It was the Portfolio Insurance in 1987, what is that now?

The outburst of sub-prime crisis in 2007 has not been well understood. There is no official report that explained what had happened. Numerous hearings on CEO’s and governing bodies show it was about credit frozen along a long food chain. However, do we know what exactly caused this? How do we prevent this from occurring again? These unanswered questions may haunt us in the future.

Whenever there are new financial products that lure in customers, there are some unexpected by products that stirred up the market sooner or later. The 1987 Crisis comes to mind to remind us what had happened. A congress report, conducted by Nicholas Brady, a then-new portfolio insurance trading (essentially a hedge trading with futures involved) was the root cause. In the report, 20% of transaction on Oct 19, 1987 was initiated by a few accounts. Because these accounts were hedged by the Portfolio Insurance, which relied heavily on market liquidity. In other words, there must be enough buyers to support the Portfolio Insurance’s sell side.

The Portfolio Insurance was invented by two UC Berkeley professors. They initially tried to protect their portfolio by switching stock and cash positions according to returns. It worked perfectly at the beginning and their customer base expanded. Later, due to cost and leverage reasons, they switched to using futures and cash position balancing. As described above, the method got into bedlam in extreme situation. Their firm was hurt. No one knows this in advance until the Brady report. On the other hand, Wells Fargo still used stock and cash position hedging so Wells didn’t get hurt too much in that crisis.

Since then, the portfolio insurance has been used rarely in the US. But Japanese still use them. It is said that it is because they took longer to understand how it works. These new products are good tools if it is well understood. So why not the sub-prime trigger crisis?