I have been in the investment business for a number of years—maybe too many—and hence have seen a number of dips, swoons, drops and three panics. The panics were all different in cause but had some common conditions. We can learn a great deal about how to cope with the current one from the commonality in the three.
The first occurred in the early fall of 1955. I was a high school student clerking on the floor of the New York Stock Exchange. The Exchange was everything back then. It was the center of all trading, populated by floor brokers, specialists and traders who ruled the universe. They were the power elite of the financial world. Late summer trading back then was a vacation-laden lull. Not much happened. Then Dwight Eisenhower, beloved president of the United States and leader of the Allied Forces in WWII, had a heart attack over the weekend. Chaos ensued when the market opened on Monday. The floor population lost its composure. The maelstrom fed on itself. Respected, even revered, NYSE floor figures ran in aimless circles. Some retreated to the august Exchange Luncheon Club to drown their fears. It was a shot show. The market went down 6% in a heartbeat—or worries about the lack of one. I was too young and too naive to really understand what was going on, but did sniff the acrid scent of fear around me.
The behavior of certain Exchange members contrasted from the panic-stricken actions, or inactions, of the majority. A notable subset of the men—there being no women on the Floor back then—went about their business as if nothing was amiss. They were not unaware of the headline, of the president’s heart attack, of the absence of bids. Still they performed in a workmanlike fashion. Over the days following, I asked some of the people—clerks as well as the actual NYSE members—about the phenomenon. In brief, the ones who reacted best were World War II veterans. They had been in the military, not all in combat but all in uniform. They disciplined themselves and went about doing that which they could control. They did not lose focus. They executed orders, traded stocks, relayed prices and kept their cool. Many of the others, both younger and older, didn’t. The contrast was sharp and the memory lasting.
Thirty-two years later, I was CEO of what became Prudential Securities. It was one of the largest securities firms in the country. The Crash of ’87 occurred on October 19th, without warning. Prices fell 23%, the largest one day drop in history. Wall Street was crushed and chaos reigned. Orders by the thousands went unfilled or reported at incorrect prices; there were rumors of rampant failures in the industry. The processing machinery collapsed. It was panic personified.
Hence, the next day, I was pleased to learn that Prudential Bache, as it was then named, had come through well. It had problems and errors, of course, but an estimate of its losses totaled less than $1million. That was modest relative to the company’s size. It was an outstanding result on a comparative basis and I was proud of how our people had performed.
In the mid morning, my bubble was burst. The gifted head of the risk arbitrage department, Guy Wyser-Pratte, came into my office. Wyser-Pratte did not report directly to me, to avoid conflicts with privy investment banking information. However, he was a senior member of the firm and highly respected. I was surprised to see him, as the nature of risk arbitrage would normally insulate it from wide swings based on market fluctuations. The essence of that activity was to be long the shares of companies being acquired and short those of the acquirors, profiting from the discount to deal terms at which the takeover candidates were selling. However, in 1987, almost all announced deals were closing, and the practice in the risk arbitrage industry had shifted. The risk arb traders were buying the stocks of the targets, but—to better utilize capital—not hedging by shorting the stock of the acquirers.
The 1987 Crash had two ramifications on the risk arb portfolio, then: the value of the takeover candidates tumbled with the market and, even more importantly, the likelihood of deals closing went down, way down. The result was that the Pru Bache risk arbitrage department had lost something over $100mm. That was no small sum, especially in the context of 33 years ago; it would be comparable to $225mm today. It was not a pittance even to the parent Prudential Insurance Company. It was a staggering amount. I was stunned.
Wyser-Pratte, a former Marine, outlined the positions and the prospects calmly. He understood the magnitude of the portfolio loss and did not minimize it. At the same time, he kept his composure; he accepted what the situation was and strategized about how best to deal with it. In essence, he recommended doubling most of the positions in the belief that the deals would ultimately close.
To my perhaps less sophisticated mind, it meant that if the various deals did not close, things were so bad it probably didn’t matter. Doubling down was a courageous course, but also the most rationale one.
That left me in the position of going to tell the CEO of Prudential, Bob Beck, about the loss and the recommended steps. I journeyed to the Prudential headquarters in Newark. It was only an hour’s journey but a very long trip emotionally. Telling your boss about hundred million dollar plus losses is not happy event.