Silver Thursday was still a week away when Ronald Reagan, starting to surge in the Republican presidential primaries, visited the New York Stock Exchange on March 19, 1980. With the casual grace of a leading man, Reagan strode toward the exchange entrance at 11 Wall Street, his tan trench coat draped over his shoulders, his dark hair coiffed and shiny. His personal glamour overshadowed the rumpled, unpretentious man who had arranged the campaign visit: John S. R. Shad, the vice chairman of E.F. Hutton and Co.
John Shad, at age fifty-seven, was a portly, affable-looking man with glasses, outsize earlobes, a sagging jawline, and a receding hairline. He had first met Reagan two years earlier, when a fellow Hutton executive invited Shad to the Bohemian Grove, a secretive summer retreat for powerful and wealthy men, located in the redwood forests north of San Francisco. Shad had recently lost a bitter battle for the chairman’s spot at the firm and had settled into an uneasy accommodation with the new leadership. He was a smart man, full of intellectual curiosity. A navy veteran, he had earned an MBA from Harvard on the GI Bill, and more or less for the mental exercise, he and his wife Pat had earned law degrees together at New York University while he worked his way up at Hutton.
When Reagan announced his presidential bid, Shad agreed to head up his New York campaign, and this high-profile visit to the NYSE was one result. After a tour of the crowded, paper-strewn trading floor, they took elevators up to the exchange’s luncheon club, a wood-trimmed haven staffed by white-coated waiters who relished stock tips more than the traditional kind. Never comfortable in front of a microphone, Shad mumbled the obligatory introduction: “Ladies and gentlemen, I present to you the next president of the United States.”
Later that summer, Shad arranged for Reagan to meet privately with some of New York’s business elite, and campaign donations followed. As one of Reagan’s earliest Wall Street supporters, Shad could hope for some role in a Reagan administration, which would lessen some of the sting from losing out on the Hutton chairmanship. His ambition came with certain costs; his Wall Street paycheck was ten times what he would make in Washington, and his complex investment portfolio would have to be unwound. Still, he remained interested in public service.
Reagan won the Republican nomination and was pitted against the incumbent president, Jimmy Carter, whose reelection hopes were shadowed by the intractable inflation that had plagued him and his two predecessors and by his own failed efforts to free the Americans held hostage for months in revolutionary Iran. Negotiations for the hostages’ release were dragging on fruitlessly. On the inflation front, however, Carter had already taken a key step toward victory by tapping Paul Volcker as the new Fed chairman, the steward of the nation’s monetary policy. Unfortunately, Volcker’s progress against inflation had come at the expense of the economy, leaving Carter to run for reelection during a slump that gave ammunition to his adversary.
When Volcker was sworn in as Fed chairman in August 1979, most adults had grown up in an era when inflation was normally about 3 percent a year. By that measure, inflation had not been “normal” since 1966. A month after Volcker took office, inflation reached an annual rate of 12.2 percent, despite fairly anemic business activity. The time-tested medicine for high inflation was to raise interest rates, but higher rates were poison to a stagnant economy. Volcker believed the corrosive effect of inflation was a bigger long-term threat to working families than the fallout from high interest rates, and Carter supported him. The Fed let interest rates rise sharply, the bond market fell into turmoil, the stock market was leery, and the economy slumped—just as the 1980 presidential campaign began.
Wall Street was deeply worried, and Carter wasn’t saying much that was reassuring.
Reagan was. His sunny optimism sweetened his more draconian attacks on government bureaucracy. Regulatory constraints on business, ranging from antipollution rules at the Environmental Protection Agency to corporate bribery investigations by the SEC, were a prominent target in his speeches. Reagan’s goal of cutting taxes and red tape was immensely popular in the business community. As Carter had already acknowledged, the federal government had enacted a lot of unnecessary rules in the early postwar years, when American businesses and banks faced little foreign competition—rules that were now a burden in an increasingly global business environment. One Reagan supporter suggested that his campaign invite major business lobbying groups to submit their ten most ill-conceived regulations for inclusion “on a ‘hit list’ much like the FBI’s 10 Most Wanted List.”
If the leaders at the Chicago futures exchanges had been surveyed in that effort, just about everything the CFTC did would have wound up on the list. Their most immediate complaint was Jim Stone’s dug-in opposition to the new financial futures pending before the commission. Financial futures promised to become a gold mine for the Chicago futures exchanges, and innovators there, who believed these new products also would be a real benefit to American businesses, were impatient to get their new ideas to market.
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AT THE HEAD of the army of frustrated Chicago traders stood a brilliant force of nature named Leo Melamed.
Born Leo Melamdovich in Poland in 1932, Melamed was a human dynamo with coal-black hair, dark hooded eyes, a broad, expressive face, and a gift for debate that hinted at the courtroom lawyer he once planned to be. After the Nazis invaded Poland in 1939, Melamed and his parents, both Yiddish educators, fled eastward across Siberia. In 1941, when he was nine years old, his family finally wound up in Chicago, by way of Japan. As a young man, Melamed charmed his way through a local college and then entered law school. Sometime around 1953, while looking for part-time work as a law student, he stumbled upon the Chicago Mercantile Exchange, where traders in loose, colorful jackets struck deals at the top of their lungs as clerks scurried around plucking up the scattering paperwork. Barely twenty years old, Leo Melamed was drawn to the vital energy of the Merc trading floor and never left.
Melamed liked loud suits and louder sports cars, and he was rarely seen without a cigarette dangling from his lips or fingers. He got his law degree in 1955 and split his time between law and futures trading until 1966, when he began trading full-time. The next year, at age thirty-five, he became the youngest trader ever elected to the Merc’s board of governors—the first step in a career of imaginative and sometimes controversial leadership that would last a half century and reshape the futures industry.
When Melamed joined its board, the Merc was the number-two futures exchange in Chicago, by a long distance. For decades, the grandeur of first place had belonged to the Chicago Board of Trade, housed in a soaring Art Deco skyscraper in the heart of Chicago’s financial district. Its neighbors were the aggressive Continental Illinois bank and the powerful Federal Reserve Bank of Chicago, located in matching Greek temples on the flanking corners.
Melamed was determined to improve his scrappy second-place market, whose only big contract was on pork bellies. Working first from a perch on the board’s new products committee and, as of 1969, from his seat as chairman, he tossed a host of new futures contracts into the trading pits to see what would prosper. Some ideas (futures on shrimp, turkeys, and apples) flopped. Others (futures on hogs, cattle, and lumber) were successful, and trading volume grew.
In 1972, Melamed led the Merc in the introduction of the first widely successful financial futures, based on the colorful and unfamiliar foreign currencies Americans encountered when they traveled abroad. By his account, he first got the idea in the late 1960s, from a fellow trader who “was the first in our crowd who had attempted to dabble in currency. He found it nearly impossible.” The big banks wouldn’t take his small orders. Not long afterward, the same complaint was raised in the Wall Street Journal by the economist Milton Friedman, an expert on monetary policy at the University of Chicago.
Under treaties signed after World War II, major Western currencies were pegged to the American dollar, and the dollar was pegged to gold. By the late 1960s, that system was breaking down. Friedman, the star of an economics faculty already known for the free-market tilt of its research, had argued for years that exchange rates should be set by traders, not by treaties. If that ever happened, though, the world would need a way to hedge the risks of fluctuating exchange rates. Melamed put the Merc staff to work on developing futures contracts pegged to foreign currencies.
The Merc’s board approved his idea early in 1970. A few months later, to Melamed’s horror, a tiny article in the New York Times reported that a struggling futures exchange in Manhattan, the International Commercial Exchange (ICE), had already developed foreign currency futures. Trading opened in New York on April 23, 1970.
“My heart sank,” Melamed recalled. He and a colleague flew to New York to take a look. When they got to the exchange’s home at 2 Broadway, they found the trading floor and slipped inside.
“It was deserted. There was no trading,” Melamed reported. To his great relief, these new contracts were too small to be of interest to large-scale hedgers and speculators, the primary players in the foreign exchange markets.
By August 15, 1971, when President Richard Nixon announced the end of the postwar currency regime, Melamed was ready with a contract that commercial hedgers and speculators could easily use. But first he had to inform his Washington regulator about the new product. In 1971 that regulator was the Commodity Exchange Authority, a tiny Depression-era agency located in the basement of the Agriculture Department building. The authority was not well versed in the foreign currency markets, to say the least, and it had no clear jurisdiction over the new contracts anyway. “Fortunately for us,” Melamed later remarked, “at the time … there were a bunch of free market folks in very high government places.”
On December 18, 1971, Western political leaders unveiled the new international currency regime. At a press conference a week later, Melamed unveiled the International Monetary Market, a Merc affiliate that would trade futures on British pounds, Canadian dollars, West German marks, Italian lire, Japanese yen, Mexican pesos, and Swiss francs.
The new market opened on May 16, 1972. Both history and Leo Melamed ignored the tiny currency futures exchange in Manhattan. As far as either was concerned, the era of publicly traded financial derivatives had dawned—in Chicago.
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THE CHICAGO BOARD of Trade, the Merc’s hometown rival, joined the Merc on the financial futures bandwagon in 1975, thanks to Richard L. Sandor, a young economics professor on sabbatical from the business school at the University of California at Berkeley. A diminutive powerhouse with boundless enthusiasm for practical innovation, he was part of the first wave of brilliant émigrés from academia to settle in the realm of finance.
Sandor, a New Yorker, had arrived on the Berkeley campus in 1966 after earning a doctorate in economics from the University of Minnesota. Perhaps no campus in America was as firmly linked to the placard-toting, slogan-shouting stereotypes of the unruly 1960s as Berkeley. The university’s hillside campus had given birth to the Free Speech Movement, an influential protest against campus curbs on political activism, and Berkeley became a key organizing point for national antiwar marches and civil rights confrontations.
By the 1970s, there was another buzz on campus, and it was occurring at the business school. Berkeley’s business school may not have had the wealth and prestige of Harvard’s or the free-market ferocity of the University of Chicago’s, but it was still at the forefront of a revolution in financial engineering.
Less than fifty miles south of Berkeley, what would later be called Silicon Valley was producing computers that could analyze huge collections of numbers, such as the daily prices on America’s stock markets. The scholars at Berkeley and elsewhere who used such data to draw conclusions about the movements of the stock market became known as “quantitative” theorists, or “quants.” They were already using mathematical ideas to guide investment strategies, and some moved beyond that to ideas that would reshape entire markets. One Berkeley faculty member laid out a theoretical sketch for a fully computerized stock market—in 1962, a decade before the most primitive automated markets took shape in the real world. In 1970, Richard Sandor designed a fully automated futures market that would make Leo Melamed’s world in Chicago obsolete. In the early 1970s, a faculty celebrity named Barr Rosenberg had come up with new computer modeling tools to help big investors select the best mix of stocks for their portfolios—and, in the process, built an international reputation and a multimillion-dollar consulting business.
These ideas challenged traditional investment managers, who firmly believed that the way to build a portfolio was to study individual stocks issued by specific companies. In the 1950s, scholarly skeptics of this “stock-picking” concept had painstakingly collected stock prices going back decades; in the 1960s, they analyzed those prices on primitive computers and reached a shocking conclusion: random collections of stocks, chosen by literally throwing darts at the stock tables in the Wall Street Journal, generally outperformed handpicked portfolios. This so-called “random walk” method of investing was an idea that, in a few years, would radically transform the way giant institutions deployed their money in the market.
Another group of “quant” scholars, loosely centered on the University of Chicago, looked at the same historical data about stock prices and reached a slightly different but equally world-changing conclusion about Wall Street. These scholars saw the stock market as a computer (vastly faster and more efficient than any at their disposal) that could absorb all the relevant information about every stock and generate the appropriate price for that stock at any moment of the day.
It was a vision of the stock market as a beehive, where information known to some was instantly communicated to all. In this beehive, prices were the product of all the rational and well-informed decisions made by all the rational and well-informed traders in the marketplace at that moment. As these theorists saw it, everyone was smarter than anyone.
This notion about how the stock market worked became known as the “efficient market hypothesis,” and it would be hard to pick an academic theory that has had a greater impact on American markets. Those who subscribed to the efficient market hypothesis believed that markets should be left alone to practice their beehive brilliance without government interference. After all, if everyone was smarter than anyone, everyone was certainly smarter than Uncle Sam. That notion, too, would shape the financial landscape far into the future.
In the San Francisco Bay area of the early 1970s, lightbulbs of financial innovation were burning bright everywhere, not just at Berkeley. A remarkable team of computer geeks and misfit bankers, working in a small unit at Wells Fargo Bank in San Francisco, had seized on the “random walk” concept and were trying to build portfolios for their pension fund clients that would behave as much as possible like the overall market. Their endeavor, called “indexing,” outraged the traditional stock-picking analysts at the bank—and helped nurture the giant institutional investors who would rise to prominence in the next decade. Dubbed Wells Fargo Investment Advisors, this innovative team was road-testing index funds long before the Vanguard mutual fund family introduced the concept to the retail market in 1975. It also pioneered the statistical tools for measuring pension fund performance, a commonplace concept now that was unavailable to corporate treasurers five decades ago.
The seeds of vast and potentially disruptive power were planted in these two innovations. Indexing gave rise to giant funds that were all likely to shift their assets in the same direction at the same time, because they were recalibrating their portfolios to track the same market index. Their clients’ ability to measure how closely they tracked that index meant money managers would be wary of deviating from the herd—and might be inspired to look for even better results if they could, to attract more big pension funds as clients. The tools they developed to seek those extra bits of profit would be as disruptive as the index funds themselves.
Careful scholars always acknowledged that each of their theoretical models was a stripped-down, simplified version of reality, and wasn’t meant to replicate the messiness and noise of the real world. Unfortunately, their caveats did not travel anywhere near as far as their theories.
By the time those theories were starting to spread to Wall Street and Washington, they already were being skeptically examined by some in academia.
Well before 1980, some bright thinkers were poking holes in the efficient market hypothesis. One hole was the paradox about market knowledge. In theory, prices in an efficient market would instantly reflect any new knowledge, so nobody could get “an edge” by finding hidden gems or overlooked bargains. And knowledge about individual companies was expensive to acquire—in those pre-Internet days, it typically meant plane fare and long-distance telephone bills, plus some leased computer time. If the market was so efficient that investors couldn’t profit from their hard-earned knowledge, why would they bother to gather that knowledge in the first place? Yet they did.
Other skeptics raised even more fundamental questions: Were human beings really the cool, rational investors envisioned by the efficient market theory? Or were they, in fact, prone to panicky overreactions, herd instincts, stubborn misperceptions, and magical thinking? Anyone who observed how actual investors behaved during a crisis probably would not describe that behavior as cool or rational. Slowly, these skeptics began to find academic followers, and the course of research began to shift toward what would be called behavioral economics.
Well into the twenty-first century, however, academic warnings about flaws in the efficient market hypothesis would be largely ignored by legislators, politicians, and financial policymakers. The notion that “markets cure themselves” without government interference had firmly taken root in Washington in the 1970s, and it would spread like kudzu over the policy-making landscape for decades.
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AT BERKELEY, RICHARD Sandor’s visionary idea for an electronic futures market languished when the traders who commissioned the research opted for a more traditional market instead. He then designed the Berkeley business school’s first course on futures trading and invited a host of important industry figures to speak to his classes. One of his guest lecturers was Warren Lebeck, a senior executive at the Chicago Board of Trade. Their relationship blossomed, and in 1972 Sandor took a sabbatical from Berkeley to become the Board of Trade’s chief economist. Lebeck and Sandor soon devised the world’s second major financial futures contract—a contract based on the interest rates on the mortgage-backed notes that Wall Street called “Ginnie Maes,” a nickname inspired by the initials of the issuer, the Government National Mortgage Association.
The nation’s banks and savings and loans owned millions of home mortgages and should have been desperately looking for a way to hedge themselves against the threat of gyrating interest rates. They weren’t—because in 1972 they could not imagine an era in which interest rates would fluctuate enough to require hedging. Sandor made the rounds of S&Ls and commercial banks in Manhattan, warning that the stable rates of the recent past were “a historical anomaly” that would likely vanish under the weight of large government deficits. One executive heard him out and then simply asked, “What are you smoking?”
However, it turned out that mortgage lenders in California were interested in the new contract, and the Chicago Board of Trade forged ahead. By 1975, Sandor’s Ginnie Mae futures contract was ready. Unlike the Merc’s foreign currency contracts introduced three years earlier, Sandor’s brainchild had to be cleared by Chicago’s new regulator, the Commodity Futures Trading Commission, which had just opened its doors in Washington.