Michael Lewis compares the 1980s and today.

Question: What lessons should we learn from the crash of ’87?

Lewis:    The crash of ‘87 was interesting, really interesting, because it was a crash without consequence or without big consequences.  Crashes, essentially, could be ignored in the end.  And when you go back and you read the literature at that time, a lot of really smart people were saying, now, we have the depression.  John Kenneth Galbraith was saying that this is the crash of ‘29 all over again and now comes the depression.  And we just sort of assumed that if there’s a crash, then there’s the depression.  And what happened there was a dramatic illustration of the disconnect that occurred between financial markets and the real economy.  And the financial markets have this life of their own that maybe was and maybe wasn’t tied to whatever was going on in the real economy.  Why that is?  Because I think probably [it’s] a deep question.  Part of it is just the size of the component of the financial markets that was pure casino is getting bigger and bigger and bigger as opposed to the part of the financial markets that’s engaged in allocating capital for real productive uses, real productive ends.  But I think when you take away, what I took away from it at that time, I mean I was in the middle of it.  I was actually sitting in the Salomon Brothers’ Equity Block Trading Department watching it happen when it happened.  And I wrote about it, you know, I was working with Salomon Brothers.  But, I think there are a couple of things that were sort of distinctive about it and worth noting.  One is I think it’s the first case where the market collapses in part because tools have been created that the people were using and don’t fully understand, financial tools.  And in this case, it’s portfolio insurance which is using… the basic idea is, you use these things that have been created in [IB] called financial futures, SMP futures to hedge yourself, and the way you do it is you sell it as the market goes down.  And if you think about it, if you start selling it as the market goes down, you sell more and more as the market goes down.  At some point, you’ve completely sold out your equity exposure.  So in theory, at some point, you’ve put a cap on your losses by doing this.  And a lot of people have bought into this idea.  This is how you hedge, you hedge dynamically by selling futures.  Well, that works if one person is doing it.  If everybody is doing it, then what happens is the market goes down and everybody sells.  So the market goes down some more and they sell even more, and a doomsday machine is created.  So here was, I think, the first example of a new, effective financial technology having these consequences that hadn’t really been considered before.  And after that, the reality of portfolio insurance was kind of doomed.  I mean, the firm that created it basically went out of business.  And so, but there was a specific lesson about portfolio insurance, but the general one about financial tools, well, that would replay itself over and over and over again in the next 20 years.  I think the other thing that came out of that period, but this isn't so much lessons that we as a people learned, because I don’t think we as a people learned anything from it.  But what the financial markets learned was that this sort of volatility, this sort of surface calamity is actually not a bad thing.  It’s a huge opportunity that the more it moves, the more we can make if we know how to manage the volatility.  Because what happened on the Salomon Brothers’ trading floor was quite interesting on that day and it’s slightly technical but I’m going to try to explain it.  When the stock market collapses, the bond market goes up because people think we’re going to have a depression, so they going to have to lower the interest rates so bonds go up.  The people who traded government bonds on the Salomon trading floor thought stock markets collapsing so let’s make a big bet.  They bought…  What was a big bet at that time, it sounds trivial now, $2 billion of the current US Treasury Bond, the 30-year treasury bond, the new 30-year treasury bond, and thinking that that would just skyrocket.  The [IB] who sat beside them who became John Merriweather, who were John Merriweather’s long-term capital management but they were still on the Salomon Brothers’ trading floor, saw that the people who were thinking about things in [IB] were creating a distortion within the US Treasury Bond market by buying up all the new 30-year treasury bonds.  They were creating this huge gap in price in return between the current 30-year treasury bond and the 30-year treasury bond that was no longer current.  That was, you know, of three months earlier maturity.  And so what they did was buy the old treasury bond and sell short the new one because everybody thought, and they made a fortune in the price discrepancy that opened up when it went back to normal.  So that was the big thing that happened on that trading floor because they made the most money and they did it by observing relationships between securities without regard to what was happening in the larger world.  And their premise was these relationships always kind of revert to their mean that they will revert to normal.  So if it gets extreme, bet on it, and it will come back.  This would later be the source of their doom.  But it laid the seeds for other things.