Steven Goldberg has an article at Kiplinger that compares today’s market to the crash of 1987:
What the market has done over the past week duplicates what happened in the one-day 1987 crash, when the Dow Jones industrial average plunged a record 23%. The week of October 6 through 10, Standard & Poor’s 500-stock index plummeted 18%. Could past be prologue?
The proximate cause of the ’87 crash was “portfolio insurance”:
The big drop came Monday, October 19. It was a 508-point crash caused mainly by leveraged derivatives-portfolio insurance-which, ironically, had promised to insulate big investors from the risk of a sharply falling market. As Wall Street fell, portfolio insurance triggered selling in stock futures in Chicago, setting up a feedback loop. By the end of the day, many Wall Street firms weren’t even answering their phones.
In other words, the 1987 crash was, like the current crash, caused by financial instruments. The exotic mortgage securities billed as low-risk by Wall Street’s rocket scientists are far more complex, but ultimately they had the same kind of nonsensical thinking behind them: They ostensibly offered a way to leverage up to great returns with no risk.
I think Goldberg’s analogy is flawed. The portfolio insurance product of today is the Credit Default Swap market. In ’87, portfolio insurance got into a loop where lower stock prices meant hedging more by selling stock futures. That is similar to what the CDS market has done. Here’s a scenario that I’ve highlighted before:
1. Hedge fund shorts financial stock.
2. Hedge fund buys CDS on target company’s bonds.
3. Seller of CDS shorts stock to hedge default risk.
4. Falling stock price gets the attention of bond holders who buy more CDS.
5. Seller of CDS shorts more stock to hedge default risk.
I am convinced this is how Bear and Lehman were taken down. I don’t have any proof that there was collusion on the part of hedge fund traders to force these company’s stocks down, but there may have been no need for collusion. Rumors in this environment will suffice.