NEW YORK — In December, 1986, New York Stock Exchange Chairman John J. Phelan warned a Washington audience that a new form of computerized stock and futures trading known as portfolio insurance could someday lead to "financial meltdown."
The markets laughed him off. But with much of Wall Street's panic selling in the last week being blamed on the activities of portfolio insurers, whose computer programs are designed to hasten selling when the markets turn down in an effort to protect clients from the impact of sharp declines, Phelan's term may now have burned itself into the stock market's permanent lexicon.
For there are strong indications that computerized portfolio insurance programs inspired the snowballing waves of selling during the market's catastrophic collapse.
The impact of portfolio insurance programs on the market's epic free fall Monday and last week cannot be precisely gauged. But estimates place the amount of assets "protected" by the programs, including the vast securities portfolios of such institutional investors as Aetna Life & Casualty Co., at as much as $61 billion.
Because of the mechanics of portfolio insurance, a significant portion of that pool of cash was poised before last week to begin marching, all at once, in a single direction: down. "If that money's all moving at the same time, it has a considerable impact," Robert Gordon, president of Twenty-First Securities, a New York investment management house, said Monday.
What's more, the leading insurance technique involves selling not stocks, but related stock-index futures, and using the proceeds to offset stock losses. As the selling waves hit the futures markets, they drive futures prices down, which in turn drag stock prices down like water spiraling down a bathtub drain. Participants in stock and futures markets say that is exactly what set off the mind-numbing stock price collapses of Thursday afternoon, Friday and Monday.
Even people who sell portfolio insurance acknowledged that the technique is probably a leading villain of the market collapse--and what's more, failed to protect clients from the losses they thought they would avoid. The reason is that stock-index futures have collapsed this week as much or more than stock prices--so the insurance clients realized only a fraction of the gains from selling the futures that they need to adequately protect themselves.
"Portfolio insurance had a lot to do with creating this market," said Preston W. Estep, head of a leading portfolio insurance firm. "Everyone who deals in it will have to go back and do what they can to repair the damage to their reputations."
Many users of portfolio insurance, say traders in the stock and futures markets, may have suffered worse losses in the last few trading sessions than they would have by just trading stocks. And the cost of the sophisticated hedges they installed while the market was still going up may have deprived them of a full measure of profits from the bull rally.
Portfolio insurance firms all use somewhat different computer models to dictate trading for clients; some were apparently more successful than others in protecting clients from losses this week and last week. But all showed they had devastating shortcomings, Estep said.
"Our customers are still ahead (of the rest of the market), so this is a day of jubilation for us," he said. "But that's got to be luck. This just happened to be our day in the sun. Everybody's going to have to adapt."
The NYSE's Phelan scarcely shied away from remarking that his prediction may have come true. He told a press conference in New York after the market's close Monday: "This is the nearest thing to a meltdown I'd ever want to see."
For more than two years, futures and stock traders have been confronting fears and charges that the growing interrelationship between the two markets was undermining traditional safeguards against a serious crash--including limitations on using borrowed money to buy stock. Because futures can be bought with down payments worth a fraction of the value of the corresponding stocks, critics have charged, the entire stock investment world was becoming dangerously dependent on borrowed money.
Today, even veteran futures traders acknowledge that might be true. "We thought the market was big enough to take care of itself," said Scott T. Ramsey, managing director at Index Futures Group in Chicago as futures prices collapsed in midday. "But maybe it's not."
Portfolio insurance is one of several investment techniques using the stock-index futures markets as tools for hedging and moneymaking. In general terms, stock-index futures are contracts traded on commodity exchanges in Chicago, New York and Kansas City that are designed to replicate the price movement of a corresponding group of widely followed stocks.