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January 30, 2008

Experts Recount '87 Crash Horrors

By Gregory Bresiger

Risk models used by traders today pose a problem and should be studied further to ensure their failure doesn't trigger another crash, a former New York Stock Exchange executive recently said.

Former Big Board CEO John Phelan made that point for a Webcast that reviewed the 1987 stock market crash, when the market fell 22 percent. In response to a question on whether another crash could occur, Phelan stopped short of predicting one.

However, he said he is skeptical about the various value at risk (VAR) models employed by some brokerages.

"The great thing about VAR is that it always works when you don't need it," Phelan wrote in a statement published at the Securities and Exchange Commission historical Web site, where the Webcast took place.

There are still many shortcomings in risk management theories, he added. And they were recently exposed in the subprime mortgage blowup, he warned.

"The ability to value and assess risk in these illiquid and rarely traded instruments," he said, "only points out the need for a great deal more work in assessing risk in these particular markets."

Jim Leman, a principal with the consultant Westwater Corp., didn't participate in the Webcast, but told Traders Magazine that he agreed that a crash was still possible-even though the trading environment is very different today. Fragmentation is why: With 40 dark pools and the dominance of electronic trading after Regulation NMS, liquidity is now more decentralized, he said, so there is the potential for greater volatility.

"You get a situation where there is a stampede," Leman said. The LTCM crisis was an example of a potential "stampede." But for the actions of the Federal Reserve, which bailed out investors, another crash could have occurred, he said.

"Anytime you have the same amount of leverage that was there and large amounts of over-the-counter securities, which don't operate through a mark-to-market mechanism in a clearinghouse, you have the potential for a big problem," said Leman, who was a vice president in charge of trading support for fixed income and equity traders for Salomon Brothers in 1987. What happens in such a scenario, Leman continued, is a problem with illiquid securities spreads.

What can be done to protect against another sudden selling flood? Phelan urged more transparency in markets. That's because of the large amounts of money going into derivatives.

"The market for derivatives is so immense that one can imagine all kinds of horror stories," he wrote. And horror stories there were aplenty on October 19 and 20, 1987.

Nasdaq dealers stopped answering their phones. Traders had few places to find liquidity as most trading was still done manually.

In 1987, the NYSE had far more specialists than the seven today. Firms then lacked capital and access to it. "To say we were frightened would be a mild exaggeration," said William R. Johnston, a former senior managing director of LaBranche & Co.

Was this the beginning of a market that would destroy the NYSE? Should it close? Those were issues Big Board officials faced in those desperate hours.

On the afternoon of October 20, the market rallied with the support of the Federal Reserve, Phelan said. The crisis passed.

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