In three turbulent days in September 1986, John Shad began a sad and surreal pivot toward the end of his career at the SEC.
His enforcement division had been waging a long, rocky fight against insider trading, which was spreading like a bad cold through Wall Street. A number of notable midlevel executives had been arrested and sued; some had pleaded guilty in criminal cases and paid substantial fines to settle lawsuits filed by the SEC. Nothing seemed to help.
Then, in May, federal agents arrested Dennis Levine, an investment banker with Drexel Burnham Lambert. One of the people listed in Levine’s address book was the arbitrageur Ivan Boesky, a veteran of the battle for Phillips Petroleum and the leading takeover speculator on Wall Street.
Boesky had not loomed large during John Shad’s years on Wall Street, but at the SEC, Shad had come to respect Boesky’s aggressive intellect. Just three months earlier, in February, Shad had welcomed Boesky to an SEC roundtable in Washington on how to curb the takeover rumors on Wall Street, a session that John Phelan had also attended. With Phelan sitting at the same big round table, Shad and Boesky made the case that it was unwise for Phelan to permit trading halts when takeover rumors swept the floor of the NYSE.
With Dennis Levine’s arrest, the SEC’s insider trading investigation was boosted into a new orbit. Levine pointed fingers at others in his ring of conspirators, including Boesky, who, he claimed, had been buying tips from him for more than a year. All through the summer, the SEC enforcement staff circled Boesky. By August they had him, and it was not long before his defense lawyer, the former SEC general counsel Harvey Pitt, secretly offered a deal: in exchange for leniency, Boesky would lead them to some of the biggest figures in the takeover game. Long days and nights later, a deal was struck—a single criminal charge, up to five years in prison, and a $100 million payment, covering both fines and restitution of his illegal profits.
On Wednesday, September 10, the SEC was scheduled to hold a public meeting to vote on a staff plan for calming down witching hour Fridays. The proposal asked that brokers send orders seeking the day’s closing price, so-called market-on-close orders, to the trading floor a half hour before the closing bell, so any order imbalances could be publicized. That was as far as John Shad was willing to go in meddling with the new quantitative trading strategies.
Before that public session, however, Shad convened a “super-executive session,” a meeting open only to the commissioners and a few key members of the enforcement staff. According to one account, this meeting was the first update on the Boesky case given to Shad or any other commissioner since earlier that summer. “They seemed stunned by the scope of the revelations, and the prospect of the reactions they were likely to trigger,” that account noted.
The plea bargain with Boesky was unprecedented—at one stroke, he would be paying a penalty almost equal to the SEC’s entire annual budget. And Boesky’s recital of his corrupt dealings with some of the royalty of Wall Street was staggering, especially for John Shad, who had come to the SEC deeply convinced of the fundamental honesty of the world where he had spent his entire working life.
* * *
THURSDAY, SEPTEMBER 11, was shaping up as a steamy late summer day when John Phelan arrived at his desk at the New York Stock Exchange. It had been a dreary week for most investors; the previous day, the market had edged down for its fourth straight losing session.
Some market pundits blamed the downturn on money managers trying to dump their losers and dress up their portfolios in the final weeks of the third quarter. Others pointed out that the market had climbed more than 24 percent since the first of the year and some profit taking was to be expected. Still others said that investors were worried about interest rates going up, which would reduce demand for stocks. Who really knew? As J. P. Morgan had once famously said, markets fluctuate.
Phelan was not happy about John Shad’s latest response to the wild fluctuations of witching hour trading, approved the day before. He didn’t think the half-hour advance notice for market-on-close trades went nearly far enough, and he didn’t hesitate to say so. He wanted the expiration value of Chicago’s stock index futures to be based on the opening prices on the NYSE on those third Fridays, not the closing prices. Phelan believed, from his decades on the floor, that it was much easier to detect and deal with big order imbalances at the opening bell than it was in the frantic, last-minute trading at the end of the day.
Given the rivalry and paralysis built into the regulatory system, the SEC could not give Phelan what he wanted. Only the CFTC could do that. But Phelan’s proposal was opposed by the Chicago exchanges, and the CFTC had not overruled them.
When the computer monitors on the credenza behind Phelan’s desk came to life that Thursday morning, it initially looked like another dispiriting trading day. It soon turned into a disastrous one.
By noon, the Dow’s decline matched the historic drop in early July. After a short-lived lunchtime rally, prices turned and dropped sharply for the rest of the day. By the time the closing bell rang at 4 p.m., traders were profoundly agitated, a record 237.6 million shares had been traded, and the Dow was down 86.61 points, more than 4.6 percent, the largest point loss ever and the largest daily percentage loss since May 1962.
One brokerage firm executive said, “I’ve never seen anything like this. I think money managers panicked.”
Market analysts searched for rational reasons for the massive decline. One Wall Street executive even pointed a finger at John Shad, citing the SEC’s vote the previous day on witching hour procedures and claiming there was “a lot of uncertainty, with the SEC putting in new ways to handle” the witching hour that was a week away.
A far more plausible explanation was tied to index arbitrage.
For the entire month of August and early September, the stock index futures contracts had been more expensive than the underlying stocks, and arbitrage traders had sold futures contracts and bought stocks—no doubt contributing to the market’s new record high on September 4. Indeed, arbitrage trading had been credited with record-setting daily gains earlier in the year.
On September 11, for some reason, the arbitrage opportunity turned upside down. In the first minutes of trading in Chicago, the price of stock index futures dropped sharply and inexplicably, creating a ripe opportunity for index arbitrage traders. They started selling stocks and buying the cheaper futures contracts.
In theory, the arbitrage traders’ sudden demand for the spooz contracts should have driven up their price, bringing the Chicago market back into line with New York. Mysteriously, that didn’t happen—there simply wasn’t enough buying by the arbitrageurs to offset the heavy selling that was hitting the spooz pit that day. Subsequent investigation showed that the S&P 500 futures contract sold at a discount “virtually throughout the day.”
This wasn’t the whole story about Thursday’s historic decline. There had been a lot of other traders in the marketplace that day, selling stocks for reasons unrelated to the markets in Chicago. But it was a large part of the story.
When the closing bell rang, the spooz was still trading at an unusually deep discount to the stocks on the Big Board. Unless that changed, Friday was going to be another very bad day, as more arbitrageurs sold stocks and bought futures.
It did not change—it got worse.
The nosedive continued in the foreign markets that opened for Friday trading while New York was asleep. Tokyo had its steepest one-day plunge in history, and London experienced a record-setting drop before recovering late in the day.
Shortly after the opening bell in Chicago on Friday, S&P 500 futures plummeted, creating a gap between the futures contract and the prices of the underlying stocks that exceeded anything the market had ever seen. Spooz traders simply did not trust the prices they saw on their screens. They later told investigators that they did not try to lock in this extraordinary arbitrage profit because they did not believe they would actually be able to sell the underlying stocks on the Big Board at the prices reflected in the index.
It is no wonder they were wary. In New York that morning, the stock market fell almost straight down from the opening bell until around 10:30 a.m., when it rallied enough to recover almost all its losses before noon. Then it pivoted again and ground out another losing day, a decline of 34.17 points, almost 2 percent, with the trading volume at just over 240 million shares, breaking the previous day’s record.
For Phelan and Birnbaum, the one silver lining in all this was that the Big Board’s processing systems were able to cope with the surge in trading volume. “In the last five years, we’ve invested $150 million in systems and communications to handle all this,” Phelan said after the closing bell on Friday. “We’re anticipating peak volume of 300 million shares a day and sustained volume of 200 million shares a day, and if we could do it with the same lack of problems we had today, we’d be very pleased.” He added, with a nod to the humans on his trading floor: “It’s computers and people.”
By the weekend, people were inevitably making comparisons with the worst two days of 1929, when the Dow lost more than 24 percent of its value, the steepest two-day drop in history. The comparisons were overwrought; in percentage terms, the 6.5 percent decline on September 11 and 12 was barely a quarter of the 1929 loss. Still, it was a shock, one that lingered even after the market eked out small gains on tepid volume early the following week and then lost about half those gains during an unremarkable “triple witching” Friday.
John Shad’s team at the SEC began investigating the two-day crash. To do so, it would have to rely on the help of the CFTC and the trading records from the Chicago pits. The former could be counted on, thanks to the genial leadership of Susan Phillips. The latter was a crap shoot, given the unreliable audit trail maintained by the two giant Chicago exchanges.
It was clear to the largest players in the stock market, if not to Shad, that the answers to what was happening in New York could be found only in Chicago. The Chicago-based chief investment officer at Kemper Financial Services put it this way: “The price of a share of stock is, more often than not, now set in Chicago [rather] than on the floor of the New York Stock Exchange.” Institutions “dominate the game,” he continued, but arbitrage-related program trading was starting to dominate “what we perceive to be normal institutional activity, which is buying or selling based on value.”
The market’s public nosedive and the still-secret Boesky case affirmed that both the morality and the machinery of the marketplace were changing in profound and troubling ways. Little about this new world resembled what John Shad thought of as “normal.”
* * *
IN BERKELEY, MARK Rubinstein watched the markets on those turbulent September days with a heavy heart.
He and his partners, Hayne Leland and John O’Brien, had prospered enormously from the portfolio insurance mania that was sweeping the pension fund industry. LOR was overseeing an extraordinary amount of money, almost $5 billion, most of it through the use of S&P 500 futures contracts. The partners had licensed their software to other firms, including two of the largest institutional money managers, Aetna Life Insurance and Wells Fargo Investment Advisors. Between their own clients and their licensees, their portfolio insurance concept covered more than $50 billion in assets—and by some estimates, copycat competitors were “insuring” an equal amount. This was a staggering number, especially when compared to the $150 million they had managed when Fortune magazine featured them so favorably in the spring of 1982.
LOR, like all portfolio insurers, had been a major seller in the S&P 500 futures pits in Chicago on Thursday and Friday, as it adjusted its hedges to reflect the losses in the market over the prior week. The firm sold not because Leland and Rubinstein were pessimistic about the economy or worried about rising interest rates, but simply because their portfolio insurance hedging strategy required them to sell.
The scale of what portfolio insurers were doing had begun to deeply worry Rubinstein. Leland, while temperamentally a calmer person, was also starting to become concerned, specifically about a possible “feedback effect,” the chance that their trades would trigger a chain reaction that would destabilize the stock market.
“From the very first day I thought of portfolio insurance I said, ‘Well, what if everyone tried to do it?’ I didn’t like the answer I came up with,” Leland later told an academic researcher. It was not a fear he had ever shared with LOR’s clients, but that hardly seemed necessary back when they had so few of them.
Rubinstein said he sometimes felt as if he and his partners had opened Pandora’s box or freed some mischievous genie. “We had one client come to us who had a huge pension plan,” Rubinstein recalled. “We wanted to tell that client that was too much money for us to handle. We were just too worried about the impact that the trading would have on the market.” But like his partners, he also understood that if LOR turned prospective clients away, they would just go to one of its rivals. Indeed, even if LOR shut down completely, the genie couldn’t be put back into the bottle.
Rubinstein was glad to hear that the SEC was going to investigate the two-day turbulence in the market, but he suspected the agency would not get to the heart of what was going on. “When I saw what happened in September,” he said later, “I thought, that’s us. That is us.”
* * *
IN EARLY OCTOBER, Congress passed the Government Securities Act of 1986. The new law was supposed to address the hazards exposed four years earlier, when a default in the unregulated Treasury bond market leapt over regulatory fences and threatened brokerage firms, thrift institutions, and banks.
Ever since the silver crisis of 1980, reality had been saying, loud and clear, “It is all one market now.” Time and again, a crisis in one market had quickly spread beyond the reach of that market’s regulators. Given this indisputable reality, the new law was a monument to regulatory inertia and legislative myopia. It gave the secretary of the Treasury some temporary power to write rules for the government bond market; those rules would be enforced by the SEC or by whichever agency already regulated the outfit that violated them. Any government bond dealers not already supervised by somebody had to register with the SEC, but a firm could request an exemption from the Treasury secretary. The law entirely ignored Treasury futures and options. And the whole statute would expire in five years unless Congress renewed it. As an example of how Congress and Washington regulators responded to an increase in fundamental market risk, it was an ominous joke.
At the SEC, John Shad had opposed extensive regulation of the Treasury market, but he accepted this weak law. Paul Volcker had been equally uneasy about any new regulatory regime, but he was also content with this flimsy arrangement.
Those two men had a more urgent issue to discuss when Shad called Volcker on Thursday, November 13, 1986.
The issue was Ivan Boesky. Shad informed Volcker that the SEC and the U.S. attorney’s office in New York would hold simultaneous press conferences after the market closed on Friday, November 14, to announce that Boesky had been arrested, had agreed to pay $100 million to settle SEC charges of insider trading, would plead guilty to a single criminal charge, and was cooperating with the government’s continuing criminal investigation.
For several months, Boesky had been secretly recording his conversations with various Wall Street figures, including Drexel’s powerful financier Michael Milken. So far, the clandestine tapes had not produced all that prosecutors had hoped for, but it wasn’t possible to keep Boesky’s undercover work a secret any longer. One of Boesky’s investment entities was publicly traded, and the next day, under SEC rules, it had to release its quarterly report—which, of course, would have to disclose the small detail of its CEO’s arrest. The news was still secret, but Shad wanted to alert Volcker in case there were aftershocks in the banking system.
The call did not reflect any greater grasp of the dangerous linkages among markets; it simply underscored how deeply Paul Volcker was trusted by his fellow regulators—especially by Shad, who did not share his blockbuster news with anyone else in the regulatory loop until the next day, when he notified the chairmen of the SEC oversight committees in Congress, just hours before the press conference.
At 2:45 p.m. on Friday, Shad alerted Jim Baker and Donald Regan to the news that Boesky, a major Republican donor, had fallen. It was clearly a jolt: within days, the two men would be conferring about whether the White House should develop some policy initiatives for the “arbitrage/junk bond arena.”
Shad waited until 3:30 p.m. to notify the CFTC, which had not been privy to the investigation, even though Boesky had routinely hedged his enormous stock portfolio in the spooz pit. Shad then reached out to John Phelan, whose floor traders would have to deal with any selling panic the news might trigger on Monday.
As it happened, Phelan was traveling in China, and the call went to Bob Birnbaum, who knew that Boesky’s timely trades in takeover stocks had frequently been flagged by the NYSE’s surveillance team.
At 4:30 p.m., as federal prosecutors stepped to a podium in New York, John Shad and his enforcement chief took their seats in front of a bank of microphones at a table in an SEC conference room in Washington. Shad read his brief remarks from a single sheet of paper.
The settlement with Boesky, which called for the return of $50 million in illegal profits and an additional $50 million fine, “is by far the largest settlement the commission has obtained in an insider trading case,” Shad said. Boesky’s various investment partnerships currently held about $2 billion in securities, Shad continued, and “for a short period of time, he will be permitted to be associated with these entities in order to preserve the assets and avoid defaults on bank and other loans.”
* * *
AFTER THE PRESS conferences, “three rumors—all of which turned out to be true—made the rounds on Wall Street,” one account noted. One rumor was that Boesky had been wearing a wire for months, another was that he might implicate Michael Milken and Drexel, and the third—“the one that seemed the most incredible, almost impossible to fathom or accept”—was that Boesky had been allowed to secretly sell hundreds of millions of dollars of stock before the announcement of his arrest.
Yes, the SEC had let Boesky start liquidating his holdings in early November. It was a remarkably ill-considered decision—not Shad’s first public relations blunder, but surely his worst. The only plausible excuse was that Shad thought the step would help ensure that Boesky retained enough wealth to pay the $100 million settlement.
As expected, the post-Boesky trading was hectic when the New York Stock Exchange opened on Monday, November 17. Takeover stocks bore the worst of the selling pressure, of course. With weekend headlines about government subpoenas being served at firms all along the Street, stock prices started falling in Europe even before New York’s opening bell and continued to decline through the afternoon.
It wasn’t the rout that John Shad had feared, but that was scant comfort. By Friday, the angry rumors on the Street about Boesky’s pre-indictment selling had surfaced, and the news rapidly spread across the country.
The criticism was fed by ill-founded speculation that Boesky had hoodwinked regulators because his firm’s profits were much larger than the penalty he paid to the SEC. Boesky’s investors had reaped most of those profits, of course; by one credible account, Boesky actually paid fully half his entire net worth to settle the SEC case. Unfortunately, Shad could not shake the unfair accusation that he had let Boesky off easy.
It later emerged that Boesky had been actively trading S&P 500 futures contracts, as well as stocks, in the weeks before his arrest was announced. But thanks to legal loopholes Shad had not been able to close, insider trading wasn’t illegal in the derivatives markets!
What should have been Shad’s sweetest hour, his vindication after years of congressional taunts about flabby enforcement work, had almost instantly curdled into public recrimination and private exasperation. Shad and his senior staff “could not understand why the Boesky case had turned against them,” one account noted. “They could not understand how so much could have gone wrong so quickly.”
* * *
SHAD’S CONGRESSIONAL CRITICS initially were just as harsh as those on Wall Street and in the media—bashing Wall Street crime had proved to be a successful election issue for the Democrats. However, by December, attention on Capitol Hill had shifted and was firmly riveted on the jaw-dropping details of what was quickly dubbed the “Iran-Contra” scandal, in which President Reagan had authorized the secret sale of weapons to Iran in an effort to win Iranian help in freeing American hostages held in Lebanon; then, members of his staff had steered the profits from those arms sales to the Contras, the rebel forces challenging the leftist Sandinista government in Nicaragua, in defiance of a specific congressional ban on military aid to that group.
The scandal would ultimately lead to several clouded departures from Reagan’s inner circle, but it almost immediately began to undermine the position of White House chief of staff Donald Regan.
Regan, for all his faults, had been a financially savvy cog in Washington’s political machinery, perceptive enough to have sought out Wall Street opinions about the new arbitrage strategies linking the stock market and the futures market. He understood the “growing concern that too much more of this would badly shake the confidence of individual investors and many institutional investors in the whole equity market process.”
He had not always agreed with Paul Volcker about the fragility of the banking system—his role in the Penn Square Bank crisis and his last-minute obstruction of the FDIC’s rescue of Continental Illinois were cases in point—but he did understand the stock market. Soon after the Boesky scandal broke, in fact, Regan was considering ways the president could publicly show his support for John Shad’s beleaguered enforcement staff—an insightful gesture that certainly would have been welcome at the SEC in those demoralizing weeks.
But as the Iran-Contra scandal eclipsed the continuing coverage of the Boesky investigation, Regan’s days in the White House were numbered.
Volcker, too, was facing an uncertain climb into 1987. The Federal Reserve voted in December 1986 to liberalize its interpretation of the Glass-Steagall Act, allowing national banks to expand into certain precincts of the securities business. Whatever Volcker’s misgivings, the Fed’s new majority apparently planned to continue chopping holes in the Glass-Steagall fence until Congress either shored up the barrier between the banks and Wall Street or tore it down entirely.
For John Shad, the public and congressional reaction to the Boesky case may have been the final straw. Years before, in a private diatribe that he scribbled out in longhand and later incorporated into some private speeches to friendly audiences, Shad opened a window into his personal ambivalence about the price he’d paid during his tenure in Washington.
He titled the piece “Trials and Tribulations.” It began: “If you’re tempted to serve in Washington, you’ll take a big cut in pay but you will have a part-time car, and get to read a lot of critical articles about yourself. It’s a humbling experience. The politically motivated criticism comes from Democratic Congressmen … Their letters are delivered to the press. Before you receive a copy, the reporters call. The standard response is no comment, but the liberal press makes the most of such stories. The volume of accusations picks up in the even numbered years—election years.”
He continued: “Some of my friends thought I was nuts to accept the job. One called me up and said, ‘Tell me again—slowly—why are you doing this.’” While Shad wasn’t ready to leave public service entirely, he let the White House know he had no appetite for another term at the SEC.