The frantic and fragile rescue of Continental Illinois early in the summer of 1984 had shown bank regulators just how quickly a crisis could erupt and how tough it was to stop one once it got rolling. However, the regulators who coped with that crisis at least recognized what they were dealing with: a bank run, albeit an especially fast and persistent one. Bank runs were a familiar species of trouble that had been around for about as long as there had been banks.
But when Jerry Corrigan looked at the rest of the financial landscape from his post as president of the Federal Reserve Bank of Minneapolis, he saw new hazards that regulators had never dealt with before, things that could blow up without warning almost anywhere in the financial system. All around the world, giant banks and brokerage firms were creating new hybrid derivatives that were privately negotiated, individually tailored, and rarely if ever traded. These derivatives were almost impossible to value, or even count, because they weren’t clearly shown on bank balance sheets or brokerage firm filings. As private contracts, they created invisible obligations between all kinds of financial institutions, debts that could suddenly go sour and leave one party to the contract exposed to enormous losses.
Corrigan had shared his concerns at a meeting of the Federal Open Market Committee in May 1984, just as the Chicago crisis was unfolding. These gimmicks, “interest-rate swaps and other things,” were piling up in the shadows of the banking system, Corrigan told Paul Volcker and his colleagues on the committee. And they involved risks that “may not be totally understood, even by those who are playing in the markets.”
He added, “And worse than that, they may not even be fully understood by us. Needless to say, this is not a point in time when we can afford to be blindsided.”
He publicly repeated that warning in June, in a speech to bankers attending the International Monetary Conference in Philadelphia. Corrigan wasn’t opposed to a future in which banks, discount brokers, and insurers could all dabble in one another’s business, he said. But that was a landscape that would contain a daunting array of risks, including systemic risk, which he called “the ever-present snowball effect.” With large banks and other financial firms tightly but invisibly linked to one another and to counterparts overseas, systemic risk was a growing concern.
“I have in mind such things as futures, options, options on futures, interest rate swaps,” and a host of other contingent liabilities, he said. These derivatives were often structured through Wall Street brokerage firms, and they were being used heavily by giant insurance companies. And because most of them were invisible to auditors and regulators, it was impossible to gauge how many Wall Street firms and insurance companies would be in danger if a major firm on one side of a derivatives deal failed.
One of the new financial derivatives that Corrigan was uneasy about, the swap, was already one of the hottest products on the financial scene. A writer for Euromoney magazine had observed in late 1983 that “the swap market has turned the world’s capital markets into a global Olympic Games. Every day, barriers are broken and records set.”
No one could be sure how big the private swaps market actually was. Citicorp was said to have handled $7 billion in swaps in 1983. There were other estimates that, by late 1984, swaps covered a total of roughly $70 billion in debt, three times the level of just one year earlier. Insurance companies, many of which were subject to state laws limiting their use of futures and options, had become a particularly hungry market for swaps; by one estimate, insurers alone had done roughly $100 billion in swaps in 1984.
Barely a week before Corrigan’s speech in Philadelphia, a vice president of a major New York bank had told the New York Times, “No one ever walks into my office and says, ‘Hey, I just made a loan to finance a forklift.’ Today all they talk about are these fancy financings that I can’t understand.” A Wall Street executive assessing the insurance industry’s appetite for swaps had urged caution: “Insurers should consider the inherent risks involved in this unregulated market.”
Unregulated? Indeed, one of the knotty problems surrounding swaps was whether they were regulated at all—and if so, by whom? The Wall Street executive who warned insurers of an “unregulated” market was repeating the common wisdom about swaps, but no one could be entirely certain that he was right.
In 1977 the CFTC’s general counsel had asserted in advisory letters that some of these new derivatives seemed to resemble futures contracts closely enough to fall under the CFTC’s expansive jurisdiction. The agency’s lawyers initially laid out a four-prong test for these hybrids, but then, over the next two years, they said their new test was not actually the final exam, and that each product would be examined “in context.”
Of course, the futures exchanges had long been clamoring for the CFTC to outlaw these over-the-counter derivatives. The rapidly developing swaps industry, a powerful collection of banks, brokerage firms, and insurance giants, insisted otherwise. The argument was far from over. As one legal scholar noted, the CFTC did not seem to have the gravitas necessary to make its position stick: “It is a relatively new agency, tiny by federal standards, something of a legislative plaything, and more than a little beholden to those it regulates for its appropriations and jurisdictional mandate.”
It seems remarkable that an agency blessed with a statute as elastic as the one Congress had given the CFTC, with the support of the politically powerful exchanges it regulated, could not make a more emphatic case for regulating swaps and other over-the-counter derivatives. Were the banks and giant brokerage firms simply too powerful? Did the CFTC staff decide it already had too much on its plate? Or was the agency just wary of regulating a market that seemed to be working fine without regulation?
For whatever reason, the CFTC persistently failed to stake out and enforce a credible claim of jurisdiction, even as the market grew exponentially larger. As a result, the financial futures markets were denied a substantial reservoir of liquidity, support they would desperately need in the crises to come, and the potentially hazardous web of swap obligations that linked giant financial institutions remained invisible to regulators for decades.
That didn’t seem to worry the Washington regulatory agencies or their congressional overseers as much as it worried Jerry Corrigan.
* * *
THE LATE SUMMER of 1984 found John Phelan settled into the chairman’s office at the New York Stock Exchange. After four years in the number-two job, he had been promoted in the spring to chairman and chief executive, a post that combined the roles he and the retiring chairman, Mil Batten, had filled since 1980.
His first day in his new office, back on May 24, had been rocky. Sometime during the day, rumors swept the trading floor: Manufacturers Hanover, among the weaker New York City banks, was allegedly trying to raise money in London because nervous investors had shut it out of the U.S. market. Both the bank and its regulators denied the rumors, but the stock market began to sink rapidly, and the concern quickly spread to other financial markets.
It was only a week after the FDIC’s rescue of Continental Illinois, and bankers and investors were acutely aware that the run on that bank had continued despite the FDIC’s public assurances. The New York Times diagnosed the Manufacturers Hanover situation as “a serious case of the jitters,” but that hardly captured the profound uneasiness that had greeted John Phelan’s first day as chief executive at the Big Board.
In his four years as an exchange executive, Phelan had steadily expanded the capacity of the Designated Order Turnaround (DOT) system, an electronic network designed to expedite the handling of small orders from individual investors. Then, in 1984, Phelan bowed to the demands of the firms that served giant institutional investors—investors whose trading was becoming more important to the NYSE every day—and made a simple but fateful change in the rules. He gradually opened the DOT system’s “in-box” to larger and larger orders—a step that turned this “SuperDOT” system into Wall Street’s preferred tool for rapidly submitting large, complicated trades, including those generated by portfolio insurance and index arbitrage.
These large transactions, calling for buying or selling a long list of stocks at the same time, were known on the NYSE floor as “program trading.” Program trading wasn’t new. For more than a decade, when a mutual fund or pension fund manager wanted to acquire or dump a variety of stocks quickly, Wall Street trading desks had used a low-tech way to accommodate them. They simply sent in big multi-stock orders to the exchange floor and relied on squads of clerks to distribute them to the right trading posts as quickly as possible. Some firms had order slips that were preprinted with the list of stocks most commonly involved in their customers’ trades, so their clerks could fan out and deliver them even sooner.
The specialists on the floor had learned to watch for these “buy programs” or “sell programs”—the sudden scattering of a covey of clerks bearing preprinted orders was a dead giveaway that a shopping spree or selling binge was occurring.
The same thing was happening now—in larger volume, at faster speeds, and much more frequently—but it was no longer as visible because a growing number of these program trades hit the floor electronically, via the expanded SuperDOT system. These stealth orders were unsettling to the specialists and other traders, because they conveyed no sense of scale. It was impossible to know how many giant orders were coming in, and the level of nervousness on the floor increased noticeably.
A savvy Paine Webber executive on the NYSE trading floor put together a “plain-English” primer on this new form of program trading and was inundated with requests for copies from other market professionals. His guidebook laid out the various ways pension funds and other big institutional investors were using program trading. Some just wanted to cut the time between making an investment decision and implementing it. Others were engaged in index arbitrage strategies, selling or buying the stocks in a certain index and simultaneously making the opposite trades in the futures or options markets. Some, such as Roland Machold at the New Jersey state pension fund, were using it as part of their “apartheid divestment” efforts, selling off big blocks of stock in companies with a commercial presence in South Africa. And some, such as Gordon Binns at the GM pension fund, needed program trading to implement the portfolio insurance strategies that fund was using to hedge its growing stock holdings.
To the professionals, these were separate and distinct uses of program trading, with different purposes and different consequences. But to most outsiders, and many journalists, they were all lumped together under one label. This would create a lot of confusion and miscommunication as the practice became more common, and more controversial.
* * *
BY LATE 1984, the other forces roiling the stock market were a little easier to define. A spate of controversial takeover deals had erupted, and fortunes were being made and lost on the latest rumors about the next acquisition target or the possible collapse of a pending deal.
It had become clear as early as the epic battle over the Bendix Corporation that John Phelan could not stay on the sidelines in these arguments. He felt the exchange had a duty to protect corporate shareholders, and some of the maneuvers that executives were using to protect their companies from would-be raiders struck at the heart of shareholder democracy.
Increasingly, though, takeover deals were squeezing Phelan between two of his important constituencies. The companies listed on the exchange wanted the NYSE to allow them to issue a class of stock that could outvote their common stock. With that “super-voting” stock in friendly hands, the firms would be safe from corporate raiders. But many major pension funds and other giant institutions, the fastest-growing source of trades on the NYSE, were firmly opposed to “super-voting” shares, which diminished their rights as common stockholders.
That opposition reflected structural changes in the investment community. Traditionally, disappointed institutional investors “voted with their feet,” selling their shares rather than challenging management. But managers of index funds never had that option: if a company’s stock was in the index their funds tracked, they had to own it. Giant pension funds such as the ones run by Machold and Binns had to be as diversified as possible, and narrowing their holdings to avoid takeover battles would increase the risks they were taking with their pensioners’ assets.
Despite his belief that takeover battles generally were not an issue for regulators, SEC chairman John Shad had expressed some concern about a practice called “greenmail,” in which a company would buy back a potential raider’s shares at a premium price to make him go away. This higher stock price was not available to other shareholders in the marketplace—including the giant institutional investors, who felt ill-used.
Though it was not in his nature to suffer in silence, Roland Machold might have quietly simmered a bit longer in the takeover debate, but two back-to-back greenmail deals, involving the Disney Corporation and Texaco, lit his fuse. As it happened, the deals had also whetted the anger of a veteran California politician who wielded enormous influence as a trustee of his state’s giant public pension funds.
The Californian, state treasurer Jesse Unruh, phoned Machold to vent his views, adding that he was reaching out to public pension fund managers in other states. “There must be a better way than sitting by and getting ripped off,” Unruh fumed. Pension funds, he went on, “have been passively standing by for too long, while their shareholder interests have been stepped on.”
Some fund managers held back, wary of Unruh’s unabashed political activism or vulnerable to local political pressures, but not Roland Machold. By the late summer of 1984, he was making plans to attend an organizational meeting Unruh wanted to hold in Chicago that fall. The idea was to form a group that could wield enough financial power to insist that corporate managers and would-be raiders sit down and explain themselves to their giant shareholders. The organizers were thinking of calling it the Council of Institutional Investors.
The council was to be open to private-sector retirement plans as well, and a few union pension funds signed on. But Gordon Binns apparently was not comfortable with Unruh’s idea. The top executives at General Motors had already decided to create “super-voting” shares to deter raiders. How could Binns join forces with other pension funds trying to prohibit such protective strategies?
Roland Machold was not constrained by corporate politics, and he heartily supported Unruh. Together they helped build an organization that would soon demonstrate just how very large and powerful these titan investors had become.
* * *
AT A PRACTICAL level, these takeover fights had another unwelcome side effect. On a growing number of trading days, John Phelan’s surveillance team at the NYSE had noticed unusually prescient trading just ahead of the headlines about a new or developing deal. The SEC’s regulatory staffers in Washington were noticing the same thing, particularly on the options exchanges. John Shad was especially hostile toward insider trading and had shifted scarce resources into his enforcement division to fight it.
For the next two years, takeovers and the insider trading conspiracies they were feeding would inflame public outrage. The takeovers profoundly reshaped the civic life of countless communities across the country, often in unfortunate ways, and insider trading increased public and congressional suspicion of Wall Street.
For all the visible storm and drama of these battles and investigations, their unseen consequences were arguably of more lasting significance, because they were a nearly ruinous distraction from the structural hazards developing in the American market. The nation’s financial stability was not directly threatened by hostile takeovers, but it surely was threatened by the invisible chains that now shackled together a host of disparate, blindly competitive, and increasingly automated markets. Greedy lawyers and unethical bankers did not increase the structural risks of this new marketplace, but gigantic and increasingly like-minded institutional investors did. These new risks did not arise because the regulatory system failed to police takeover practices or criminal trading activity; they arose in a regulatory community that was poorly equipped, ridiculously fragmented, technologically naïve, and fatally focused on protecting turf rather than safeguarding the overall market’s internal machinery.
Nevertheless, hostile takeovers and insider trading became the primary preoccupation of regulators and lawmakers. Facing continuing pressures on its budget, the SEC found the resources to attack insider trading by, among other things, spending less on market regulation. Bank regulators worried about banks financing risky takeover deals and savings and loans buying deal-linked “junk bonds,” but failed to challenge closely the bank mergers producing a breed of financial giants. Regulators across the board neglected the unregulated swaps that were flooding the markets and linking giant players together in new and invisible ways. Congress shifted its focus to headline-grabbing criminal cases against Wall Street plutocrats and largely abandoned any serious effort to address these profound market changes.
In short, amid the distractions and demands of takeover battles and criminal investigations, Washington mostly ignored the real hazards that were developing in the financial landscape. Titan investors got exponentially bigger, their investment strategies grew dangerously more similar, and their effect on daily market trading grew more pronounced. The computer power of investors on Wall Street grew at a pace that outstripped that of regulators and traditional traders. The links between stocks, bonds, options, futures, and unregulated derivatives such as swaps grew stronger, less visible, and more dangerous.
To be sure, a growing body of opinion saw the new derivatives as tools for reducing risk—and, examined deal by deal, they may have been. Aggregated across the financial landscape, they weren’t. As Jerry Corrigan had pointed out to the bankers in Philadelphia, the whole world could not be hedged against the same risk at the same moment. Risk could be passed around, but it couldn’t be eliminated.
* * *
SENIOR BANKERS ACROSS the country heard the bad news first, thanks to sunrise calls on Wednesday, October 3, from the bank’s chairman and president. The calls alerted them to brace for a rocky day.
Still, the bankers were surprised—shocked, in fact. The calls were from the formidable First National Bank of Chicago, the eighth-largest bank in the country and the city’s leading bank since the sudden eclipse of Continental Illinois that summer. The bank announced that it was writing off hundreds of millions of dollars’ worth of bad loans and reporting the first quarterly loss in its long history. Wall Street analysts immediately began to worry that this was just the first in a string of immense third-quarter losses in the banking industry. Shares of almost every major bank in the country fell sharply that day.
The anxiety in the market did not deter Congressman Fernand “Fred” St. Germain, a silver-haired Democrat from Rhode Island who was chairman of the House banking committee. In September, St. Germain had held two scathing hearings questioning the rescue of Continental Illinois. The first session opened with him reading a seven-page denunciation of the toothless regulators and reckless bankers who had allowed the crisis to happen. He then spent the day interrogating a quartet of former and current senior bank examiners. The next day, he pounced on Todd Conover, the comptroller of the currency, and did not let up for five hours.
On Thursday, October 4, with First Chicago’s loss the biggest financial news of the day, the St. Germain panel convened once again, with FDIC chairman Bill Isaac waiting to be interrogated. Before the hearing, he had emphatically assured reporters that First Chicago was in no danger of becoming the next bank rescue target.
St. Germain gaveled the crowded room to order and devoted most of the first hour to a staff report disputing Todd Conover’s testimony in September about how many other banks might have failed if Continental had been allowed to go under. The subcommittee’s staff had come up with a much smaller number than Conover had.
On the strength of that, St. Germain asserted that regulators “knew full well that the domino theory was concocted. At most—and this stretches a pessimistic scenario pretty far—maybe a half-dozen institutions would have been on the edge of a failure line.”
It was a bizarre and naïve argument, given the frightening risks that had been building up in the financial system since 1980 and the panic that had engulfed the banking world during the Continental crisis in May. If a Continental failure had been immediately followed by the collapse of a dozen other banks, what would the reaction have been? Would it have been markedly less if only a half-dozen banks had failed at that moment? Who could possibly say? No one could confidently guarantee that First Chicago would not be in trouble before that day’s hearing adjourned.
Unexpected scheduling conflicts forced St. Germain to postpone Bill Isaac’s testimony until that afternoon. When the FDIC chief returned to the witness table, he was angry.
“Frankly, I’d like to get something off my chest,” Isaac said. “I took great personal offense at what I witnessed here this morning.” The attack on the regulatory estimate of how many banks were threatened by the Continental crisis called into question his “intelligence and integrity” and that of his team, he said. “The committee staff knows better,” he went on. “They have met with our staff. They know what we did. They know why we did it. And what we heard this morning, frankly, was disgraceful.”
In May, with a giant bank rapidly circling the drain, he had not had the luxury of pinpointing the consequences for each of the several thousand banks with money deposited there, he explained. Besides, the exact number of banks at risk had been irrelevant to his decision to rescue Continental. Regulators had acted to save the giant Chicago bank, he continued, because the overall consequences of its collapse would likely have been “catastrophic.”
Isaac painted a vivid picture of what he believed would have happened if the FDIC had taken the same route with Continental Illinois as it had with Penn Square—if it had paid off the 850,000 insured depositors up to the FDIC limit, wound down the bank, and given everybody else IOUs that might be worth something when the long bankruptcy process was over.
He pointed out that the insured depositors, the lucky ones, would have had to wait several months to get their money. “No grocery money, no payroll, no money to pay your mortgage. Accounts would’ve been frozen for 850,000 depositors for one month, two months,” he said. “Now you go to the uninsured—those people had over $30 billion worth of exposure. And that money would’ve been frozen in a bankruptcy proceeding for years and years and years.”
About 2,300 other banks insured by the FDIC would have had $5.8 billion frozen in the event of a payoff at Continental Illinois. They, too, would have received IOUs that ultimately might have been worth seventy or eighty cents on the dollar, “but it would have taken a good long time and they would’ve had a piece of paper until it happened.”
Then there would have been the corporate casualties, he continued grimly. Continental Illinois had been the largest domestic lender to American businesses. If the FDIC had shut it down, “we would have been in a collection mode on every one of its loans. Every one of those borrowers would have had their lines of credit cut off. You would have had corporate bankruptcies throughout the land.”
Moreover, he said, “You would’ve shaken confidence in other major institutions … if we had closed down a solvent bank and paid off [only] insured depositors, what message would we have sent to the rest of the world trying to deal with U.S. banks?” In the midst of the crisis in May, he and his fellow bank regulators were also dealing with other distressed banks and savings and loans across the country. He asked: Would any of them have lasted twenty-four hours if Continental had failed?
Congressman Frank Annunzio, a Democrat and the only Chicago legislator on the subcommittee, ruefully suggested a silver lining to the disaster Isaac described. In the wake of those catastrophes, the lawmaker quipped, “the Democrats might have won the [upcoming] election.”
“I won’t touch that line,” said Isaac, a loyal Republican. “All I am saying is, the ramifications could have been catastrophic … I think I’m probably about as hardline on the need for discipline in the banking system as anybody in the country, and I frankly didn’t have the courage to do it.”
Annunzio seemed a little ashamed of the beating Isaac was getting for the sin of rescuing Chicago’s biggest bank. “I am just wondering,” he said, “if you would have been sitting here today, before this committee, being praised if Continental had gone under?”
If the FDIC had let that happen, Isaac responded, “I think this committee probably would have been justified to consider lynching me.”
The grilling continued for several more hours, but Isaac never wavered in his insistence that, in the same circumstances, he would have made exactly the same decision—to save Continental Illinois.
Neither he nor his persecutors in Congress could have known it then, but if he hadn’t done so, events three years later might well have been even more destructive than they were.