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Saturday, October 20, 2012

How I Caused the 1987 Crash

 

I got a chuckle from the biz blogs and TV yesterday with the rehash of the 1987 stock crash. Twenty-five years is a very long time. I’d forgotten most of the events of that day.

 

I was at Drexel, and at that time, Drexel was a powerhouse. The firm had plenty of capital and huge capacity to borrow money to fund positions. Money was rolling in; risk taking was encouraged. I was working with a small group of people on one of the screwier sub-sets of the high yield bond market. It was referred to as LDC debt (Less Developed Country debt). These were the busted bank loans of all of the countries in South America.

 

You might wonder why anyone would spend time mucking around with the debts of Brazil, Mexico, Argentina and Chile. Actually, it was a great business. We were coining money. The key to our (and others) success was the ability to make a price on illiquid assets. If some regional bank needed to sell $25Mn of Brazilian debt, we would make a bid on the phone. If a company were in need of some Mexican debt that would be used in a debt for equity transaction, we would offer the paper to the buyer, even though we did not own it.

 

My old days of currency trading came in handy as some of the paper we traded was denominated in currencies other than the dollar . The fact that I had a “license” to trade currencies gave me the opportunity to speculate pretty freely, and I/we did. The shop that I worked in was no different than any other on Wall Street. We had a “book” of positions. Some were outright specs, others were hedges against commitments we had made. To hold this book together, we required equity (cash).

 

The Crash of 1987 happened on a Monday. But the crash really started the week before. The S&P tanked 9% on the week, Friday was a particularly bad day. The big move in stocks set things in motion over a very nervous weekend. I got the call from the controller’s office on Saturday. It went like this:

 

Controller:

Hi, Sorry to bother you, but we have some issues with our bank lenders (It was Bankers Trust that first pulled the plug on street liquidity). They are nervous, and want to cut back our funding lines. You are using a fair bit of capital in your trading book. Can you tell me what all this money is being used for?

 

BK:

Sure. We have a matched book of longs and shorts on the prop trading side. We also have some open currency positions. We have an inventory of hedges against open client positions. We also have some naked longs.

 

Controller:

Ah, can you be more specific?

 

BK:

Sure. We are long Brazil, Mexico and Chile; we are short Ecuador, Peru and Venezuela. We are naked short the USDHK$ and have $60Mn of Cuban bonds in inventory.

 

Controller:

You’re shitting me. What is that junk? Is any of this liquid? Can you sell this book of crap?

 

BK:

I might be able to run things down a bit. How much time do I have?

 

Controller:

Close half by Monday night.

 

And that is how the crash of 87 happened.

 

Sunday night October 19, at the opening in Tokyo the HK$ position was closed off (at a loss of course). I got up at 2am and started the calls to London where there was a market for LDC paper. I was hitting bids on anything I could. The prices for the long assets were getting clobbered. There was no liquidity in the markets I was short. It was about minimizing losses and cutting a book. There was no finesse about it.

 

Of course I was not alone in those early morning hours. Hundreds of players from NYC were on the phone hitting bids on all sorts of squirrely assets. The folks who make markets in London were never dopes. When their phones lit up with Americans looking to lighten up, they voted with their feet. Bids for everything dropped like a stone. By eight o’clock in NY everyone knew that wholesale liquidations were going on, and that stocks were going to get beat to a pulp when the market opened up.

 

I think I stood all of that day. The phones rang and rang. Both buy and sell side clients were panicked. Most were sellers; the buyers went on strike. Prices were dropping without any trading taking place. The brokers were all, “offered without the bid”. It was next to impossible to get trades off.

 

Some where’s around 2pm NY time, the Cuban paper got sold (more losses). There was not much more that could be done. So I sat down and watched the Reuters screen and the Dow tape for the rest of the day. I’d had next to no sleep, drank a ton of coffee and smoked too many cigarettes. I’d sweated all day, and stank. I left before the 4pm close.

 

To me, there are today many similarities to the market conditions that triggered the 87 crash. These two ring a bell:

 

In 87 I bet on Cuban paper. The rumor at the time was that Castro was sick. The thinking was that when he died, the bonds would increase in value. I’d bought the bonds at around 5 cents on the dollar. Exactly the same bet, for the same reason, is being made today:

 

 

The Hong Kong dollar was pegged to the USD in 1983. Four years later guys like me were betting that the central bank could not hold the peg. Money was flowing into Hong Kong; the central bank was forced to intervene in the market to keep the lid on the HK$. This same trade is popular today:

 

 

The most important comparison has not yet shown up yet in 2012. In 1987, over the course of a weekend (and many panicky phone calls), market liquidity and the ability to finance off-the-run assets dried up. It started at the bottom of the rung of asset quality, by the end of the day it had spread to the most liquid stocks.

 

On Thursday, October 15, 1987, the farthest thing from my mind was a squeeze on the equity capital I was using to support a book of business. If anything, I was (everyone was) being encouraged to put more money to work. That vaporized in hours. It was one giant “risk off” event.

 

There were no external factors of significance that led to the 87 crash. The market did itself in on that day. All it took was a few calls that said, “I want you to cut back at open”.

 

The repo markets that fund the zillions of assets (good and bad) in 2012 are exponentially larger and more complex than in 1987. If anything, that market is more vulnerable today to the call that says, “Cut it back”.

 

Note:

Of course I didn’t really start the 87 crash. I was a small cog in a very big wheel. There were thousands of folks who were scrambling on that day.

On Monday night, 10/19/87 the Fed (Greenspan) called the heads of the big banks and told them to open the spigots. The Repo markets were flush with cash on Tuesday morning.

From my perspective, it was much ado about nothing.

 

 

Comments

  1. I seem to recall in “Den of Thieves” that Milken was taking something like 14 points on bonds during that time.. lol. Oh how things change, and yet.. stay exactly the same.
    Great post.. thx Bruce!

  2. Fantastic account. And valuable. Thanks!

  3. amazing info BK,your info is part of why i am not in mkt since march.Missed some gains but better than loseing all.You addresed aapl recently.Would you please sometime address gold in all of this. thanks

  4. Great stuff !
    O.K., so what´s the drill this time when the Fed´s got no bullets left ?

  5. Bruce, feels like you are one of the few “adults” out there, too many campers, not enough counselors.

    Great post. Peace.

  6. But What Do I Know? says:

    You’re being far too modest! If you consider that the cure for the Crash of 1987 was a flood of liquidity, and that this led Alan Greenspan to believe that he could fix any problem the same way, then in some sense you are also responsible for the internet and housing bubbles and the GFC. . .

    Hope you can sleep nights :>)

  7. Great read Bruce – thanks a bunch.

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  9. Very good account. Would like to know the motivation of the controller who had a clear picture of your book and its quality yet said anyway “close half by Monday” Was it simply a knee jerk, costly, thoughtless attempt at risk off? Are they that stupid? Or (my sinister conspiracy side) was there an attempt to trigger something. Did someone at a high level have positions that would benefit from such a move? An army of American traders calling London all through the night indiscriminately unloading positions is like shouting fire in a theatre, -intended to cause panic if you will.

  10. There is no money in the U.S. There is no large, trillion debt either. The Constitution requires Gold and Silver coin (A1s10), A1 s8 says we empowered the Congress to borrow, A1 s8 cl5 money needs to be coined, A1 s10 says no State can make anything but gold and silver coin as tender in payment of debt, If noone has lent g and s coin, then they are not going to get paid back g&s. Paper Federal Reserve Notes have not been redeemable for lawful (coined) money since before 1965. No redemption, no coined money, no borrowed money, no debt. Caveat emptor, China. Let’s get to the bomb shelters, quickly!

  11. Great post, brought back memories.
    I was short 335 S&P futures contracts going into the crash.
    So, I was on the right side that day and still likely lost a few years on my life. Back then there was no e-mini and the full size contract was twice the current full sized contract.
    I remember walking across the street (from the Board of Trade) to my bank Continental and withdrawing $3,000 in cash that I carried around for a few months in my wallet.
    Thanks for the post.
    And, thanks for the website.

    Best,

    George