The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (9 page)

Sometime around
midnight, October 19, 1987, Leo Melamed reached out a sweaty-palmed hand, picked up the phone in his nineteenth-floor office at the Chicago Mercantile Exchange, and dialed Alan Greenspan. The newly appointed chairman of the Federal Reserve, Greenspan was staying at the upscale Adolphus Hotel in Dallas to address the American Bankers Association’s annual convention the next day. It was to be his first major speech as chairman of the central bank.

The speech would never happen. The Dow industrials had crashed, losing 23 percent in a single day. Other exchanges, including the Merc, were in chaos. Many players in the market were bankrupt and couldn’t settle their bills. Greenspan had been fielding calls from executives at nearly every major bank and exchange in the country. His single goal: make sure the markets were up and running Tuesday morning.

Greenspan wanted to know if the Merc would make it. Melamed, the exchange’s president, wasn’t sure. The Merc had become a trading hub for a new financial product, futures contracts linked to the S&P 500. At the end of a typical trading day, traders who’d lost money on any contracts would transfer cash to the Merc’s clearinghouse, which would deposit the money into the winners’ accounts. Typically $120 million would change hands every day. But that Monday, buyers of S&P futures owed sellers an amount in the range of $2 billion to $3 billion. Some couldn’t pay.

If the Merc couldn’t open its doors for business, the panic would spread. The whole system could come crashing down. That night, Melamed made frantic phone calls to institutions around the country trying to settle accounts. By morning, $2.1 billion in transfers had been completed, but a single client still owed $400 million to Continental Illinois, the Merc’s financing agent.

Melamed still wasn’t sure if the Merc could open without that $400 million. Around 7:00
A.M
. he decided to call Wilma Smelcer, Continental’s financial officer in charge of the bank’s account with the Merc. If Smelcer couldn’t help him, his next call would be to Greenspan … with very bad news.

Smelcer didn’t think she could look past $400 million in missing funds. It was a deal killer. “Wilma, I am certain your customer is good for it,” Melamed pleaded. “You’re not going to let a stinking couple of hundred million dollars cause the Merc to go down the tubes, are you?”

“Leo, my hands are tied.”

“Please listen, Wilma. You have to take it upon yourself to guarantee the balance, because if you don’t, I’ve got to call Alan Greenspan, and we’re going to cause the next depression.”

After a few moments of tense silence, Smelcer said, “Hold it a minute, Leo. Tom Theobald just walked in.” Theobald was chairman of Continental.

After a few minutes, Smelcer was back. “Leo, we’re okay. Tom said go ahead. You’ve got your money.”

It was 7:17
A.M
., three minutes before the opening of the Merc’s currency markets. The world had little idea how close the financial system had come to a catastrophic seizure.

The critical
factor behind the crash of Black Monday on October 19, 1987, can be traced to a restless finance professor’s sleepless night more than a decade earlier. The result of that night would be a feat of financial engineering called portfolio insurance. Based on the Black-Scholes formula, portfolio insurance would scramble the inner workings of the stock market and set the stage for the single largest one-day market collapse in history.

On the evening of September 11, 1976, Hayne Leland, a thirty-five-year-old professor at the University of California at Berkeley, was having trouble sleeping. He’d recently returned from a trip to France. A weak dollar had made the trip excessively pricey. Stagflation, a crippling mix of high inflation and slow growth, was rampant. The economy and the stock market were in the tank. California governor Ronald Reagan was threatening cutbacks in the salaries of academics such as Leland, who worried that the prosperous American lifestyle of his parents’ generation was in danger.

As he pondered this bleak reality, Leland recalled a conversation he’d had with his brother, John, who worked at an investment management company in San Francisco. Stocks had cratered in 1973, and pension funds had pulled out en masse, missing out on a bounce that followed. “If only insurance were available,” John had said, “those funds could be attracted back to the market.”

Leland was familiar with the Black-Scholes formula and knew that options behaved in ways like insurance. A put option, which pays off if a stock drops, is akin to an insurance policy on a stock. He thought of it step by step.
Say I own IBM at $50 and am worried about it losing value. I can buy a put for $3 that pays off if IBM falls to $45 (allowing me to unload it for $50), essentially insuring myself against the decline for a premium of $3
.

Leland realized his brother had been describing a put option on an entire portfolio of stocks. He sat down at his desk and started to scribble out the implications of his revelation. If the risk of an entire portfolio of stocks declining could be quantified, and if insurance could cover it, then risk would be controlled and managed, if not
effectively eliminated. Thus portfolio insurance was born. No more sleepless nights for jittery professors.

Over the next few years, Leland and a team of financial engineers, including Mark Rubinstein and John O’Brien, created a product that would provide insurance for large portfolios of stocks, with the Black-Scholes formula as a guidepost. In 1981, they formed Leland O’Brien Rubinstein Associates Inc., later known simply as LOR. By 1984, business was booming. The product grew even more popular after the Chicago Mercantile Exchange started trading futures contracts tied to the S&P 500 index in April 1982. The financial wizards at LOR could replicate their portfolio insurance product by shorting S&P index futures. If stocks fell, they would short more futures contracts. Easy, simple, and sweet. And enormously profitable.

By the autumn of 1987, the company’s portfolio insurance protected $50 billion in assets held by institutional investors, mostly pension funds. Add in LOR copycats and the total amount of equity backed by portfolio insurance was roughly $100 billion.

The Dow industrials had soared through the first half of 1987, gaining more than 40 percent by late August. The so-called Reagan Revolution had restored confidence in America. Inflation was in retreat. Japanese investors were flooding the United States with yen. New Agers around the country discovered the healing power of crystals. A new, young Fed chairman was in town. The New York Mets were the Cinderella world champions of baseball, having won the 1986 World Series in seven games, led by a young power hitter named Darryl Strawberry and a dazzling pitcher named Dwight Gooden. What could go wrong?

Plenty. By mid-October, the market had been knocked for a loop, tumbling 15 percent in just a few months. The block trading desk at Shearson Lehman Brothers installed a metal sign with an arrow that read: “To the Lifeboats.”

The mood was grim. Traders talked of chain reaction declines triggered by mysterious computer-assisted trading strategies in stocks and futures markets. As trading wound down on Friday, October 16, a trader in stock index options on the floor of the American Stock Exchange shrieked, “It’s the end of the world!”

Early on Monday, October 19, investors in New York were bracing for an onslaught well before trading began. Over in the Windy City, it was eerily quiet in the stock index futures pit at the Chicago Mercantile Exchange as traders waited for the action to begin. All eyes were on Chicago’s “shadow markets,” whose futures anticipate the behavior of actual prices. Seconds after the open at the Merc—fifteen minutes ahead of trading in New York—S&P 500 index futures dropped 14 points, indicating a 70-point slump in the Dow industrials.

Over the next fifteen minutes before trading began on the NYSE, massive pressure built up on index futures, almost entirely from portfolio insurance firms. The big drop by index futures triggered a signal for another new breed of trader: index arbitrageurs, investors taking advantage of small discrepancies between indexes and underlying stocks. When trading opened in New York, a brick wall of short selling slammed the market. As stocks tumbled, pressure increased on portfolio insurers to sell futures, racing to keep up with the widely gapping market in a devastating feedback loop. The arbs scrambled to put on their trades but were overwhelmed: futures and stocks were falling in unison. Chaos ruled.

Fischer Black watched the disaster with fascination from his perch at Goldman Sachs in New York, where he’d taken a job managing quantitative trading strategies. Robert Jones, a Goldman trader, dashed into Black’s office to report on the carnage. “I put in an order to sell at market and it never filled,” he said, describing a frightening scenario in which prices are falling so fast there seems to be no set point where a trade can be executed. “Wow, really?” Black said, clapping his hands with glee. “This is history in the making!”

In the final seventy-five minutes of trading on October 19, the decline hit full throttle as portfolio insurance sellers dumped futures and sell orders flowed in from brokerage accounts around the country. The Dow snapped, sliding 300 points, triple the amount it had ever dropped in a single day in history and roughly the equivalent of a 1,500-point drop in today’s market. The blue chip average finished the day at 1738.74, having dropped 508 points.

In the new globally interlaced electronic marketplace, the devastation wound around the globe like a poisonous serpent Monday
night, hitting markets in Tokyo, Hong Kong, Paris, Zurich, and London, then making its way back to New York. Early Tuesday, during a brief, gut-wrenching moment, the market would lurch even deeper into turmoil than Black Monday. The blue-chip average opened down more than 30 percent. Stocks, options, and futures trading froze. It was an all-out meltdown.

Over in Newport Beach, Thorp’s team was scrambling. Thorp had watched in dismay Monday as the market fell apart. By the time he got back from a hastily snatched lunch, it had lost 23 percent. Trading was closed, and Thorp had a severe case of heartburn. But he quickly figured out that portfolio insurance was behind the market meltdown.

As trading opened Tuesday, a huge gap between S&P futures and the corresponding cash market opened up. Normally, that meant a great trading opportunity for arbs, including Thorp, always attracted to quantitative strategies. The massive gap between futures contracts, created by the heavy selling by portfolio insurers, and their underlying stocks was a sign to buy futures and short stocks.

By Tuesday, most of the arbs were terrified, having been crushed on Black Monday by the plummeting market. But Thorp was determined. His plan was to short the stocks in the index and buy the futures, gobbling up the big spread between the two.

The trouble was getting the orders through in the fast-moving market. As soon as a buy or sell order was placed, it was left behind as the market continued to tumble. In the heat of the crisis, Thorp got Princeton/Newport’s head trader on the phone: “Buy $5 million worth of index futures at the market and short $10 million worth of stocks.”

His best guess was that only half of the stock orders would be filled anyway because, due to technical reasons, it was hard to short stocks in the free-falling market.

At first his trader balked. “Can’t, the market’s frozen.”

Thorp threw the hammer down. “If you don’t fill these orders I’m going to do them in my own personal account. I’m going to hang you out to dry,” Thorp shouted, clearly implying that the trader’s firm wouldn’t share any of the profits.

The trader reluctantly agreed to comply but was only able to
make about 60 percent of the short sales Thorp had ordered up due to the volatility. Soon after, he did the trade again, pocketing more than $1 million in profits.

Thorp’s calm leap into the chaos wasn’t the norm. Most market players were in a this-is-the-big-one hand-wringing frenzy.

Then it stopped. Sometime Tuesday afternoon, the market landed on its feet. It started to climb as the Federal Reserve pumped massive sums of money into the system. The Dow finished the day up 102 points. The next day, it soared 186.84 points, its biggest one-day point advance in history at the time.