Black Monday gave just a taste of what was to come

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I have read that stock market crashes of the depth of the Oct. 19, 1987 version – Black Monday – occur once every 75 years or so. I guess that makes me privileged to have been a reporter when the Big One happened.

I was in my late 20s and working as a business reporter in Toronto when Black Monday hit investors – and our newsroom – like a sledgehammer. A quarter-century later, I recall the newsroom buzzing with manic energy; reports of panicked brokers refusing to take calls from clients (later confirmed); and of the Bay Street brokerages, notably Wood Gundy, losing fortunes on the privatization of British Petroleum.

The brokerages had no "market out" clause to cover losses related to an extraordinary market plummet. They were forced to buy shares from the British government at 21 per cent more than they were able to sell them to Canadian investors.

As it turned out, the losses on the BP shares almost exactly matched Black Monday's overall stock market losses. The Dow Jones Industrial Average fell by 508 points, taking it down a record 22.6 per cent. An equivalent crash today, in percentage terms, would see the Dow lose 2,900 points.

In retrospect, Black Monday was a relatively harmless event. The panic was short-lived; the Dow finished 1987 slightly higher in spite of Black Monday. The crash did not trigger a crisis in confidence in stock markets, capitalism or market regulation. While the crash was global – it hit Hong Kong before London, New York and Toronto – it did not jeopardize the global financial system, as the 2008 credit crunch did.

The cult of equity remained intact. Black Monday turned out to be a once-in-a-lifetime buying opportunity, ushering in one of the longest bull markets in history. Mike Lenhoff, the chief strategist at Brewin Dolphin, one of Britain's biggest investment management firms, looks back on 1987 as "notably a big correction at a time when the markets were richly valued against a backdrop of rising interest rates."

Indeed, the crash took the S&P 500 index from a rich price-to-earnings multiple of 23 to a low of about 11.5, attracting investors like lions to a fresh kill. The U.S. Federal Reserve also did its bit to restore confidence by dropping interest rates, though the Fed would soon reverse course as the market and the economy took off. Since then, central banks have moved with alacrity to protect market confidence, and the wider economy, even if they haven't always displayed impeccable timing (the European Central Bank infamously raised rates in the summer of 2008 amid ample signs of economic and market deterioration).

That is not to say, however, that Black Monday taught us only to have the guts to buy equities when the herd is selling. Looking back, Black Monday left us with one big lesson that was largely ignored and would come back to haunt us: Beware the dangers of financial engineering.

The causes of the 1987 crash have been debated endlessly. Unusually high valuations were part of the story – the Dow had climbed 43 per cent between the start of 1987 and its August peak. Another element was rising interest rates and tightening credit, which made the savviest investors realize that share prices were headed for a fall. They were trading into bonds well before the crash. Still others think the rising U.S. trade deficit was a big unsettling factor (even though the deficit then was insignificant compared to the one that would come).

There is one factor on which many market archeologists agree: that derivatives played a big role in the 1987 horror show. The culprit, it appears, was "portfolio insurance."

In the mid- to late-1980s, investors in the United States and in Europe, if not quite yet in Asia, were using increasingly sophisticated computerized trading techniques to protect themselves from market selloffs. One such technique was portfolio insurance, in which investors hedged against losses by short-selling stock index futures.

It didn't work. In the summer of 1987, too many investors tried to sell the same futures at the same time and the whole gamble blew up. Paul Tudor Jones, the billionaire American hedge fund manager, made a fortune on Black Monday after having bet the market would plunge.

In an interview in 2000 with analyst Joel Ramin, Mr. Jones said: "There was a tremendous embedded derivatives accident waiting to happen in the crash of '87 because there was something in the market that time called portfolio insurance that essentially meant that when stocks started to go down it was going to create more selling because the people who had written these derivatives would be forced to sell on every down-tick."

Indeed, the selling turned into a cascade, which in turn triggered more selling. By the end of the bloodbath, Mr. Jones had reportedly made as much as $100-million (U.S), a mouthwatering fortune at the time.

Faulty financial engineering, of course, would surface in later market slumps and downturns, notably in the 2008 credit crunch that cost Lehman Brothers Inc. its life, wrecked banks across the United States and Europe and pushed those two continents into grinding recession (the euro zone is now back in recession). One of the key trigger events was the blowup of the mortgage-backed securities market and the derivatives that were designed – and failed – to protect them, known as credit default swaps.

"The 1987 crash gave us our first taste of the brave new world of financial engineering and, in particular, how socially useless instruments like derivatives contribute to market instability," said market strategist Marshall Auerback, a director of Toronto's Pinetree Capital. "Portfolio insurance turned out to be another one of those false gods that didn't deliver what it promised to deliver, namely a hedge against falling markets, much as today's CDS fail to hedge against an event like a Greek default."

The lesson of Black Monday? Derivatives can cause a lot of damage when they go wrong. That was the time when the derivatives market should have been tightly regulated, and some of the more esoteric products banned. Those products were largely left alone. The consequences were dire.