A little before 9 o’clock in the morning on Wednesday, August 25, 1982, word went out to the New York Stock Exchange, the Dow Jones newswire, and the corporate world at large: Bendix, a diversified manufacturing corporation based near Detroit, was launching an uninvited takeover bid for Martin Marietta Corporation, a defense industry giant based in Bethesda, Maryland. One of the wildest corporate battles in modern market history had begun, an opening salvo in the takeover wars that would define the 1980s—and would distract lawmakers and regulators from the vastly more important structural changes occurring in the financial marketplace.
The stock market had frequently been a battleground for control of American corporations—during the great railroad wars of the nineteenth century, the smaller postwar corporate raids of the late 1950s, and the shopping sprees of the so-called conglomerate kings a decade later. In all those battles, the New York Stock Exchange had hewn to its traditional standards: every share of stock in a corporation was good for one proxy vote on the company’s future. That had long been the rule on the Big Board—one share, one vote—but it had been years since shareholder votes had been used in the wild, disruptive ways that Bendix and Martin Marietta had used them.
SEC chairman John Shad had built his career at E.F. Hutton handling corporate mergers and acquisitions, courteous deals that “were prudently financed and made sound business sense.” He believed the SEC had no business telling shareholders how to vote their shares, or telling corporations what they could do with their cash—or their borrowing power. As members of Congress grew increasingly agitated over hostile takeovers that threatened major corporations back home, Shad braced himself for the political heat.
But the Bendix battle whispered something else to those who listened carefully: the really big money on Wall Street was stirring, flexing its muscles, testing its power. Size mattered: the bigger you were, the more risks you could take, and the more money you could make. With Washington pulling back on enforcing the nation’s antitrust laws, institutions that couldn’t grow internally could get the wealth and power they wanted by using the takeover game to scoop up their rivals.
Pension fund managers such as Roland Machold in New Jersey and Gordon Binns at GM were giant shareholders, with stakes in hundreds of American corporations, any one of which could become a takeover target tomorrow. Suddenly, shares of stock weren’t just investments that could outpace inflation; they were ballots that would help determine the future for a major corporation and tens of thousands of American workers. Until the Bendix battle, casting those ballots didn’t seem like a very important chore—Binns routinely delegated proxy decisions to the money managers he hired, and Machold referred the task to an in-house committee.
Now it was clear to everyone that the giant institutional investors, who had been steadily adding to their stock holdings since the late 1970s, could be a decisive force in the takeover wars. And both sides, corporate officers and aggressive “raiders,” were eager to enlist them to vote as a bloc for one side or the other.
* * *
WITH THE BENDIX circus helping to fuel it, the stock market shot up like a rocket in early October. The market’s continuing advance, which pushed the Dow to 965.97 points on Thursday, October 7, was the top story on the front page of the New York Times the next morning—the rally was news, of course, precisely because no one could be sure it would last.
The deluge of orders that hit the New York Stock Exchange at the opening bell that day set a record, 43.6 million shares in the first hour, and slowed the exchange’s public ticker down by almost forty minutes. Each hour, the trading volume grew and the intensity of the celebration grew with it. By the final hour, traders were waving at news photographers in the visitors’ gallery, flinging scraps of paper into the air and blowing police whistles like happy children. The closing bell brought a roar that filled the cavernous space above the trading floor.
It was a new record: 147.1 million shares, almost three times larger than the daily trading volume at the Dow’s nadir in August. That evening, according to the Times, the lines in front of Merrill Lynch’s stock price video screens in Grand Central Terminal “were longer than those in front of the commuter information boards.”
The heavy opening had been a bit of a strain for John Phelan’s upgraded order-processing machinery, but the ticker had caught up before the closing bell. If Phelan had felt any anxiety during the morning’s crush, it had evaporated by the time he spoke with reporters that evening.
“We’ve built models and tested them up to about 300 million shares and 250,000 transactions,” he exulted. “That’s twice the volume today, and five times the number of transactions.”
Phelan’s pride was evident: if the bull was back, the Big Board was ready.
* * *
THE RALLY WAS still going strong a dozen days later, on October 19, when Jerry Corrigan stepped up to address the annual conference of the American Bankers Association in Atlanta. Corrigan was now serving as the president of the Federal Reserve Bank of Minneapolis, but he still had Volcker’s ear, and thus his words were given extra attention. He was in Atlanta to talk about financial deregulation—and he wasn’t singing the tune the American banking industry wanted to hear.
In recent years, banks had persuaded Congress and their own regulators to approve new products that looked remarkably like the money market mutual funds that were regulated by the SEC. Brokerage firms were getting regulatory permission to buy banks outright, saying they just wanted to provide a few helpful services to investors. Sears, a retailer of clothing and household goods, had recently opened its first “financial supermarket,” offering insurance services from its Allstate subsidiary, real estate services from its Coldwell Banker subsidiary, and brokerage services from its Dean Witter Reynolds subsidiary. Prudential Insurance, which was regulated by insurance commissioners in each state, already owned Prudential-Bache Securities, regulated by the SEC, and was negotiating to buy a major bank in Georgia.
The new reality, as one legal scholar put it, was so chaotic that any bank “can choose the regulatory system to which it will subject itself.”
The big banks could get even bigger, feasting on new lines of business previously closed to them. Financial operations were becoming more tangled, with odd couplings that regulators had never confronted before. In the face of those changes, Corrigan wanted the bankers in Atlanta to ask “hard questions about what banks are, and what we want them to be.”
Banks took in money from depositors, made loans to borrowers, and made their money by charging borrowers more than they had to pay depositors. Taking in deposits, in Corrigan’s mind, had an almost sacred aspect; putting money in a bank was an act of faith. This made banks inherently different from, say, Sears or a trucking company. “Public trust and confidence in individual banking organizations—at some point—is only as strong as is public trust in the banking system as a whole,” he added.
A shoe store could open its doors, lease space in every shopping center for miles around, build up lots of inventory as styles changed, provide poor service—and fail. But shoppers would still confidently buy shoes at another store down the street.
Corrigan knew for sure that what was true for America’s shoe stores was emphatically not true for America’s banks.
* * *
CHICAGO’S FINANCIAL LEADERS had never been fond of Washington regulators, especially if their guidelines reined in growth, stifled innovation, or curbed profits.
Yet, in July 1982, in the immediate aftermath of Penn Square’s collapse, Continental Illinois had been forced to rely on the Fed for emergency loans. As the summer lurched from crisis to crisis, Volcker grew increasingly concerned about the Chicago bank—and was baffled that CEO Roger Anderson didn’t seem as worried as he was. In mid-August, while coping with Mexico’s mounting problems, Volcker summoned Anderson and his entire board of directors to a meeting in Washington. It was time for some serious jawboning, while the Penn Square memories were still sharp and painful.
Staff notes of the meeting give a flavor of Volcker’s remarks. He said that “it was important to deal with this credibility problem as soon as possible,” because the Penn Square episode raised “important questions about the bank’s management.” As he saw it, the bank should show that it was serious about reform by changing its management and its lending policies, taking all the necessary write-offs, conserving its cash, and building a sounder capital base.
Anderson’s responses were not preserved for the record, but a few weeks later he confidently announced that “the bank had dealt with its difficulties and could now go forward confidently, business as usual.” A few upper-level retirements, a few mid-level departures (the banker who was too friendly with Penn Square among them)—and that was that.
Volcker was not fooled by these cosmetic changes. He kept trying to persuade the bank to take more meaningful steps. He visited Anderson and his board in Chicago, striding like a Visigoth giant through the bank’s Roman lobby. He made the same arguments again to Anderson; he got the same responses. He argued with the directors that Anderson should be replaced; he got nowhere.
The Fed was theoretically a powerful regulator. It could have tried to force the bank to change course by threatening to deny it loans or seeking a court order to keep it from paying dividends. However, as one Fed lawyer later conceded, those steps likely would have triggered exactly the crisis they were trying to avoid.
That was the fundamental conflict Volcker faced. As he saw it, the Fed’s first duty was to preserve the stability of the financial system. Its work as a bank examiner often took a back seat to bigger things, such as the global debt crisis, the pace of inflation, or the liquidity of the financial markets. Moreover, there were other regulators, lots of other regulators, supervising the nation’s banks; presumably, they would address risky lending habits or reckless management if they saw problems arising.
Yet, none of these agencies seemed to know what to do about the brash, irrepressible executives at Continental Illinois, the biggest bank in Chicago and one of the shakiest banks in the country.
* * *
AMID THE HEADLINES during that unsettled summer of 1982, there was one that delighted two ambitious young economics professors at the business school at the University of California at Berkeley. It read “A Strategy for Limiting Portfolio Losses,” and it sat atop an impressively long article in the June 14 issue of Fortune magazine.
At the foot of the article’s opening page was a charming photograph of the two professors: Mark Rubinstein, a small, puckish man with a dark mustache and thick, wiry eyebrows; and Hayne Leland, tall and graceful, with a lanky frame and curling sandy hair. Casually dressed, they were sitting cross-legged on a grassy slope.
The opening words of the Fortune article were calculated to catch the reader’s attention: “It sounds too good to be true.” The story was a generally positive look at a concept the professors had developed, a way to protect a portfolio of stocks from steep losses without giving up too much of the market’s future gains. The article also noted that the professors had put their ideas into practice, having founded a small firm that managed about $150 million for a half-dozen pension funds.
Just two years earlier, none of that had seemed possible.
In the early months of 1980, Hayne Leland had carved out time from his classes and research papers to make sales calls, pitching this new hedging strategy to banks and brokers in New York and Chicago. Each time, he had returned home full of optimism; each time, he waited for follow-up calls that never came.
Sometimes, there were a few guys at the meetings who knew enough statistics or math to follow his formulas. Too often, though, his idea was met with blank stares. It was so unlike the bright-eyed discussions he enjoyed at Berkeley, where the atmosphere buzzed with investment ideas that merged mathematics and markets, computers and cash, physics and finance.
Selling research ideas to Wall Street was perhaps not how Hayne Ellis Leland had expected to spend his academic career. His casual, California surfer looks belied a polished pedigree. His father’s family had deep roots in the Boston area; his mother had named him for her own father, Admiral Hayne Ellis, an aide to President Wilson’s secretary of the navy and later Franklin Roosevelt’s chief of naval intelligence. In the 1920s, the Ellis family had owned the historic Woodley mansion in Washington, D.C., an elegant Georgian-style brick pile that was used as a summer White House by four U.S. presidents. Leland’s mother and her parents had moved easily in the best circles of Washington society.
Leland was born in Boston in 1941 but grew up in Seattle. He returned east for four years of prep school at Phillips Exeter Academy, and then followed the family tradition by entering Harvard, where he majored in economics and was tapped for several elite clubs. After graduating magna cum laude in 1964, he married the debutante daughter of a titled French family, in a ceremony at the American Cathedral in Paris. He spent a stimulating year working on a master’s degree at the London School of Economics and then returned to Harvard, where he earned his doctorate in economics in 1968.
Leland joined the economics faculty at Stanford, but the department there was not a good fit; the research he found most intriguing was being done in the business school. He did not get tenure in economics at Stanford, and academic politics precluded him from getting tenure on the business school faculty. So, in 1974, he moved to the University of California at Berkeley.
The Berkeley business school was buzzing with theoretical innovations that had a distinctly practical tone. Each working paper had the same caveat mimeographed on its cover: “Papers are preliminary in nature; their purpose is to stimulate discussion and comment.” And they did—at annual conferences and faculty dinner parties and professional gatherings and sidewalk conversations, year in and year out. That atmosphere was catnip to Leland after the constraints he felt at Stanford.
On a September morning in 1976, Leland was convinced he had found an idea that could be valuable to those people who managed investments in the real world—a notion that came to him when, during some sleepless hours, he turned his mind to something his brother had recently said.
His brother, an investment adviser, had bemoaned the fact that there was no way to insure a stock portfolio against market losses, the way you could insure your home against fire. It couldn’t work exactly like insurance, of course. What sane insurance company would write policies that could all produce claims at the same moment? A stock market decline wasn’t like an isolated house fire. If one policyholder experienced big market losses, all the other policyholders would probably have big losses, too.
Maybe there was some other way. In his dark Berkeley bedroom, Hayne Leland was struck by an idea. He immediately got up, went to his study, and settled down to work, to see if his insight would make sense on paper.
There already were financial products that, if used correctly, could work almost like insurance policies: stock options, which allowed their owners to buy (“call”) a stock or sell (“put”) a stock at a fixed point in the future for a specific price. Stock options had been around for years, and most corporate executives understood how they worked. It was obvious to Leland that if you had only one stock in your portfolio, you could use stock options to protect yourself against future losses. If your stock’s price had recently climbed from $20 to $40, you could buy a put option that would allow you (but not require you) to sell the shares to someone else for $40 at some point in the future. If the stock fell back to $20, or even lower, the option would still let you sell it for $40 a share, avoiding any loss and locking in your earlier gains. Without giving up the chance to ride the investment up to, say, $60 a share, you still protected your $20 profit—in effect, you “insured” yourself against a decline in the stock price.
Call options on individual stocks, which allowed you to buy shares at some point in the future at a fixed price, had been actively traded since 1973 in a formal marketplace, the Chicago Board Options Exchange. However, in 1976, put options for individual stocks, which allowed you to sell shares at a specific price sometime in the future, were available only on a limited basis and generally had to be negotiated piecemeal in an informal “over-the-counter” marketplace.
Leland could see that he needed a way to apply the logic of a put option to an entire portfolio of stocks. That kind of broad-based option didn’t exist, but the sudden inspiration that got him out of bed that night was the notion that he could create a “synthetic put option” by using a shifting combination of stocks and cash. He tried to sketch out the mathematics before grabbing a few hours of sleep.
The next morning, he realized he needed someone who knew more about the mechanics and theory of options than he did. Specifically, he needed Mark Rubinstein, his trusted friend and colleague on the business school faculty.
Rubinstein was a rumpled man whose formidable intellect was clothed in almost childlike curiosity. He got his high school education at the Lakeside School in Seattle, the “haven for math freaks” that would also educate Bill Gates, the cofounder of Microsoft. Rubinstein had been two years behind Leland in Harvard’s undergraduate economics department, and had gone on to earn his master’s from Stanford and his doctorate from the University of California at Los Angeles. He developed an early passion for computer programming languages, which appealed to his innate sense of mathematical order.
Rubinstein was not only more familiar with options theory than Leland was, but he had even done some actual options trading on the Pacific Stock Exchange in San Francisco. He lost money as a trader but gained invaluable experience.
Rubinstein was intellectually delighted with Leland’s concept, chuckling and expressing surprise that he had “never thought of that myself.” The two young professors immediately decided to form a consulting firm to market their strategy to professional investors, once they got it perfected.
Leland wasn’t sure that Rubinstein, who seemed amused by the whole enterprise, had really considered what they might be on to—how big it could be. One day, as they walked past the motley shops on Telegraph Avenue on their way back to campus, he turned to Rubinstein and said, “You realize, there could be an enormous market for this.”
Rubinstein looked a little blank, and shrugged.
“Pension funds!” Leland said.
In a flash, the penny dropped. “Pension funds,” Rubinstein replied. He got it.
Given the press of family and work, the two young professors spent several years ironing out the wrinkles and testing their concept on a small scale in the market. It was a great success. By 1979, they were ready to introduce their idea for “portfolio insurance” to the world.
* * *
NEITHER HAYNE LELAND nor Mark Rubinstein had any experience with Wall Street marketing, though they did have an endorsement from Barr Rosenberg, the Berkeley faculty star whose consulting firm was one of the emerging giants in the young field of “quantitative” investment strategies. Rosenberg’s blessing opened doors at a number of major banks and trust departments, but nothing came of it.
Then, in the spring of 1980, Leland finally got a call about his portfolio insurance idea—but it wasn’t from a prospective client. It was from a prospective partner.
The caller was a soft-spoken Midwesterner named John W. O’Brien, who worked for one of the top pension consulting firms in the country, A.G. Becker in Chicago. Leland had met O’Brien a few months earlier, at the small Berkeley conference where the portfolio insurance idea made its debut, and he had been struck by O’Brien’s perceptive questions.
O’Brien, an engaging man in his early forties with curly auburn hair and a ruddy smile set off by a neat beard, had already had a remarkable career in finance. A graduate of MIT and the Harvard Business School and a former air force officer, O’Brien had started on Wall Street in 1969, when he joined an obscure but venerable firm, Jas. H. Oliphant and Company. O’Brien helped Oliphant develop and sell so-called beta books, which showed how sensitive specific stocks were to the overall market’s fluctuations.
In 1972, he and some colleagues left to form O’Brien Associates, a trailblazing financial analysis firm with offices on Wilshire Boulevard in Los Angeles. Its innovations included new tools to measure portfolio performance, software to help a pension fund create a model of its assets and liabilities, and a novel market index, much broader than the S&P 500, called the O’Brien 5000. In 1975, worried that the firm’s business model would not survive the end of Wall Street’s fixed-commission regime, O’Brien unwisely sold the business to a partner, who changed its name to Wilshire Associates and eventually became a billionaire.
John O’Brien then joined A.G. Becker, greatly expanding the quantitative tools it offered to its pension fund clients, and he was routinely scouting for new ideas at academic conferences around the country. Inevitably, he wound up at Berkeley—at the precise moment that Leland and Rubinstein rolled out their portfolio insurance idea.
With his quantitative background, O’Brien easily followed the math. After years on Wall Street, he knew that the concept would be attractive to large pension fund managers who were increasing their stock portfolios but were wary of increasing their risks. Best of all, he was a gifted communicator who could easily translate the professors’ idea into language that corporate pension fund executives could understand.
Within a year of that initial phone call, the three men had established a three-way partnership, which they called Leland O’Brien Rubinstein Associates, or LOR. Their business plan called for Leland and Rubinstein to continue teaching full-time at the business school, while John O’Brien, the new firm’s CEO, worked from Los Angeles, closer to his home in the beachfront town of Pacific Palisades.
Armed with an address book stuffed with high-level contacts at pension funds and trust departments, O’Brien found a spare office in a one-man law firm in Century City, on the west side of Los Angeles. The new firm’s address sounded impressive: 1900 Avenue of the Stars. In fact, the small tenth-floor suite housed O’Brien, the accommodating lawyer, a computer, some telephones, and two part-time secretaries, one of them O’Brien’s wife.
A short time after setting up shop, O’Brien landed the firm’s first client, an investment manager with whom he had worked at A.G. Becker. It was a tiny account by Wall Street standards, just $500,000, but it was a start. Then, on one remarkable Friday, the phone in John O’Brien’s little office rang three times with three new clients signing up to “insure” a total of $50 million: the pension funds of Honeywell Corporation, the Gates Corporation, and the Automobile Club of Southern California.
The Honeywell pension fund, like the General Motors fund overseen by Gordon Binns, used more than a half-dozen different money managers, and they were not especially eager to let LOR tinker with their portfolios. One manager agreed to try LOR’s portfolio insurance concept, and reported favorably on it. Soon, Honeywell was entrusting $200 million to LOR’s strategy.
In March 1982, LOR placed a dramatic advertisement in Pensions & Investment Age, an influential industry publication. The ad explained that the firm’s strategy “has the effect of insuring an equity portfolio against loss—a guaranteed equity investment.” LOR had started referring to its product as “dynamic asset allocation,” and the ad claimed that a dollar invested according to the strategy in 1971 would have grown to $2.61 ten years later, compared to $1.89 from an investment in the S&P 500 and $2.18 from Treasury bills.
Michael Clowes, a founding editor of the pension industry publication, offered a blessedly simple explanation of the new strategy: “Leland and Rubinstein had developed a computer program that would tell a pension fund, or the fund’s money manager, to sell stocks and increase cash in a carefully measured way as stock prices fell. By the time the stock prices had declined the maximum amount the pension fund could tolerate, the fund would be all cash. For example, if the fund was willing to accept a 5 percent loss of capital on its equity portfolio, the program would begin to sell stocks as prices began to decline, and the portfolio would be all cash by the time its value had declined by 5 percent. As stock prices began to recover, the program would control the purchase of stocks until the portfolio was again fully invested.”
It seemed like a persuasive argument. Yet many money managers still resisted letting the brainy professors from Berkeley take the wheel with their portfolios. O’Brien, one of the most engaging salesmen ever to pick up a telephone, kept making calls, running ads, and conducting seminars.
One such seminar was held in Manhattan in late 1982, at the splendid Hotel Pierre on Fifth Avenue and Sixty-First Street. In the audience was a young mustachioed man named Bruce I. Jacobs, who had earned a doctorate from the Wharton School and had recently left a teaching position there to join the asset management group at Prudential Insurance.
When Jacobs heard about the LOR strategy, he immediately spotted a flaw. The strategy assumed that when it was time to sell stocks and move into cash, those stocks could be readily sold. Was that realistic? “From a macro perspective,” he wrote in a prescient memo to clients in January 1983, “if a large number of investors utilized the portfolio insulation technique, price movements would tend to snowball.” Rising prices would trigger more buying, and that would drive prices up further; falling prices would trigger more selling, with the opposite effect.
Jacobs had hit on the aspect of portfolio insurance that troubled the market’s traditional traders, people who shared John Phelan’s instincts and history at the New York Stock Exchange. They believed in the old rule of “buy low, sell high.” With portfolio insurance, you were deliberately supposed to do the opposite—buy when prices were rising and sell when they were falling. It just felt wrong.
Indeed, the portfolio insurer’s success depended on a lot of other people believing the strategy was, in fact, wrong. The LOR concept assumed there would always be a large population of wealthy, unflappable bargain hunters who would persist in buying low and selling high, investors who would step into a falling market to buy all the shares the portfolio insurers would be selling.
Those opportunistic bargain hunters certainly would not come from the rapidly growing community of index funds, who bought only those shares that helped their portfolio track some index such as the S&P 500. Firmly believing markets were rational and efficient, index fund investors weren’t going to be looking for bargains when LOR’s clients needed to sell. Indeed, as stock prices fell, the index funds might well be selling, too, to cover redemptions from nervous retail investors.
Indeed, if the “Chicago School” was right—if markets were rational and efficient, and current prices reflected all the information known to all rational investors—how could such bargain hunters survive? In a truly efficient market, they would soon go broke. And if that happened, it was not clear who would buy stock from LOR’s clients in a falling market.
Fortunately for LOR, there were still some pension fund managers, such as Roland Machold at New Jersey’s state retirement fund, who believed in buying bargains, when the price was right. How much longer would that be true?
After enjoying the fine Hotel Pierre coffee and listening to the LOR sales pitch, Bruce Jacobs didn’t dwell on the “snowball” problem. There was so little money in the accounts that were using portfolio insurance that it seemed more an academic concern than a real hazard. According to the June 14 Fortune article on Rubinstein and Leland, LOR was guiding investments totaling $150 million—almost a rounding error for multibillion-dollar investors such as Prudential and General Motors.
It might have been just an academic concern, but the “snowball” scenario was a puzzle, and a warning.