BERKELEY RISING, BANKS FALLING
For several years, John O’Brien had been talking about portfolio insurance with executives at the Denver-based Johns-Manville Corporation, and his diligent visits finally paid off in 1984—with results that put portfolio insurance, and LOR, into the spotlight and significantly sped up the changes transforming America’s financial markets.
Johns-Manville was facing a future of legal claims from people sickened by its original flagship product, asbestos insulation; those potential liabilities had led the company to file for bankruptcy protection in 1982. As its creditors wrangled, the bull market that began that August pushed the value of its pension fund higher and higher. By 1984, the pension fund’s assets totaled $350 million, considerably more than was needed to cover its retirement obligations. That surplus could be used to help pay ailing workers—unless the gains were suddenly washed away by a market downturn. Many lawyers representing creditors wanted the fund to take its winnings and get out of the stock market, but the pension fund’s managers said that would deny the fund any future market gains, which might produce even more money for creditors.
To O’Brien, it looked like a case study for an LOR sales pitch, but he had not been able to sell that argument to the company.
Then, sometime in early 1984, O’Brien received a phone call from the assistant treasurer at Johns-Manville. How, exactly, would LOR set up a hedging strategy to protect the pension fund’s gains while still capturing some future profits, beyond the cost of the portfolio insurance? That call led to a meeting in Denver with Johns-Manville’s treasurer, who asked if O’Brien would explain the strategy to the creditors committee, which would meet two weeks later.
When he arrived at the company’s home office on the day of that meeting, O’Brien was shown to a conference room occupied by members of the creditors committee and representatives of J.P. Morgan, which was advising them. “You have fifteen minutes,” he was told. A snowstorm was threatening; several people around the table had planes to catch and wanted to beat the bad weather.
Startled, O’Brien did the best he could in the time allowed—but his pitch was slightly different from those he had been making since 1981. Thanks to guidance from Kidder Peabody’s Steve Wunsch, LOR now implemented its hedging strategy by buying and selling the S&P 500 index futures contracts on the Chicago Mercantile Exchange, not by buying and selling stocks on the New York Stock Exchange.
The use of S&P 500 index futures had become increasingly popular with pension funds, endowments, and banks. In January 1984, less than two years after the new derivatives were introduced, the SEC had agreed to let mutual funds use them “as hedges against the effects of changing market conditions.” No one around the conference table could sensibly oppose the LOR proposal just because it used futures contracts instead of stock transactions.
After O’Brien finished his presentation, someone at the table said, “This sounds plausible to me.”
O’Brien suspected that the J.P. Morgan adviser was “calling the tune.” After a brief absence that O’Brien assumed was used to consult with the home office, the Morgan banker returned and told the committee that the LOR approach was “theoretically possible” but had never been done on this scale before. O’Brien, still in the room, was thanked for his time, and he returned to the airport to catch his own flight, back to Los Angeles.
The following Monday, the treasurer of Johns-Manville called O’Brien, reporting what initially sounded like a “good news, bad news” joke. LOR was being hired to implement its signature strategy, but it would have to share the assignment with J.P. Morgan. The bank had tried to persuade Manville to let it handle half the $350 million portfolio, the executive said. “I told Morgan that wasn’t fair,” the executive continued, “but they could have 20 percent of the portfolio.”
O’Brien was glad LOR would be managing 80 percent of the Johns-Manville assets, but he still was “kind of miffed” that the big New York bank had horned into the deal. However, a few weeks later, a major pension industry publication reported that Johns-Manville was using portfolio insurance, advised by J.P. Morgan and Leland O’Brien Rubinstein. Suddenly, LOR was in the same sentence, in the same deal, with one of Wall Street’s most prestigious firms. In a stroke, new business streamed in, and the assets being managed by LOR grew to $700 million. “What seemed like a defeat turned into a huge advantage,” O’Brien acknowledged. It gave the firm, and its strategy, tremendous credibility in the community of institutional investors.
Of course, it also meant that the formidable J.P. Morgan was joining the ranks of those selling portfolio insurance to the giant pension fund market.
* * *
AS CHICAGO PREPARED to welcome the new year of 1985, Leo Melamed at the Chicago Mercantile Exchange got an extremely welcome holiday present.
For two years, he had been braced for the conclusions of an ongoing study of the new financial futures and options markets being conducted by the Federal Reserve, the CFTC, and the SEC, with assistance from the Treasury Department.
When Melamed counted noses, he feared the CFTC would be outvoted, 3 to 1, on the study’s final conclusions, unless the Treasury sided with the CFTC to create a tie. The SEC was likely to be hostile toward financial futures, based on the long struggle over who would regulate them. And Paul Volcker had long been wary about financial futures and most other Chicago innovations.
When the report, an inch-and-a-half thick and weighing more than four pounds, was finally delivered to Congress in December, Melamed was exultant. Indeed, the primary conclusions could have been written by Melamed himself: The futures and options markets served “a useful economic purpose” by allowing economic risks to be shifted from “firms and individuals less willing to bear them to those more willing to do so.” The new markets “appeared to have no measurable negative implications for the formation of capital” and may actually have improved market liquidity, the researchers concluded.
The new study, larded with investor surveys, complex definitions, and “rational” economic theories, did not offer any ammunition for the turf war between the CFTC and the SEC. The study noted the similarities between financial futures (regulated by the CFTC) and options (regulated by the SEC)—they served similar functions, were traded by many of the same players, and “have similar potential for causing harm if they function improperly.” Therefore, it continued, “there is need for close harmonization of federal regulation of these markets.”
The study’s authors were confident—despite nearly a decade of contrary evidence—that the two agencies could achieve that harmony through communication and cooperation, so there was no need for new legislation to “establish an appropriate regulatory framework.”
Remarkably, little attention was devoted to the fundamental changes in the architecture of the markets being caused by the widespread and rapidly growing use of futures and options by the largest and most active investors in the country. The study briefly acknowledged that arcane strategies such as portfolio insurance and index arbitrage had caused some aberrations in the market, but it suggested that “the potential for such disruptive trading” should merely be monitored.
* * *
FLURRIES OF SNOW mixed with the leftover New Year’s Eve litter in Manhattan on Wednesday, January 2, 1985, Jerry Corrigan’s first day as president of the Federal Reserve Bank of New York. It was a homecoming of sorts, anticipated since the announcement of Corrigan’s appointment to the post in September. He now sat at the desk that used to be Paul Volcker’s.
Corrigan’s first task was to address the takeover deals and debt-fueled management buyouts that were outraging members of Congress. The giant Manhattan bank holding companies, such as Citigroup, were the only players in that game that the Federal Reserve directly regulated. Corrigan knew that many of the debt-heavy deals that were raising hackles were being financed by New York banks that, frankly, should have known better.
Meanwhile, in Washington, his mentor Paul Volcker was watching a job change that could prove risky for his own tenure. Treasury secretary Donald Regan and James A. Baker III, the president’s chief of staff and an architect of his reelection victory in November 1984, were switching jobs. Volcker knew that Baker was a political savant of great charm and effectiveness, but the new secretary of the Treasury would almost certainly have his eye on a possible 1988 presidential campaign by his close friend, Vice President Bush. In all likelihood, he would want to be sure that the economy didn’t deliver any unpleasant election-year surprises because of high interest rates.
Baker was a practical conservative, and his primary task was to reshape a tax reform proposal drafted under Regan’s supervision and get it through Congress. The job switch meant that, for the next few years, the Treasury’s top job would be held by someone whose focus was intently on politics and the presidential agenda, not on the flaws in the regulatory system that were becoming more apparent with each new financial crisis.
* * *
ON VALENTINE’S DAY 1985, Roland Machold made his way from his home in Princeton to Lower Manhattan, his destination the office suite occupied by New York City comptroller Harrison J. Goldin. Goldin was also expecting Jesse Unruh, California’s pension fund power broker, to join them. A tall, beefy man, Unruh hated to travel, preferring to do his organizing work by phone from Sacramento. Less than a month earlier, though, the Council of Institutional Investors had held its first formal meeting in Washington, and today the group was going into action for the first time.
Machold, Unruh, and Goldin were presiding over a daylong engagement with the key players in a takeover drama being acted out at Phillips Petroleum. In December, the company had made a greenmail payment to deter the corporate raider T. Boone Pickens, who walked away with a $90 million profit. The company now planned to “recapitalize” itself by giving a third of its shares to its employees and offering other stockholders (who included the pension funds run by Machold, Goldin, and Unruh) a package of new stock and bonds whose value was in dispute on Wall Street.
That recapitalization scheme prompted another corporate raider, Carl Icahn, to launch his own takeover bid for Phillips, mustering the services of the investment bank Drexel Burnham Lambert along with several Drexel clients to help him finance an $8.1 billion bid. He also had the support of the takeover speculator Ivan F. Boesky, who was unhappy with the package of securities Phillips had offered. The company’s greenmail payment to Pickens had been deeply unpopular among institutional investors, and Phillips stock had been on a roller coaster ever since.
Icahn and Boesky were hoping that the big institutional investors would side with them, and Phillips executives were hoping they wouldn’t. This Valentine’s Day meeting was a chance for all sides to make their case to the newly formed Council of Institutional Investors—and one by one, they did.
It was better than any Broadway show, Machold thought, but it was more than theater, really. It was the debut of a new force in the takeover battles to come—public pension fund chiefs wielding shares worth tens of billions of dollars were claiming a seat at the takeover table.
The best way to see the new reality taking shape in the market is to jump forward two weeks, to a congressional hearing on a broad range of takeover issues, initially focusing on the Phillips battle. As Carl Icahn, Boone Pickens, and several Phillips executives sat simmering beside him, Jay Goldin carefully explained the new institutional council’s origins and its agenda. Almost two dozen public pension fund directors, with authority over more than $100 billion, were now part of the new council, he reported. As an initial priority, they were determined to speak out against “the dangers to our beneficiaries” of the practice “often caricatured as greenmail.”
When management used company money to pay greenmail, he explained, the payment was made with assets owned by all the shareholders but it benefited only the hostile few. Someone had to speak up for all shareholders, and that’s what this new council of titan investors intended to do. In the Phillips case, their opposition would eventually contribute to the defeat of the company’s recapitalization plan.
“Clearly, the role we represent is likely to grow, as assets owned by pension funds increase exponentially in the American economy,” Goldin said, matter-of-factly. “The leviathan that these funds represent is only beginning to be felt as a distinct and powerful economic factor.”
The impact of this “leviathan” would not be limited to takeover battles. Congress couldn’t say it had not been warned.
* * *
WITH EACH PASSING year, it came to seem that potentially disastrous financial explosions could occur anywhere—and how far the shock waves could spread was anybody’s guess.
That was evident from the extraordinary gathering in Paul Volcker’s lofty conference room on Wednesday, March 13, 1985. The leather chairs around the vast central table were occupied by members of the Ohio congressional delegation, who had brought along some anxious savings and loan executives from back home—where frightened depositors were suddenly lining up to withdraw their cash.
The unlikely fuse that triggered this crisis had been lit nine days earlier and a thousand miles away, with the failure of ESM Government Securities, a small bond trading firm in Fort Lauderdale, Florida. One of ESM’s biggest trading partners was the Home State Savings Bank in Cincinnati, a large thrift that estimated about $150 million worth of its government securities were in ESM’s hands when the Florida firm failed on Monday, March 4.
Like almost six dozen other thrifts in Ohio, Home State did not have federal deposit insurance. Instead, its deposits were insured by the Ohio Deposit Guarantee Fund. Although the fund sounded official—its motto was “All savings guaranteed in full”—the fund was actually a bargain-priced private insurance company with no ties to the state government. With about $130 million in assets, it was supposed to insure $5 billion in deposits in the state that were not covered by the Federal Savings and Loan Insurance Corporation (FSLIC), the FDIC’s sister agency serving the thrift industry.
Within days, the risk that ESM’s collapse posed to Home State was front-page news in Cincinnati. Depositors rushed to retrieve their cash, and Home State had a bank run on its hands. The Cleveland Fed and top aides in Volcker’s office in Washington quickly made emergency loans to the thrift. On March 6 the state of Ohio announced it would “safeguard” all deposits covered by the private insurance fund. Rationally speaking, that should have been the end of the panic.
Yet, as in the Continental bank crisis of a year earlier, frightened depositors paid absolutely no attention to these government assurances. The run at Home State continued through the rest of the week; by the time the thrift closed its doors on Friday evening, March 8, an estimated $154 million in cash had been withdrawn.
On Sunday, March 10, Ohio officials put Home State into receivership, unable to find a buyer for it. By the following Wednesday, long lines were forming outside other thrifts insured by the private insurance fund, even though they had no exposure to the failed firm in Florida. News coverage about the bank runs was starting to attract notice far outside Ohio.
That’s why the thrift executives had flown to Washington that morning and gathered in Volcker’s office.
The towering central banker had done everything he could to show his concern, but the tools Volcker had available were limited. He could extend emergency loans to help with the bank runs, but what these thrifts really needed was federal deposit insurance, and the Fed didn’t sell that—the thrifts had to get it from the FSLIC. With congressional pressure, and perhaps a little rumbling from the Fed, the FSLIC chairman agreed to meet with the Ohio visitors the next day.
That meeting did not go well. The FSLIC’s parent agency, the Federal Home Loan Bank Board, had been bailing frantically for years against a rising tide of red ink in the savings and loan industry. Its chairman had no interest in insuring these Ohio thrifts, much less insuring them on an expedited basis in the middle of a panic. It would take months to examine them, he said, and there was a mandatory ten-day waiting period. Besides, as he reportedly told the thrift executives during the tense session, this was a state problem.
On Friday, March 15, Ohio’s governor declared a “bank holiday” for all the privately insured thrifts in the state, asking merchants to be patient with customers who had suddenly lost access to their cash. The greater Cincinnati area was hardest hit, with more than forty institutions shut down and no clue when or if they would reopen.
Bank holiday was a term that conjured up anxious Depression-era memories for older depositors, especially in the four other states where some thrifts were covered by private insurance: Maryland, Pennsylvania, Massachusetts, and North Carolina. Officials in those states began to worry in private even as they expressed confidence in public. The news was full of scenes of panicked depositors in Ohio who had camped out on cold sidewalks overnight to make withdrawals.
Early on Saturday, and into the dark hours of Sunday, senior Federal Reserve staffers, FDIC aides, and state officials convened at the Federal Reserve Bank of Cleveland, trying to cope with a crisis that began in the Treasury bond market and now had spread across more regulatory borders than the Ohio River.
The Fed and the FDIC had airlifted two hundred bank examiners to help the grudging and underfunded FSLIC handle the applications from the healthy Ohio thrifts seeking federal deposit insurance. There were efforts to find national banks to buy Home State and perhaps other thrifts as well, which would make them immediately eligible for FDIC coverage, but regulatory barriers at the state and federal level confounded the search.
On Monday, the foreign currency market delivered its verdict on the expanding mess. The dollar plunged in value against the British pound and the German mark; the price of gold soared to its highest level in weeks. Many currency traders pointed directly to the Ohio thrift crisis, citing fears that this sharp spike in fragility would tie the Fed’s hands in monetary policy. On Wall Street, the concern was broader—investors were worried that the crisis would continue to be contagious. “If this drags on too much longer, there’s a systemic risk in those states where there is private deposit insurance,” one financial analyst said. “That’s why everybody wants it over.”
Paul Volcker wanted it over, too. On Tuesday, March 19, he invited the governor of Ohio to fly in for a meeting with the chairman of the FSLIC. With Volcker there, an authoritative presence without any actual authority, the FSLIC chairman assured the governor that applications from the Ohio thrifts were indeed being expedited.
That seemed to reassure Ohio depositors, but how could Volcker reassure the markets? He couldn’t just step out in front of microphones and make calming statements—for the world’s senior central banker even to announce a press conference in such nervous times would risk a market reaction. Fortunately, on Wednesday he was scheduled to give a speech to the National Association of Cattlemen. Speaking more to the markets than to the bemused ranchers, Volcker said that the Fed was “working with the Ohio authorities” and “will be prepared to lend to them as they are deemed to be in strong enough condition to reopen.”
But the stability of the financial system relying on the Fed’s promises was growing ever more uncertain.