We present evidence that a tax bill containing antitakeover provisions proposed by the U.S. House Ways and Means Committee on October 13, 1987 and approved by the Committee on October 15 was the fundamental economic event causing the greater than 10% decline in the stock market on October 14–16, which arguably triggered the October 19 crash. The bill, which eventually passed without most of the antitakeover provisions, would have limited the deductibility of interest on debt incurred to finance corporate takeovers, leveraged buyouts and recapitalizations, and imposed other restrictions on hostile takeovers.

We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.