Thursday, June 16, 1983, was the fiftieth anniversary of the Glass-Steagall Act, the landmark Depression-era law that was intended to firmly separate the nation’s banking industry from the risky world of Wall Street. To mark the occasion, Congressman Timothy E. Wirth of Colorado opened a hearing that afternoon to examine how porous the Glass-Steagall wall had become and what, if anything, should be done about it.
Wirth was specifically incensed by the FDIC’s approach to the issue. In a handful of cases since 1969, the FDIC’s lawyers had quietly determined that the Glass-Steagall Act applied only to banks in the Federal Reserve System. By 1983, many state-chartered banks were not Fed system members but nevertheless were buying federal deposit insurance from the FDIC. These banks were eager to exploit this apparent Glass-Steagall loophole. The FDIC believed it was simply setting sensible rules for any FDIC-insured state banks that wanted to expand into new businesses, an expansion the FDIC saw as legal and probably inevitable.
Wirth emphatically disagreed. “This, it seems to us, is a legislative issue, not one to be left to an obscure regulatory institution,” he said as he opened the hearing. “I find it absolutely astounding that this proposal has been made without congressional input.”
His witnesses that day included SEC chairman John Shad and another SEC commissioner, Bevis Longstreth.
Longstreth, lean and crisp despite the muggy weather, was almost the mirror opposite of the portly SEC chairman. He was a New York Democrat and had been appointed to the SEC in 1981 by President Reagan, who by law could put no more than three Republicans on the five-member commission.
Earlier in 1983, Longstreth had been involved in an embarrassing split within the SEC over Shad’s proposed budget for the coming fiscal year. Shad had submitted budgets in 1981 and 1982 that called for no increase in staffing, even though those years had seen a dramatic rise in the SEC’s workload. Now Shad’s budget request in 1983 called for a 6 percent cut in staffing. Congressman Wirth, who opposed the cuts, had asked Shad’s colleagues on the commission for their views. Longstreth and his three fellow commissioners, in a private response to the congressman, said they thought staffing should in fact be increased by 4 percent. Wirth had promptly released the exchange of letters to the media.
However, on the topic of the Glass-Steagall Act, John Shad and Timothy Wirth were almost allies. Shad had frequently argued, in congressional testimony and public speeches, that the banking industry’s forays into traditional Wall Street activities should be curbed until the regulatory borders could be more clearly drawn and rule books written.
The landscape Shad described was certainly in an uproar. Although the nation’s banks were overseen by an entire village of state and federal regulators, none of those overseers had any jurisdiction over the securities markets. The major securities firms competed with giant banks in the commodity markets, regulated by the CFTC, and in the Treasury markets, which were barely regulated at all. Increasingly, they also competed with banks in the rapidly growing private market for over-the-counter “swaps,” a new type of derivative contract that the futures exchanges wanted the CFTC to regulate in the face of resistance from both banks and brokerage firms.
At the time, most members of oversight panels such as the Wirth subcommittee seemed to have no idea what swaps were or how they worked. Swaps are simply contracts by which two parties agree to exchange two future streams of cash that each is entitled to receive. In the case of interest rate swaps, the fastest-growing category in the mid-1980s, the streams of cash being “swapped” are the future interest payments on loans. Say Bank A is due to get fixed interest payments on a $100 million loan over the next ten years. On an identical loan, Bank B is due to collect variable interest payments, which will fluctuate with the market. Assume that Bank A is worried that interest rates will rise, which would leave it stuck with fixed payments lower than it might otherwise get. Bank B, on the other hand, is convinced interest rates will fall and wants to lock in a higher rate before that happens. A swap transaction allows each party to get what it wants. They simply swap the future stream of interest payments on the two loans. (Of course, they cannot both be right about interest rates, so one of the banks may be due for a big loss on its swap strategy.)
As the swaps market matured, major banks and brokerage firms started taking each side of these swaps, acting almost like clearinghouses, collecting payments from one and making payments to the other, and pocketing a bit of profit in the process. Of course, like clearinghouses, they were also taking on future liabilities—they would have to keep making payments even if one party to the swap defaulted. The wiser bankers and brokers tried to hedge those swap risks with exchange-traded interest rate futures, which sent a fresh fault line into the futures markets. But the futures markets arguably would be far more liquid if all these swaps were traded in their pits, instead of in a private institutional marketplace.
Although these arcane derivatives had not sprung up overnight, there still was no coherent regulatory structure for them, and John Shad believed that time was running out for Congress to act.
“Just since [last] August, we have witnessed the strongest bull market in history, rising trading volume in new financial futures and options, and unprecedented movement of capital,” Shad testified. “In sum, the marketplace is thundering over, under, and around Glass-Steagall.”
The result was an increasingly uneven playing field. Shad noted that the FDIC’s proposal would allow the 8,800 FDIC-insured banks outside the Federal Reserve System to underwrite securities, while the 5,600 banks in the Fed system could not. Banks inside the system would inevitably be tempted to shift to state charters. Clearly, the FDIC’s policy was a loophole big enough to accommodate the entire banking industry.
A partial solution, Shad argued, was for Congress to adopt a Treasury Department proposal that would allow banks to enter riskier Wall Street businesses, but only through holding companies. The holding companies could set up separate units for their securities business, regulated by Wall Street’s traditional regulators. Similarly, Wall Street brokers would be allowed to participate in the banking business, but only through similar separate entities overseen by bank regulators.
When offered five minutes to share his views with the subcommittee, Bevis Longstreth agreed with Shad that radical shifts in the financial landscape “have reduced Glass-Steagall to a rubble.” However, he strongly doubted whether a few legislative fixes would help.
“Market discipline, which is much in vogue these days, can only assure soundness in an environment where institutions are permitted to fail,” he said. But the simple truth was that financial institutions could no longer be allowed to fail—the links among them were “simply too extensive to prevent one failure from triggering another.” Therefore, “market discipline” alone was an utterly inadequate regulatory tool in a financial environment where one firm’s failure could put the whole system at risk.
What was needed, Longstreth said, was “a new safety net,” one broad enough to cover the entire financial system but “flexible enough to enable the forces of full disclosure and market discipline to do their share—which, I submit, is not the whole job.”
Longstreth pointed out that the time available for regulators to respond to a threat was shrinking, given “the velocity at which money travels” and the unexpected links among institutions. “It’s like an accident on the freeway where everyone is going sixty miles an hour, and they are almost bumper to bumper,” he said. “The results are going to be different at that speed than they would be at five miles an hour.”
There was simply no established, coherent system for dealing with a high-speed, high-impact financial crisis. Whenever there was a crisis, the financial system held together “because there was someone there like Paul Volcker, who had been through this before,” Longstreth concluded. “But it is all in his head—it is not in any statute.”
* * *
IT REMAINED UNCERTAIN how long Paul Volcker would remain the primary tool in the nation’s financial crisis response kit.
His term as chairman of the Federal Reserve would expire in August 1983; it was the middle of June, and still President Reagan had not indicated whether Volcker would be reappointed. Newspaper articles reported that there were two Republican candidates being considered for the job—Preston Martin, already on the Federal Reserve Board, and Alan Greenspan, who ran an economic consulting firm in New York and had been the chairman of the Council of Economic Advisers in the Ford administration. Wall Street was nervous, and it showed; the Dow gyrated on every rumor, and even Treasury secretary Don Regan conceded that the market favored Volcker “by an overwhelming majority.”
In early June, Volcker had met with Reagan in the private quarters at the White House and told him that, if reappointed, he expected to step down after about a year and half. Reagan did not respond then, but at 11 a.m. on Saturday, June 18, Volcker received a telephone call from the president, who told him that he was being reappointed for a second four-year term. An hour later, Reagan opened his weekly radio address with what he jokingly called a “news flash.”
“I’m not wearing a hat or clutching a phone” like a fedora-topped reporter with a hot story, the president said, “but before getting into today’s broadcast, I’d like to make an important announcement.” With an informality that was a sharp break with tradition, he told Wall Street and the world that he was reappointing Paul Volcker to the Federal Reserve chairmanship.
The nation’s primary financial crisis response system, Paul Volcker’s brain, was securely in place for a bit longer. It would be needed sooner than anyone expected.
* * *
“THE HOUSE THAT Leo built.”
That may have been how most of Chicago’s financial community thought of the new Chicago Mercantile Exchange Center, which opened for business on the Monday after Thanksgiving 1983. The Merc’s tireless and creative leader, Leo Melamed, had played a pivotal role in turning a struggling market for pork bellies into the roaring hive of prosperous financial innovation that underwrote the new structure.
The $57 million building had a million square feet of office space and a forty-thousand-square-foot trading floor, the largest column-free trading floor in the world, hardwired with about fourteen thousand miles of telephone cable. A soaring forty-story office tower rose on the south side of the gigantic rectangle of the trading complex; a twin would eventually stand on the north side.
It would be almost as accurate to call the new CME Center “the house that the spooz pit built.”
Since its debut on April 21, 1982, the Standard & Poor’s 500 futures contract had fulfilled all Leo Melamed’s hopes. The spooz had the hottest launch in the history of the futures market, with more than 27,000 contracts traded before the end of April. All but two of the remaining months of 1982 set records.
It was becoming an unequal fight. Flaws in the design of the Value Line futures contract traded in Kansas City were starting to surface, and its trading volume remained thin. On the New York Futures Exchange, the NYSE Composite index futures contract was generating more interest than other NYFE products, but it, too, was having trouble finding its market. Meanwhile, the spooz trading volume was regularly four and five times higher than that of the other active stock index contracts.
By the fall of 1983, the S&P pits were loud and crowded. “Most commodities have moments of calm—but not the S&P,” Melamed had told a reporter in August. “You literally have to close out your position if you want to get a cup of coffee or smoke a cigarette.”
The growing volume of spooz trading was riding the back of the bull market in New York. By June 1983, the Dow stood 50 percent higher than it had a year earlier, a record-setting gain. After treading water in the early summer, it stroked steadily ahead from August until October, when it began to flag. Anyone eager to speculate on its future course could do so on a shoestring by buying or selling S&P 500 index futures on the Merc, and a growing horde of investors did. “The world’s index futures and options enable investors to play the stock market without owning a share,” one account noted.
By the middle of 1983, nearly a dozen pension funds and almost half of the three hundred largest banks doing business in the United States were using the futures market to hedge interest rate risk and stock market positions. Giant insurance companies had found their way to the futures pits, too. At least ten states, including New York, had amended their insurance laws to allow the use of derivatives. Reliance on interest rate futures traded in Chicago had quickly become almost commonplace for bond portfolio managers in the insurance industry. Wall Street banks and brokerage firms were rapidly ramping up their private marketing of swaps, and more of them were hedging their risks with offsetting positions in the futures markets. It was not surprising, then, that financial futures made up more than a third of all futures market trading in 1983, and that the spooz pit generated more than 20 percent of the total trading volume on the Merc.
That success only increased Chicago’s appetite for new financial futures. By June 1983 regulators had approved twenty-five new stock index futures, options on stock index futures, and options directly on stock market indexes, in addition to the first interest rate options, which competed with the popular futures contracts based on Treasury securities.
Three months earlier, in March, the Chicago Board Options Exchange had added its own new wrinkle by introducing its own stock market index option, which it initially called the “CBOE 100 option.” In July, it was rechristened the Standard & Poor’s 100 option, with the symbol OEX. Like the spooz, the OEX had a stellar debut and never looked back, quickly becoming the most deeply traded option in the market. On the heels of that success, the CBOE introduced an option directly on the S&P 500 index, ostensibly a competitor for the Merc’s own option based on the spooz futures.
The flood of complicated new financial derivatives was so swift and full that Wall Street’s primary lobbying group, the Securities Industry Association, had unsuccessfully appealed to regulators in June for a moratorium on new products, just to give Wall Street firms time to train their sales staff and adjust their paperwork procedures. And even if regulators grasped all the complexities and risks of these new derivatives—an arguable assumption in 1983, and for years to come—lawmakers in Congress were rapidly falling behind the financial innovation curve.