October 18, 2014

Jim Chanos' 1987 Lesson on the Fragility of the Financial System

Question: Tell me about the back half of 1987. Did you do well in the stock market crash?

Chanos: Yes, we did extremely well in 1987. But people forget that the market ended flat for the year. It had a big rally for eight months and then peaked at the end of August. The stock market crash was the end of the move, not the beginning. I remember vividly being at my brother’s wedding in Wisconsin the weekend it peaked, thinking that the market would never go down.

By September my performance was back to flat on the year and the October crash put us up. What really scared me in October of 1987 was that after Monday’s crash, on the Tuesday and Wednesday of that fateful week, there was a lot of concern about not getting paid, that brokerage firms would have to liquidate. That was a wake-up call that really helped us to protect ourselves later during the crisis in 2008.

It was my first lesson in the fact that if you do not watch your balance sheet correctly as a short seller, you are an unsecured creditor of a brokerage firm. It was a quick education in the importance of prime broker and credit relationships and how, for example, it was preferable to be in the US rather than London from this perspective.

That lesson also shaped my understanding of how fragile the system was. I believe the system was much closer to going down in two days in 1987 than at any point in 2008. People think I am crazy when I say that. But people who remember those two days remember that we were worried that the clearing system was not going to work and that people were not going to get paid. I was worried that I was not going to get paid our profits.

From the new book The New House of Money

The New House of Money - Chapter 2 - Jim Chanos