiden Lane. You might know the building from Die Hard with a vengeance. It’s where they keep the gold. Cool tour by the way with Gerry Corrigan the NYFED governor.

So we started to comb data. There was no excel at the time and we only had an IBM AT with Lotus 123. Nonetheless the data we had was fantastic. We had every futures trade done by every executing broker tagged with the end client. We had ever trade that was marked “program” or part of a basket of stocks sold all at once. By the way at the time the DOT system (which let sellside firms electronically send orders to the NYSE) had just been installed also every NYSE stock trade was arranged by a NYSE specialist firm. Prior to DOT program trades were sent to an army of floor brokers who carried paper tickets to the specialist for execution. All futures orders were phoned to the CME where this happened.

As I mentioned index options were a new product that had been invented only a few years before. But already there was skew in the market and a few “bright” guys came together and founded a firm that marketed a cheaper way to purchase downside protection. The firm was named LOR (Leland, O’Brien, and Rubinstien.) Some of you may recognize the last name as he and another academic names Cox wrote one of the Bibles of option theory and really invented the valuation that uses binomial trees to value options. These guys sold there service to the biggest pension funds in the world. The idea was that instead of buying expensive puts the pension fund would follow their proprietary algorithm to dynamically replicate a long put at a lower cost. They called it Portfolio Insurance. Catchy name back then. Dynamically replicating a long put requires a strategy of selling a portion of one’s portfolio when the market fell and buying it back when the market rose. Sell low/buy high. That seems stupid. Nope by doing this one cuts there exposure as the market falls and adds back as the market rises. Just like buying a put. The losses taken in this activity were supposed to be less than the price of a put. RV<IV and the strategy wins. The problem was they over sold the idea and underestimated the impact the activity would have exacerbating large moves.

On October 19th we were able to identify two huge portfolio insurance clients of LOR who followed the strategy. As we went through the data we saw them first selling baskets to stocks via program trading desks. As the market fell they sold more and then more again. Finally these funds ran out of stock to sell. They still had a ton of other stocks to “Insure” but they were out of baskets. By the way every time a basket was sold the buyer would buy the basket and hedge by selling futures. That transmitted the selling to the futures markets. (There was no SPY ETF) as the stock desks stopped selling the market bounced a bit. Apparently a very famous trader name Mark (I forget) stood up on his desk at Drexel and started buying. But the end client had simply stopped selling stocks and started using futures. Now when the futures get sold the buyer of the futures needs to hedge by selling baskets. So those who had facilitated the basket trades orignally started dumping the baskets and Mark got run over. But these guys ran out of baskets too. To buy futures from the seller who kept selling because of his LOR algo they would need to sell short baskets of stocks. At the time the plus tick rule prevented selling short at a price lower than the prior trade. Of course there were no plus ticks so the baskets couldn’t get sold. Futures markets started dislocating from the cash market and traded iirc at as much as a 10% discount to the arbitrage fair value. The market was broken. All due to Portfolio insurance and the pension fund which blindly followed the algo. We saw it all and placed blame without ever Identifying the end client.

To this day I don’t think anyone actually knows unless they know the 5 of us who figured it out on our IBM PC AT in Gerry Corrigans office in late 1987. I was driving the keyboard and my colleagues sat over my shoulder. It was a blast. Our recommendations are still in place. Prior to our task force The CME and NYSE didn’t have coordinationated market closure procedures, the circuit breakers now in place were invent by us. We also suggested that the plus tick rule failed to protect market function. It was later abandoned. Just as a reminder the October 19th crash saw the SPX fall 27% in one day. It had rallied 36% YTD at the peak in August and ended the year surprisingly exactly flat.

RIP Gerry Corrigan. He passed away this morning. I had no idea when I wrote this. Sad.

I made these charts! Skills! Futures fair basis broke on Monday But Tuesday was even more nuts with futures literally broken for an hour. Then Bob Mnuchin (GS) and yes the smart father and Stanley Shopkorn (SB) talked on the phone and decided to save the market

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