John Shad was sworn in on May 6, 1981, as the twenty-second chairman of the Securities and Exchange Commission. Phil Johnson wasn’t confirmed as the new chairman of the CFTC until June 8, but when he finally got settled in, one of his first official acts was to arrange to have lunch with his counterpart at the SEC.
The Monocle restaurant in Washington had the ambience of a neighborhood pub, but the neighborhood it served was Capitol Hill. Occasionally, the phone near the tavern’s door would ring to summon lunching lawmakers for an important vote. On an afternoon in the early summer of 1981, Phil Johnson and John Shad slid into a booth in the back of the restaurant.
Both men were newcomers to public service. Both agreed with President Reagan that American business was smarter and contributed more to the common good than government did. And both knew that they needed to craft a peace treaty in the turf war over financial derivatives before the courts or Congress imposed an outcome that neither agency could stomach.
So here they were, scanning the tall, stiff menus at the Monocle and sending the waiter on his way with their orders.
Wouldn’t it be better, Shad said, if the two of them worked out these jurisdictional disputes without “making a major issue of it”? He added, “I really think that it would be desirable if we could do this quietly.”
Johnson agreed. What would it take, for example, to resolve the dispute over Ginnie Mae options? And what would persuade Shad to accept other CFTC-approved derivatives—especially the stock index futures that Chicago wanted so badly?
Well, stock index futures worried Shad. He could not ignore what had happened the year before, when the crisis over the Hunt brothers’ futures contracts destabilized the cash market for silver. What if that happened in the stock market? Why couldn’t the contracts just be settled with an exchange of money, Shad suggested, eliminating the need for traders to buy and sell all the underlying stocks?
Johnson must have smiled to himself. What Shad wanted was something called “cash settlement”—and it was precisely what he had hoped to persuade Shad to accept when they sat down to lunch.
The commodity markets had long been wary of settling futures contracts with cash; they saw physical delivery as the force that kept futures markets tethered to reality. The price of wheat futures would necessarily converge with the price of wheat because sometimes—rarely, but sometimes—a trader would have to make or take delivery of actual wheat at the going price at some grain elevator.
Yet there was an important difference between traditional commodity futures and financial futures: The price of wheat futures effectively became the price of wheat, because wheat didn’t really trade anywhere else. Stocks did—every day, the publicly accepted prices of the stocks in the Dow Jones Industrial Average were determined not in a trading pit in Chicago but on the trading floor of the New York Stock Exchange.
What if the stock market produced one value for the Dow and the futures pits produced another? Without physical delivery, the price of a Dow futures contract could fall under or float above the real-world price of the Dow stocks on the NYSE. What would happen then? In the summer of 1981 the answer to that fateful question wasn’t clear—indeed, it wasn’t even considered.
As it happened, the financial engineers in the futures markets had already figured out that cash settlement was the only way stock index futures could work for traders in their pits, and Johnson and his fellow CFTC commissioners were inclined to agree.
The scene might have been funny if the consequences had not been so profound. Here, over lunch, John Shad was urging Phil Johnson to do exactly what Johnson already wanted to do. And to get Johnson to do that, Shad was prepared to make major (and arguably unnecessary) concessions—ceding jurisdiction over stock index futures contracts to the CFTC and forgoing any meaningful control over the design and approval of those contracts.
“Both of them thought the turf fight between their staffs was unseemly,” according to one well-informed account. To Shad, it seemed like “two kids sorting marbles. You take the red ones and I’ll take the green ones.”
Johnson and Shad returned to their offices and gave new marching orders to their surprised staffers, proud that the logjam of pending applications for new financial derivatives could finally be broken.
* * *
ONE DAY DURING that same summer of 1981, the executive who ran AT&T’s giant employee pension fund entered the tall, icy-white marble lobby of the General Motors building on Fifth Avenue in Manhattan and took an elevator to the twenty-fifth floor, a wood-paneled setting with thick hall carpets and brass doorknobs. The visitor, David P. Feldman, found the right suite and told the receptionist he was there for lunch with Gordon Binns, the new head of General Motors’ $12 billion employee pension fund.
Binns greeted his visitor with a faint Virginia drawl. He was instantly likable, projecting both Southern courtliness and unpretentious warmth. As Binns arranged for sandwiches to be delivered, Feldman took a seat at a small conference table by a window with a view of Central Park. Binns grabbed a pen and a fresh legal pad, settled down across from Feldman, and started asking questions.
How did Feldman measure the performance of money managers who used very different investment strategies? Did he rely much on bank trust departments? Had he looked into the “quantitative” investment strategies coming out of academia? What did he think about index funds?
Two hours later, Binns had pages of notes—and Feldman had a new friend in the increasingly powerful community of pension fund managers.
Walter Gordon Binns Jr., was born a few months before the 1929 stock market crash and grew up in Richmond, Virginia. A gifted student, he majored in economics and earned a Phi Beta Kappa key at the College of William and Mary, but he didn’t linger in the South. In August 1949, a month after his twentieth birthday, he graduated and immediately headed north to Harvard, where he earned a master’s degree in government. He later added an MBA from New York University. After service in the U.S. Army, he joined General Motors in 1954 and started rising through the ranks in its finance department. Somewhere along the way, he started drinking heavily—and somewhere a bit further along the way, he stopped. A cheerful teetotaler for the rest of his life, he faithfully sought out Alcoholics Anonymous meetings in cities around the world as he traveled.
By 1980, he was assistant treasurer at the giant automaker, familiar with every aspect of the GM pension fund’s operations. He knew General Motors had added some common stocks to its pension portfolio years before. That portfolio was managed by seven major banks; its performance had been anemic, to put it kindly. The pension fund stood dead last among nineteen comparable corporations, based on recent rankings, and GM’s new chairman, Roger B. Smith, wasn’t happy about that.
To fix it, Smith turned to Binns, who suddenly needed to learn everything he could about selecting and monitoring the money managers who could produce the gains Smith was demanding. Dave Feldman of AT&T would not be the last pension fund executive Binns would invite to lunch as he explored ways to steer his pension fund deeper into the stock market.
In the summer of 1981, that looked like a smarter move than staying in the “safe harbor” of the bond market, the traditional mooring for many conservative pension funds. Interest rates were high and still climbing, as the Fed fought inflation. High interest rates reduced the value of older bonds that paid a much lower rate of interest, and some traditional pension fund portfolios were packed with those old bonds, losing value with each upward tick in interest rates.
Other pension fund managers had weighed anchor and sailed out of the bond market years earlier. One of them was Roland M. Machold, the director of the New Jersey Division of Investment and the hands-on manager of that state’s employee pension fund.
When Machold first arrived as the investment division’s deputy director in 1975, the state pension fund held about $5 billion but owned only fifty stocks—mostly “bondlike” utility stocks paying high dividends but rarely gaining in value. That had to change—and under Machold, it did.
Roland Morris Machold was a product of Philadelphia society and old Wall Street. His father was a partner in the prestigious Philadelphia investment banking firm of Drexel and Company; Machold went to Yale, as his father had, and then to the Harvard Business School. After graduating in 1963, he took a job at Morgan Stanley, which had only about a hundred employees and served only blue-chip corporate clients.
Over the next decade, Wall Street changed. Cherished clients started shopping for better deals; gentlemen’s agreements were shockingly broken. Trading desks got bigger and louder. Investment bankers seemed more ruthless. The hours were long, and the work grew less congenial.
Machold was tired of taking the last train home to Princeton, New Jersey, where he and his wife were raising a young family, so in 1975 he resigned from Morgan Stanley, with no strong sense of what to do next.
The answer came on a very cold Sunday morning at the historic Quaker meeting house, a tiny one-story stone building a bit south of Princeton that had been in use since before the Revolutionary War. Machold was that month’s designated leader of the contemplative Quaker service, which meant he was responsible for tending the fire in the wood-burning stove, the building’s only source of heat, and for bringing worship to a close at an appropriate moment by stirring in his seat and greeting the person beside him. That morning, the fire wasn’t cooperating. As Machold fretted silently about how to get up and stoke it without prematurely terminating the service, a genial older man near the door caught his eye, then slipped out to his car and returned with tightly crumpled pages of that Sunday’s New York Times to feed the fire.
When the service ended, Machold went over to thank his rescuer, who introduced himself as Richard Stoddard, the longtime director of the New Jersey Division of Investment. Prodded by Stoddard, Machold shared a bit of his own career history and admitted that he was at a crossroads.
Stoddard, too, was at a crossroads. He was on the brink of the state government’s mandatory retirement age but had not been able to find a successor at the salary available. Perhaps Machold would consider applying for the job?
He did, and was promptly hired. He reported for work at a stately but slightly shabby mansion left over from Trenton’s prosperous past. Windows were framed by chintz curtains on the inside and ivy on the outside. One former bedroom held a tiny market news ticker and five or six small desks pushed together to form the division’s “trading desk.” The employee directory read like the United Nations phone book; many employees had grown up in immigrant families and found work with the state government, perhaps after getting a degree from a local college. It was definitely not Morgan Stanley, but Machold loved it.
In December 1976, Stoddard retired after a dozen years of service; in those twelve years, the pension fund had grown from $1.4 billion to $5 billion. While still deputy director, Machold had encouraged Stoddard to raise the percentage of the fund’s assets invested in common stock to about 20 percent, from just 10 percent when he arrived. As director, he pushed that figure higher. He hired a retired Prudential executive to actively manage the bond portfolio. The fund’s performance got better, and Machold began to be noticed in the pension community. By 1981, despite a less-than-roaring stock market and a turbulent bond market, the fund had grown to $8.3 billion.
Machold and Binns were members of a growing army that would reshape the financial landscape in the 1980s. Since 1974, the nation’s pension funds had increased their stock holdings almost 20 percent a year; as of 1980, their combined portfolios exceeded a quarter of a trillion dollars and were still growing. They were rapidly becoming the eight-hundred-pound clients that Wall Street could not ignore—titans whose concentrated financial power was unprecedented in the American market.
* * *
DESPITE HIS COMMITMENT to streamlining the NYSE’s operations, John Phelan’s vision of the exchange was unapologetically traditional: he believed the stock market existed primarily to serve individual investors, in sharp contrast to the bank-dominated stock markets of Europe and Japan. In Phelan’s view, individual investors tended to be long-term investors and were the ballast when a storm hit. His staff regularly monitored the proportion of Big Board trading that was done by individuals, as opposed to institutional investors. He took pains to emphasize publicly that, on his trading floor, small investors were on an equal footing with these emerging giants.
The major Wall Street brokerage firms that owned seats on the exchange did not share Phelan’s vision. They were growing less interested in individual investors and instead coveted clients such as Roland Machold, who directly managed billions of dollars and always had fresh money to invest, and Gordon Binns, who hired a host of managers to move hundreds of millions of dollars around the market. These institutional investors were hungry for new ideas, extra research services, faster responses. To serve them, Wall Street was harnessing its trading desks to new back-office computers, which were collecting institutional orders and driving them into the stock market on a scale and at a pace that humans had never seen before and could not match.
For the brokerage firms, this transformation was essential if they were to compete for these institutional clients—not just pension funds, but also giant mutual funds, vast college and charitable endowments, and big foundations, all newly interested in adding stocks to their once-stodgy portfolios of bonds or mortgages.
The emergence of these titans as stock market investors did not seem to trouble market regulators, who apparently took comfort in outdated studies showing that institutional investors did not disrupt the market because they tended to pursue a variety of different investment strategies. Regulators did not focus on what would happen if that ever changed and Wall Street’s biggest clients started moving in lockstep.
By 1981, that shift had already begun. Institutional investors were putting more and more money into the hands of “index fund” managers. Based on academic theories about how rational markets worked, these giant portfolios, an ocean of money tens of billions of dollars deep, replicated, on a smaller scale, the entire blue-chip market represented by broad market measures of value, such as the Standard & Poor’s 500 index. Even some individual investors were starting to seek out mutual funds using this approach.
These index funds, although still a relatively small factor in the overall market for common stocks, tended to buy and sell the same stocks at the same time. The most vivid example of this herd instinct came when one company was dropped from an index and a new one was added. Vast amounts of the former would be sold; vast amounts of the latter would be bought. Once a stock was in a popular index, big index funds had no choice but to buy it.
Could this trend turn into Joe Granville’s “Sell everything” day on overdrive? John Phelan wanted to guard against this, so he worked to increase the NYSE’s ability to handle big surges in trading volume. His goal was to install computer systems capable of handling 150 million shares a day.
Reared in an era dominated by “the little guy,” Phelan could see that most of the newcomers to his market were likely to be giants—funds holding tens of billions of dollars steered by smart, profit-oriented people such as Gordon Binns and Roland Machold, who needed to make money so they could keep the retirement promises that had been made to millions of American workers.
In the shadows beyond, new private pools of cash, known as “hedged funds,” were attracting money from the most affluent speculators in the world and steering it into the U.S. stock market. As an institutional investor, Gordon Binns had heard about them and was intrigued, as some were producing spectacular returns. Roland Machold occasionally got a wrongheaded sales pitch from such a fund—as a state pension fund director, working under a very conservative investment council, he wasn’t interested.
None of these men, least of all John Phelan at the NYSE, could be certain what these private funds were doing, or how big they were, or what their investment strategies might be, or which markets they were playing in—options, futures, stocks, Treasury bonds, bank CDs, mortgages? These funds were not required to register with any regulatory body, much less report their portfolio holdings. In the turf wars of Washington, these were the forgotten provinces. Nobody was fighting for the right to regulate them.
* * *
THE TRUCE IN the war between the CFTC and the SEC was announced on December 7, 1981. In a conference room at the Capitol, John Shad and Phil Johnson sat at a table in front of a dark velvet curtain as an SEC spokesman explained the deal. The CFTC would no longer oppose the bid by the Chicago Board Options Exchange to trade Ginnie Mae options (though the Chicago Board of Trade would continue its fight), and the SEC would no longer challenge the CFTC’s plans to approve futures contracts based on the stock market.
Beyond that, it was a hodgepodge. The CFTC would continue to regulate all futures contracts, whether they were based on pork bellies or stock market indexes. The SEC would continue to regulate stocks and single-stock options, and would regulate options on government securities and stock indexes, if those ever came into being. Shad insisted that any stock index futures contract approved by the CFTC should be based on a well-established, broad-based index. Johnson agreed that the SEC would be consulted before the CFTC approved new index futures products, but insisted that his agency was free to ignore any SEC objections.
Under the “Shad-Johnson Accord,” an already complex regulatory scheme morphed into a Rube Goldberg contraption that would plague the nation for decades. The simple question “Who regulates options?” could only be answered, “It depends.” However, the answer to the question “Who regulates stock index futures contracts?” was finally clear, and it was the CFTC.
Shad and Johnson had made their deal and had gotten government out of the way of the financial innovation sweeping the marketplace—innovation that would tie the futures market and the stock market together tighter than either man could have imagined.
Unfortunately, Shad and Johnson were not traders, and their accord ignored the facts of daily life that traders confronted in the stock market: Stocks didn’t trade constantly throughout the day, without interruption or limitation. Sometimes, for various reasons, trading in a particular stock had to be halted. There were rules forbidding you from buying or selling a stock at all, if your trades were based on confidential inside information, or if you were betting that a declining stock would keep dropping. None of these rules applied to the markets where stock index futures contracts were going to be traded—markets that expected to rely on constantly fresh stock prices from New York as the basis for their own trading.
Moreover, the two markets ran on entirely different settlement schedules. If you made a profit on your stock index futures trade, you got your cash overnight; if you made a profit trading stocks, you got your cash in five days. If you needed profits from your stock sales to cover your futures position, you had better have a friendly banker or a big bank account to tide you over.
These rules and practices had been in place in the stock market for decades, and there was no requirement in the Shad-Johnson Accord that they be harmonized or changed. After all, Chicago wanted to piggyback on John Phelan’s market, not vice versa. For Chicago to demand that the stock market change its rules to suit the futures traders would have been like a hitchhiker jumping into a car for a lift and promptly changing the radio station—or, worse, grabbing the wheel. The NYSE was the long-established cash market for stocks; Shad and Johnson apparently expected that stock index futures would merely piggyback on that cash market without affecting it. Consequently, they did not think to ensure that the design of these new stock-based futures contracts accommodated the stock market’s rules and habits. That omission would come back to haunt both markets.
For Chicago, though, the new pact was a godsend. The legal battle over stock index futures was over, and Chicago had won—well, officially, the CFTC had won, but it amounted to the same thing.
Now the Merc and the Chicago Board of Trade, and all their lesser brethren, were free to start trading the futures contract they believed every institutional investor, the emerging behemoths of the decade’s markets, would want to trade.
* * *
PHELAN WASN’T THE only one preoccupied with the rise of titan investors and the changing demographics of Wall Street. Some prescient bank regulators were worried, too. One of them was a ruddy-faced, grizzly-size New Yorker named Jerry Corrigan, a young protégé of Paul Volcker at the Federal Reserve Bank of New York who had remained a close aide and ally when Volcker moved to Washington in 1979.
Like Phelan, Jerry Corrigan was an Irishman. Both liked a good drink, a good party, and a good story. Also like Phelan, Corrigan had a first-class mind that could grasp complicated problems and get them solved, usually without alienating everyone in the neighborhood.
E. Gerald Corrigan was born in the blue-collar town of Waterbury, Connecticut. In 1967, after a Jesuit education and a doctorate in economics from Fordham, he was offered a research job at the New York Fed, housed in a massive Florentine-style palace three blocks from the New York Stock Exchange. The research department, he recalled, was populated “by economist types, all from Ivy League schools or Stanford or Berkeley. And then there was me.” Within eighteen months, he was the chief of domestic research.
Sometime around 1972, the second-ranking officer at the bank summoned him to the executive offices on the tenth floor. Corrigan was alarmed. “Unless you were a close relative of God, you never saw the tenth floor,” he said. Moreover, it was summer, and he had chosen a pretty loud cotton blazer as the day’s attire. This isn’t so good, he thought. His reputation outweighed his wardrobe, though, and at the end of that interview, he found himself the new corporate secretary of the Federal Reserve Bank of New York, working directly with its board of governors. That is where Paul Volcker found him two years later when Volcker became president of the New York Fed.
“I don’t know what happened,” Corrigan later recalled, “but for unknown reasons, he and I hit it off like Ike and Mike.”
Like Phelan at the NYSE, Corrigan had to wrestle early on with the challenge of modernizing a tradition-bound system—in his case, the New York Fed’s accounting department which worked around the clock, under the command of a man who had worked there for thirty years. After studying what needed to be done, Corrigan told the veteran accounting director that he was going to automate the department’s general ledger.
“No, you’re not,” the older man said calmly. “You can automate it after I retire, but for now, we’ll leave my control mechanisms in place.”
Corrigan was taken aback, afraid he’d missed something in his research. “Forgive my ignorance, but what control systems are those?”
The older gentleman explained that the final cash-flow tally each day was “entered into the ledger with fountain pen ink, so it can’t be changed.” The culture of the bank was such that Corrigan actually did have to postpone the automation for a year and a half, until the fountain pen champion had retired.
That inauspicious project—Corrigan later recalled that Volcker “laughed for a half hour” when he heard the story—launched his career as Volcker’s troubleshooter. In August 1979, when Volcker was tapped by President Carter to be Fed chairman, he summoned Corrigan to his office and said, “Pack your bags. You’re going to be my special assistant in Washington.”
Corrigan had been at Volcker’s elbow when Harry Jacobs at Bache called in the spring of 1980 to alert him to the silver crisis. Days later, he had been Volcker’s eyes, ears, and telephone operator in Boca Raton as anxious bankers negotiated a new loan for the Hunt brothers.
By then, Corrigan already was getting worried about how rapidly Wall Street was changing. Banks were regulated by the Fed and the Office of the Comptroller of the Currency and the FDIC; insurance companies were regulated by officials in the fifty states; and mutual funds and brokerage firms were regulated by the SEC—and these were all becoming more deeply entwined with one another. Financial futures trading, under the oversight of the same overmatched regulators who presided over the silver crisis, would forge new and very worrisome links among all those markets.