Stock Market Studies Are Booming Since Crash

Investment banker Nicholas F. Brady is finding it tough to stay dry these days.

Brady publicly admits that he has a problem that has led to this condition: determining the causes of October’s stock market collapse and making recommendations to President Reagan for reforms.

“It is sort of like lying down in the river and trying to figure out what makes it go up and down, why it floods and why it gets low,” Brady said last week. “You have to stare at it for awhile before you come to a conclusion.”

But the former New Jersey senator promised that the presidential commission he is heading will weigh in soon with its conclusions, meeting the 60-day time period specified by the President through a report to be released early in January.

Brady also predicted that the report, which has the potential to spur significant changes in the regulation of the nation’s stock, options and futures markets, will not be harmed by the relatively short time allotted for study. “I think you get to the point where you know 88% of the story and the next 12% doesn’t change your conclusions,” the Dillon Read investment banker said.

Brady has plenty of company in the “study the stock market collapse” business, with more than a half dozen major probes under way. At least four preliminary or final studies--those conducted by the New York Stock Exchange, the Chicago Mercantile Exchange, the Commodity Futures Trading Commission and a group of pension fund managers--are scheduled to be completed early enough to influence the Brady commission, before it submits its final report to the President.

Gathering Market Data

“We have created a new growth industry in Washington with all of these studies,” Drexel Burnham Lambert Vice Chairman James Balog joked last week.

Because it is an independent study for the President, rather than an inquiry sponsored by a regulatory agency, a stock exchange or group of investors, the Brady study is viewed by some congressional staff members as the most objective look at what caused Black Monday’s 508-point plunge in the Dow Jones industrial index. Staff members of key congressional committees said last week that the elected officials they serve are withholding proposals for reform, including possible legislation, until the Brady study is released.

Brady, four other commission members appointed by the President, and about two dozen staff members operating out of the Federal Reserve Bank in New York are gathering data about the market crash through questionnaires mailed to large, institutional investors; interviews with market professionals by Brady staff members; interviews by Brady and the other commission members, and trading records provided by the major exchanges and regulators.

“I suppose we have had somewhere between 30 and 40 hours of testimony,” said Robert Kirby, chairman of Los Angeles-based Capital Guardian Trust Co. and one of the five commission members appointed by the President. “We all get locked in the Federal Reserve Bank from 8:30 in the morning until 7 p.m. at night, and you can’t even phone your wife to find out how things are going at home.

“I think we are going to be wise enough (that) if we come up with any suggestions at all they are going to be ones that don’t try to change the world overnight,” Kirby said. “I think we are increasingly understanding what happened. The hard part is to determine how close you came to risks that didn’t occur. If you came within an inch of hitting a train track while a Super Chief was coming thorough, you don’t want to do that again even though you didn’t get hit.”

Securities and Exchange Commission Chairman David S. Ruder said last week that preliminary analysis of the market collapse shows a need for an emergency system to provide additional capital to brokerage and specialists firms during a financial crisis. While specialist firms on the floor of the New York Stock Exchange are obligated to stabilize trading by buying when the public is selling and selling when the public is buying, the selling pressure was so great on Black Monday, and the days that followed, that numerous trading halts and sharp declines in prices occurred. Ruder said many of the specialist firms simply ran out of capital.

In addition to studying the capital adequacy problem, Ruder said other issues to be examined in the SEC study are the role of stock index futures trading, the orderliness of trading on the major exchanges, the financial soundness of investment firms, operational capacity of the markets, the global element of the collapse, stock-price volatility, the role of takeover stocks and brokerage firm treatment of individual versus large institutional investors.

Ruder said the SEC study is expected to be released early next year, about the same time as the Brady report. Richard G. Ketchum, director of the SEC’s division of market regulation, said 20 to 25 commission staff members are working on the report.

Ketchum said preliminary indications are that markets in London, Tokyo and New York influenced one another primarily by affecting opening prices at the outset of trading in each market. “The international relationship is there; I’m not sure how significant it is,” he said. Ketchum said the lack of sufficient capital in London and among specialists on the floor of the New York Stock Exchange caused major problems that virtually crippled trading in U.S. stocks. He added that a trend already spotted by the SEC was that stocks of companies involved in corporate takeovers began declining ahead of others. Sharp drops of these takeover stocks punished professional speculators, known as arbitragers, with hundreds of millions of dollars of trading losses.

One of the major issues to be addressed in the studies is the role of computer-directed program trading in the stock market collapse. Program trading strategies revolve around the trading of stock index futures such as the Standard & Poors 500 index on the Chicago Mercantile Exchange. The index gives investors the opportunity to bet on the future direction of stock prices by buying financial contracts that represent an average of the 500 stocks in the index.

What Fixes Are Needed?

In the days immediately following the market collapse, there were numerous allegations that stock index futures trading had a negative impact on stock prices. The Chicago Mercantile Exchange and NYSE studies are expected to focus on the role of program trading in the stock market collapse.

The Merc study will address stock index futures trading by examining whether there is a need to increase the margins--or initial deposits--required to purchase contracts, according to Merc Vice President Charles M. Seeger. The Merc already has imposed, on a temporary basis, daily limits on the amount that index futures prices can go up or down. The Merc is considering permanent daily price limits to diminish volatility in stock and futures prices.

Seeger said the Merc study, primarily conducted by a panel of academic experts, will be based on an analysis of trading data, rather than interviews with investors or traders. “They are not after anecdotal information,” Seeger said. “Our data from our surveillance reports tells us with total precision who was trading . . . minute by minute.”

“The data has got to lead the way and tell me if something needs fixing,” said Kalo A. Hineman, acting chairman of CFTC, which regulates futures trading on the Merc. “I’m going to demand a lot of specificity. I don’t want short-cut approaches.”

In a preliminary study, CFTC said one type of program trading (index arbitrage), which involves the simultaneous trading of stocks and index futures, accounted for 9% of the volume on the NYSE on Black Monday. Hineman said the agency has not determined the precise impact of another type of program trading, portfolio insurance, which involves the sale of futures contracts in lieu of stocks in a declining market.

In contrast to the quantitative approach at the Merc and CFTC, the NYSE study is expected to be “more of a thought study, than a data study,” the SEC’s Ketchum said.

Nicholas deB. Katzenbach, the former IBM general counsel and current Washington Post Co. director who is heading the study, said he began focusing last spring on program trading but had to expand his study after the market collapse last month. Even though NYSE Chairman John J. Phelan Jr. has for months been sharply critical of the impact of program trading, Katzenbach said he has been given authority to deliver an independent analysis.

“I’ll be in sometime in December, maybe put it under the tree for the stock exchange,” Katzenbach said. “I have a person here doing statistics on the 19th (Black Monday was Oct. 19) and all those days surrounding it, which probably is not essential to my conclusions. But if (the numbers) are going to contradict (my conclusions) I would like to know before I put it out.”

Another study to be completed in December and delivered to the “Brady Bunch,” Wall Street’s nickname for the Brady commission, is being prepared by W. Gordon Binns Jr., the General Motors Corp. vice president who manages the company’s $30 billion in pension assets. Binns said the study, offering the perspective of pension fund managers at major corporations, is being prepared under the auspices of the Financial Executives Institute. Binns appeared concerned that some studies may call for restrictions on trading in stock index futures.

“These new approaches, the use of futures and program trading and index arbitrage and portfolio insurance, they do have some usefulness to pension funds,” Binns said. “The different agencies looking into what needs to be done need to move cautiously until everyone has had a chance to say their piece. I appreciate the need for speed because there is still some danger in the marketplace, but I worry about . . . hasty decisions. I question whether the 60 days the Brady group has got is enough time.”