Stock crash probe focuses on portfolio insurance

New York Times Service

As investigators sift through mountains of data in an attempt to understand the cause of the mid-October collapse of the stock market, the influence of so-called portfolio insurance has remained in the spotlight.

Recently released figures on trading activity seem to substantiate widely held suspicions that portfolio insurance--a hedging technique that mainly involves the sale of stock index futures to protect a stock portfolio from the ravages of a declining stock market--was an important factor in the market's plunge.

But even before all the evidence is in, many executives overseeing huge pension funds in the United States have reached a verdict on the value of portfolio insurance. Disillusioned with the protection it afforded them during the crash, they have abandoned the strategy. Brokers estimate that only $30-billion (U.S.) to $45-billion worth of stock is now covered by portfolio insurance--down from $60-billion to $90-billion before the October plunge.

This disillusionment could have profound implications for the stock market. With pension fund managers feeling more vulnerable to a further slide in stock prices because they no longer have their portfolio insurance in force, experts predict that these huge funds may continue to sell stocks to reduce their equity exposure. That, in turn, could send stock prices even lower.

The disillusionment with portfolio insurance could also affect a rebounding market. Without the feeling of protection, pension executives are unlikely to be as bullish as they were last summer. Thus, if the market resumes its climb, it may not go up with the same intensity.

The way portfolio insurance is supposed to work is simple: when the stock market falls, the cash raised by selling stock index futures--contracts based on the value of a basket of stocks--offsets the decline in the stock portfolio's value. But in a rapidly falling market, such as mid-October's, this strategy not only failed to provide adequate protection but may have accentuated the market's decline.

Portfolio insurance was hardly the only force behind the mid-October plunge. Others include rising interest rates, a falling U.S. dollar, panic selling, stock-index arbitrage and the insufficient capital of the New York Stock Exchange specialists charged with maintaining orderly markets for stocks.

The effect of each one on the stock and futures markets and the linkage with each other may be too complicated to ever sort out. But there is growing evidence to suggest that the power, both real and psychological, of portfolio insurance had a significant impact on the market--both during the days leading up to the plunge and on Oct. 19 itself.

While some preliminary data released by the Chicago Mercantile Exchange and the Commodity Futures Trading Commission differ, they agree that a hefty portion of the trading in the key Standard & Poor's 500 futures contracts in the crucial days of mid- October were connected with portfolio insurance.

The CME estimates that about 50,000, or nearly a third of the record 162,000 S&P 500 futures contracts that traded on Oct. 19, were insurance linked.

A preliminary report by the CFTC, which oversees the futures exchanges, found that portfolio insurance was a bigger factor on Oct. 19 and 20 than stock index arbitrage trading, which involves a simultaneous buying and selling of stock and stock index futures.

Trades connected to portfolio insurance accounted for 12 to 24 per cent of the trading volume in S&P 500 futures contracts on Oct. 19. The next day it made up 19 to 26 per cent of the volume, according to the CFTC. Trading volume on the New York Stock Exchange that can be tied to stock index arbitrage, however, was much smaller, the CFTC said. On Oct. 19, only 9 per cent of the volume resulted from stock index arbitrage. During the next day, it was less than 2 per cent.

Portfolio insurance is being criticized more than index arbitrage because it exerted direct selling pressure on the futures markets during October. Stock index arbitrage trading, on the other hand, is considered by some investors to have created liquidity. By buying and selling stocks and futures contracts, these traders gave other investors a way to unload their stocks or futures, according to this school of thought.

Portfolio insurance was developed five years ago by two Stanford University professors. Leland O'Brien Rubinstein Associates, the firm they started in 1981, was so successful that it licenced its strategy to other institutional investors. Imitators quickly followed.

While there are variations on the strategy, including the use of stock index options, all are designed to provide stock investors with some protection in a declining market. The "cost" of that protection is that these portfolios do not rise as much as unprotected portfolios in climbing markets--because a portion of their funds are invested in futures and because the strategy typically will saddle its user with higher trading commissions.

In essence, those using portfolio insurance sell stocks after a decline and buy after they rise. Mainstream investors generally try to buy stocks before they move up and sell them before they fall.

But portfolio managers using insurance did not operate in a vacuum. Their computers that orchestrated the hedging strategy operated in the same markets with the program traders using stock index arbitrage. The combination of the two in a falling market has been compared with the effect of pouring gasoline on a raging fire, rendering the portfolio insurance inadequate.

When the market declined, the computerized insurance programs would sell a mathematically determined amount of futures contracts that are linked to the market. But selling of futures contracts drove down the price of the contracts. At that point, they became attractive in the arbitrage program traders, who sold stocks and bought the futures, locking in the difference, or spread, between the prices of the two investments.

The selling of stocks by program traders, in turn, drove down stock prices even more. That set the stage for additional insurance selling of futures, causing a downward spiral.

The fear that portfolio insurance would exert a strong downward pressure on the stock market was as important a contributor to the market plunge as actual futures selling was, according to investment managers and traders.

The trading rooms of Wall Street and the futures pits in Chicago thrive on rumors. Market professionals suspect that when the stock market began to fall in mid- October, the fear of insurance-linked selling caused some investors to begin unloading stocks to beat the insurers and program traders to the exits. That simply drove prices lower.

By Monday, Oct. 19, investors frantically called each other with wild rumors about the numbers of contracts insurers were trying to dump on the Chicago Mercantile Exchange.

"I had calls all day," said Jeffrey Geller, vice-president at BEA Associates, a New York-based money management firm. "The anticipation was much much worse than the actual event."

(text of December 2, 1987 Globe and Mail article)

'Betrayed Africa'

LUSAKA, Zambia--Developed countries have not fulfilled their part of a 1986 United Nations plan for economic aid to African countries, said Stephen Lewis, Canadian ambassador to the UN. He says the international community has betrayed the trust of African countries.

(text of November 18, 1987 The Province article)

African leaders propose delay in debt payments


African leaders have proposed radical measures to solve the continent's debt crisis, including a 10-year suspension of payments to service its $200-billion (U.S.) of debt.

A special two-day summit of the Organization of African Unity also called for all the debt to be rescheduled over 50 years, without interest, and asked for more aid and an international conference next year to discuss these proposals with Western creditors.

OAU chairman Kenneth Kaunda, President of Zambia, told reporters that Africa would not impose the 10-year suspension before next year's debt conference, stressing that it was merely among proposals for discussion with creditors.

"We take no action until we have discussed these matters with our colleagues on the other side of the coin, so there is no confrontation, we are merely making proposals," Mr. Kaunda told a news conference at the end of the summit.

"I believe that all wise people, and there are many on both sides, wish to put their heads together and not through confrontation but through co-operation, and try to work out methods of resolving this problem," he added.

The African meeting followed a summit in Acapulco of eight major Latin American debtors who issued a document on Sunday saying that failure to make progress in alleviating their debt burden would provoke unilateral action.

Africa now spends 40 per cent of its export income to make payments on its debt.

Mr. Kaunda said Africans had asked in vain for a conference with creditor governments and banks for two years, but said he now hoped it would go ahead.

"The atmosphere has changed completely in the last few months," Mr. Kaunda said.

He said he was encouraged by the consideration given to Africa's economic problems by the Group of Seven industrial nations at their June summit in Venice.

"Nordic countries have moved a step further and have written off some of their debts," Mr. Kaunda said. "Canada has followed the same path and some right type of noises have been made by the British Government."

The OAU summit, which was attended by only nine of the organization's 49 heads of government, issued a declaration outlining a wide range of proposals.

These also included an appeal for all government loans to Africa to be converted into grants and suggested that part of Africa's debt should be repaid in local currencies.

The OAU called for increased aid to help pursue economic development and urged industrial nations to pay more for Africa's commodity exports and open their markets to its goods.

Mr. Kaunda said in his opening speech to the summit on Monday that the continent's export receipts had declined by $18.4-billion in 1986 because of falling world commodity prices.

(text of December 2, 1987 Globe and Mail article)