On February 26, 1982, a cold gray day in Washington, Phil Johnson arrived early at the Russell Senate Office Building, a massive stone trapezoid across from the Capitol. The building was a few blocks from the Monocle, the restaurant where he and John Shad had opened their peace talks the previous summer. In a few minutes, Johnson would be explaining that deal to a Senate agriculture subcommittee weighing whether to renew the CFTC’s lease on life.
He would be the first to testify, so he settled in immediately at the witness table. Behind him, in the second row of seats set aside for spectators, was Jim Stone, who was still a member of the commission.
When Senator Richard Lugar of Indiana, the subcommittee chairman, opened the hearing, Johnson graciously made note of Stone’s presence, calling him “a very valuable asset to the commission.”
Three days earlier, Stone had sent a remarkable letter to the full Senate Agriculture Committee detailing his worries about how the borders between securities and commodities had “rapidly eroded.” He noted that three of the largest commodity firms regulated by the CFTC had recently merged with Wall Street firms regulated by the SEC. The NYSE, under the SEC’s wing, had a new futures exchange, regulated by the CFTC. And ten days earlier, on February 16, the CFTC had approved the first futures contract based on a stock market index: the Kansas City Board of Trade’s new Value Line futures contract.
Stone had cast the only vote against the new contract, whose debut he saw as “final proof that the lines have been blurred.”
The Value Line approval was a tribute to Johnson’s deft diplomacy in Washington. Paul Volcker had serious concerns about stock index futures, particularly on the issue of margins. These concerns boiled down to how much skin a speculator should have in the game. Using stock index futures, an investor could control a block of stock with far less cash than would be needed to control the same stake on the NYSE. That kind of lopsided leverage didn’t sit right with Volcker, especially in the aftermath of the silver crisis. Johnson had met repeatedly with the Fed chairman, trying to persuade him that margins in the futures market were adequate to prevent excessive speculation. Volcker finally agreed not to openly oppose the new contract, but he still had misgivings.
Now applications for at least sixteen new stock-based futures contracts were pending before the CFTC, including a bid from John Phelan’s New York Futures Exchange to trade futures based on the NYSE Composite index. “Should this trend continue, the arguments for maintaining two separate regulatory agencies, and two distinct philosophies, will dissolve,” Stone observed in his letter. “If the industries become one, the CFTC and the SEC should consolidate as well.”
At the reauthorization hearing, Phil Johnson just wanted the lawmakers to bless and quickly codify the deal he had worked out with Shad. If Congress did not act, the courts no doubt would; the CFTC and the SEC were awaiting a ruling in the Chicago Board of Trade’s lawsuit to block the SEC’s approval of Ginnie Mae options trading.
A few moments into the sparsely attended hearing, Senator Lugar was interrupted politely by Senator S. I. “Sam” Hayakawa of California, whose modest manner veiled a brilliant mind. With a nod from Lugar, Hayakawa turned his gaze to Johnson: “I understand that trading has been approved for stock index futures by the CFTC. This appears to be an instrument through which speculators on the stock market could hedge their bets on the futures market.”
Johnson nodded. “That is right,” he replied.
Hayakawa seemed perplexed. “I do not understand the economic purpose of this contract,” he said. Indeed, he continued, stock index futures seemed to be “thousands of miles away from agriculture. I must say, Mr. Chairman, this disturbs me very much.”
Not long afterward, Senator Robert Dole of Kansas also spoke up about stock index futures. “What we are authorizing is, in effect, legalized gambling,” he said, disapprovingly.
* * *
FORTUNATELY FOR PHIL Johnson, neither Dole nor Hayakawa had been at the Kansas City Board of Trade two days earlier, when the Value Line index futures started trading. In the crowd was Joe Granville, the flamboyant market guru who had triggered a small stampede on the Big Board in January 1981. “It’s like a new game in Las Vegas,” he said with evident delight. “Now, instead of betting on a stock, you can bet [on] the entire market. It will tell me how the people feel about the future of the market.” This was not a view that would have reassured Senator Dole.
About two thousand contracts were traded that day, and the gold rush was on. Barely a week later, a CFTC economist told a futures industry gathering that the commission was reviewing fifty-seven applications for new stock index futures and futures-related options products.
In the futures market, the first exchange to develop a new contract tended to own the lion’s share of trading in that contract going forward. So, there was some chagrin in Chicago that Kansas City had beaten them into the history books with the first stock index futures contract.
It wasn’t for lack of trying, and no one tried harder than Richard Sandor, the former Berkeley professor who was now the chairman of the New Products Committee at the Chicago Board of Trade. He had been working on a stock index futures contract since at least 1978.
After some initial setbacks, Sandor and his team decided to pursue a futures contract based on the Dow Jones Industrial Average, arguably the most widely published stock market barometer in the world. Sandor flew to New York to pitch Dow Jones executives on the idea, offering the company between $1 million and $2 million a year for the use of its name. Dow Jones, the publisher of the Wall Street Journal and Barron’s magazine, wasn’t interested.
Sandor wasn’t daunted. Back in Chicago, he made a fresh pitch to officials at the Board of Trade—one that opened, oddly, with a thumbnail history of aspirin. Aspirin had once been a brand owned by Bayer for its version of acetylsalicylic acid, but the company had not defended its trademark, and aspirin gradually became a generic term. Sandor argued that Dow, like aspirin, had become a generic term, free for anyone to use.
The exchange gave his theory a try. Two days after the Value Line index’s debut, the Chicago Board of Trade sought CFTC approval for the CBT Index, a Dow clone. Dow Jones sued, the lawsuit inched along for months, and the Board of Trade ultimately lost.
Meanwhile, Leo Melamed at the Chicago Merc had gone in a different direction, eyeing the Standard & Poor’s 500 index. It was nowhere near as familiar to retail investors as the Dow, but the Merc’s research showed that big equity-portfolio managers—the kind of people Gordon Binns was hiring to manage the stocks in GM’s pension fund—almost uniformly used that index as the benchmark for their performance. Melamed felt they were the natural hedgers for a stock index futures contract, so he put the Merc’s chips on the S&P 500.
And whereas Dow Jones had rebuffed the Chicago Board of Trade, Standard & Poor’s, a division of the McGraw-Hill publishing company, was at least willing to talk to the Merc. Over dinner with S&P executives, Melamed explained that he wanted an exclusive deal and said he was willing to pay S&P a dime for every contract traded, up to a maximum of 10,000 contracts a day. So far as Melamed knew, that greatly exceeded the maximum daily trading volume of any futures contract in history. A deal was struck, and the Merc entered the stock index sweepstakes two months behind Kansas City.
On April 21, Melamed watched proudly as a scrum of traders poured into a pit at the Merc to start trading the new S&P 500 futures contract, quickly dubbed the “spooz” (which rhymes with “booze”). The first day’s volume easily exceeded 10,000 contracts. Spooz trading would falter a bit in the next four months, as the stock market suffered the last wounds of a bear market, but Melamed was certain that, when the next bull market found its legs, the new product would become one of the most successful futures contracts ever.
* * *
ON MARCH 24, 1982, as the Merc was preparing for the spooz debut, a bombshell from Chicago’s federal appeals court hit Washington.
The Seventh Circuit Court of Appeals had heard oral arguments the previous November on the Chicago Board of Trade’s challenge to the SEC’s approval of Ginnie Mae options. Since then, the SEC general counsel’s office had been watching and waiting. Their lawyers in Chicago got the call from the court and quickly retrieved the decision. When it was read to the SEC lawyers in Washington, they were appalled.
The Board of Trade’s legal theory had been remarkable: it claimed that Ginnie Mae certificates had been magically converted into commodities the minute the futures contracts based on them started trading in Chicago. Thanks to this alchemy, an option on a Ginnie Mae certificate was an option on a commodity, not an option on a security—and commodity options, like commodity futures, fell squarely under the exclusive jurisdiction of the CFTC. The argument had raised a host of alarming questions for other regulators: Had Treasury bills also become commodities the minute the Merc started trading Treasury bill futures? If someone started trading a futures contract on IBM stock, would that suddenly turn the stock into a commodity? Was the CFTC’s jurisdiction limited only by Chicago’s imagination?
Giving a literal reading to the remarkably elastic CFTC statute, and ignoring the terms of the Shad-Johnson Accord, the judges ruled that the SEC had no authority to approve the Ginnie Mae options contracts. As the court saw it, the law’s language meant that “literally anything other than onions could become a ‘commodity’ and thereby subject to CFTC regulation simply by its futures being traded on some exchange.”
Indeed, the appellate court found that the expansive law that created the CFTC might even be interpreted as denying the SEC any authority at all over the stock options market. In a challenge to lawmakers, the court wrote, “Given the possible expansion of ‘commodity’ to include even corporate securities on which options have traditionally been regulated by the SEC, the CFTC exclusive jurisdiction clause must have some limits.” Apparently, the judges felt it was the job of Congress, not the courts, to define those limits.
The ruling ignited a frenzy of alarmed protests. Even Phil Johnson at the CFTC was surprised at its reach. He was still awaiting formal reauthorization of his agency, and this was exactly the kind of thing that could inflame the SEC’s allies in Congress and undo all his careful diplomacy.
Congressman John Dingell, a Michigan Democrat with strong New Deal sympathies, quickly called for hearings on amendments that would affirm the SEC’s authority over the stock options market. Dingell also questioned the entire realm of financial futures, especially stock index futures. The amendments would pass easily. Dingell’s profound uneasiness over stock index futures would not.
* * *
WHILE THERE WERE obviously disputes over the SEC’s jurisdiction over stock index futures and Ginnie Mae options, it was absolutely certain that the SEC did not have jurisdiction over the market for U.S. Treasury bonds. Nobody did, in any practical sense. It was one of the hidden canyons in the financial landscape where a brushfire could erupt and spread to other markets almost without warning.
When the SEC was created in the 1930s, the relatively small market for U.S. government securities had been explicitly placed outside its regulatory fences. That remained true, although the government now depended on an immensely larger Treasury market to borrow money to cover a growing federal deficit.
In that market, tens of billions of dollars in Treasury securities changed hands daily among corporate treasurers, traders at giant banks, senior vice presidents at local savings and loans, and government finance officers in city, county, and state agencies around the country. Although the titans had arrived, the Treasury bond market was still governed by gentlemen’s agreements and quaint notions of accounting.
The Federal Reserve had a small bit of power over this market—although “influence” would be more accurate than “power.”
The New York Fed, where Paul Volcker had once presided, designated three dozen major Wall Street institutions as “primary dealers,” which gave them the coveted right to submit bids when the Treasury auctioned off new securities. In exchange, these primary dealers volunteered to give the New York Fed regular updates on their financial health.
Of course, almost all the primary dealers also fell under some formal regulatory regime. The big national banks were monitored by the Office of the Comptroller of the Currency and the FDIC, and their holding companies were overseen by the Fed. The big Wall Street brokerage firms were regulated by the SEC.
However, if a financial firm put its Treasury bond trading desk into a separate business unit, that unit was regulated by no one. And that’s what Drysdale Securities did.
Drysdale was a small New York brokerage house whose roots went back to a firm that had joined the New York Stock Exchange in 1890. In early 1982, Drysdale had set up Drysdale Government Securities, a separate unit controlled by the firm’s star bond trader, David Heuwetter. Heuwetter had recently used some peculiar features of Treasury market accounting, and very little cash, to build up risky trading positions of at least $5 billion, a staggering amount for a firm Drysdale’s size. The assumption, of course, was that Heuwetter’s borrowing and trading strategy would be profitable—and so long as interest rates kept rising, pushing down bond prices in the process, that was a pretty good bet. Within the firm, the trader was “rumored to be using a secret and sophisticated computer-based trading strategy.”
Drysdale Securities was a member of the NYSE, and this risky bond business did not escape the attention of John Phelan’s staff. The Big Board insisted that Drysdale either insulate itself from Heuwetter’s adventures or shut the operation down. The result was the spin-off in early 1982.
The spin-off alone might have been enough to worry some of Drysdale’s trading partners. However, a lot of Drysdale’s trades were conducted through Chase Manhattan Bank, the Rockefeller family’s bank and the third largest in the country; a lesser amount was handled by two smaller but still substantial institutions.
Business practices in the immense market where older Treasury securities were traded were so casual that it was not clear—to the marketplace, at least—whether Chase and the other banks were acting simply as Drysdale’s agents in the trades or were serving as clearinghouses, guaranteeing the trades in some way. Many people lending their bonds to Drysdale apparently thought they were doing business with Chase; some bond lenders in the savings and loan community or in county finance offices in the hinterland might never have heard of Drysdale.
None of these feckless traditions—which one senior banker later conceded were “not rational”—seemed to worry anyone in this huge unregulated market until Monday, May 17, 1982. That was the day Heuwetter was supposed to send Chase Manhattan a payment of $160 million, to cover the interest due on some of Drysdale’s borrowed bonds. Chase would then forward the cash to the bonds’ various owners. Unfortunately, the previous evening, Heuwetter had called his banker at home to ask if Chase would lend him the money to make the next day’s interest payment. He would be unable to pay it otherwise.
Frantic calls were made; word quickly reached Willard C. Butcher, Chase’s CEO. Bank lawyers assured Butcher that Chase had merely been an agent for Drysdale and was not legally obligated to cover the default, so Chase declined to extend the loan to the beleaguered bond trader.
Of course, that $160 million would surely be missed by the firms to whom it was owed; the default might actually put some of the smaller firms in peril. So, on Monday morning, Butcher quite responsibly reached out to the one government agency with at least a sliver of authority over the situation: the New York Fed. A group of senior staffers there met with him at 2:30 p.m. and listened as he explained the situation. He proposed calling a meeting with all the major firms involved, at which Chase would suggest they jointly cover Drysdale’s default to protect the smaller firms at risk.
The New York Fed officials promptly notified Paul Volcker, who immediately summoned his one-man SWAT team, Jerry Corrigan. They both knew the Treasury market would quickly get wind of the Drysdale problem—too many firms were affected to keep it quiet, and Treasury prices were already falling sharply. What if other dealers began to fear that they would not be paid on their deals because their counterparties had not been paid by Drysdale? That could disable the market, an important source of daily working cash for countless entities in business and government. If Drysdale wound up in bankruptcy, billions of dollars in bonds could be tied up for months, even years.
Although the Federal Reserve had no clear authority in this crisis, Volcker agreed that the New York Fed should convene the meeting Chase had requested, just to learn more about what was going on. Then he tried to focus on getting ready for the next morning’s meeting of the nation’s key monetary policy panel, the Federal Open Market Committee (FOMC), which he chaired. Corrigan made plans to travel to New York.
Around 6 p.m. Monday evening, senior executives from seven major Wall Street firms filed into the New York Fed’s fortress-like headquarters in Lower Manhattan. With Chase executives at his elbow, a Fed official carefully explained that the Fed was concerned about the “potential market consequences of the problem,” but was not endorsing any plan that Chase might present.
Chase’s suggestion that the banks jointly cover the Drysdale default sat on the table like a stale fruitcake. As far as these major dealers were concerned, this was Chase’s problem because it had handled Drysdale’s trades. Sure of his legal position, Butcher urged the dealers to sleep on the idea and reconvene at 7 o’clock the next morning at his bank’s headquarters, a few blocks away.
At the Fed in Washington, alerts were going out to Treasury officials, the comptroller of the currency, and SEC staffers to warn them of possible domino effects from Drysdale’s default. The SEC had some authority over Drysdale Securities, but it was soon clear that the brokerage firm was not the entity involved in this mess. The comptroller of the currency supervised Chase Manhattan Bank, but that agency’s chief concern was for Chase’s bottom line, its “safety and soundness,” not its moral obligations to the market. Treasury officials could do little but worry about the next auction of two-year Treasury notes, less than two days away. If Drysdale’s default was still hanging over the market, it could drive up the interest rate that taxpayers would have to pay on those notes.
Once again, as in the silver crisis two years earlier, Corrigan found himself in a world without tidy regulatory borders—a world where everyone seemed to be groping frantically in the dark for a lever that would prevent an explosion.
* * *
THE MEETING AT Chase Manhattan’s headquarters on Tuesday morning did not go well. By one account, thirty angry brokers and bankers crowded into the conference room, having heard via Wall Street’s supremely efficient grapevine that Chase was not going to cover the default.
The Treasury market continued to wobble, as word spread that Drysdale also had defaulted on interest payments owed to two other banks. Remarkably, more than thirty-six hours after Drysdale announced its default, Jerry Corrigan could not say for certain how big this problem was or how many other banks and bond dealers might be affected.
The rest of the day, Corrigan and other Fed officials wrangled with officials from Chase and the two other banks left holding Drysdale’s empty bag. The decision was entirely theirs, Corrigan told them, but he thought “a decision to pay interest would have a calming effect.”
Back in Washington, Corrigan’s boss was complaining out loud about the Drysdale debacle. He had called the day’s Federal Open Market Committee meeting to order at 9:15 a.m., but explained that he would be ducking in and out during the day to take urgent calls from New York.
“We have a rather abnormal development in the market, to say the least,” he told the startled committee members, explaining that a government securities firm “can’t meet its bills.”
“Is this a dealer?” asked one of the Fed governors, referring to the big primary dealers designated by the New York Fed.
“It’s not a recognized dealer,” Volcker replied. “It is a fringe operator who apparently operated in very large size” using money raised “with some kind of rinky-dink scheme.”
His concern was evident. “Chase Manhattan is in the middle of this, as the middleman.” People on the other side of the firm’s trades “claim that Chase is liable and Chase claims it is not, so we have a mess there. Losses are well in excess of $100 million just on that set of transactions, and we don’t know what else is involved. We’re trying to find out.”
He outlined the stabilizing steps the Fed could take in the marketplace, if his worst fears materialized and a bankruptcy judge froze the assets of other dealers who had left securities in Drysdale’s hands.
Most of Drysdale’s lenders were “major security houses in New York—there is a group of seven or eight of them, they’re all well-known firms,” Volcker said. “They should be able to withstand the loss if things ever settle, so far as we know about the loss,” he said. “But that doesn’t mean it won’t send ripples of very deep concern all through the market.”
He paused and looked around the room, a circle of anxious faces.
“Any comments, or questions that I won’t be able to answer?”
There was one, from Lawrence K. Roos, the president of the Federal Reserve Bank of St. Louis: “Paul, as the Federal Reserve, what is our responsibility in a situation like this? Just to keep order?”
“Our general responsibility is to the economy most broadly, Larry,” Volcker replied. “The problem in this case, as in all cases, is that the guy who is responsible is only the smallest part of the problem. If all of the financing arrangements in the government securities market are disrupted, we have a major problem.”
The president of the Federal Reserve Bank of San Francisco, John J. Balles, then spoke up: “Just looking at the other side: is there any risk of our being accused of a bailout of private dealers, or whatever?”
“Yes,” Volcker answered abruptly. “There is no way to avoid that.” He added after a moment, “That is the nature of being a lender of last resort.”
* * *
THE NEXT MORNING, the two other banks involved in the Drysdale default announced that they would cover the interest owed on the bonds. Fifteen minutes before noon on Wednesday, Chase announced that it, too, would pay the interest due on the Drysdale bonds. The call was made to Volcker: Success. Persuasion and maybe a little moral pressure from the Fed had resolved a crisis that no one had clear regulatory authority to handle—a crisis that no one had seen coming, and a crisis that no one had even been able to measure accurately in the time available.
With the silver crisis, Corrigan had seen the financial fault lines stretch in a new direction, toward the Chicago commodity markets. Now a crack in an arcane corner of the Treasury market, regulated by no one, had shaken several major banks, regulated by the Fed and the comptroller of the currency, and some Wall Street firms regulated by the SEC.
America in 1982 had become a place where an adventurous Treasury bond speculator—or, for that matter, two silver speculators in Texas—could create an earthquake that could shake any corner, or every corner, of the nation’s financial landscape.