Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession

by Frederick Sheehan

  2 http://www.derivativesstrategy.com/magazine/archive/1999/0799qa.asp.

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  Looking back, there were several good reasons the stock market crashed in 1987. (Looking back, there always are.) Secretary of the Treasury James Baker enjoined the Germans to devalue the deutschmark. Congressman Dan Rostenkowski had threatened a bill that would hamper leveraged buyouts. Stock prices were too high (the Dow had risen 350 percent over the previous five years). A derivatives strategy had blown apart.

  The last topic will be discussed, since that is Alan Greenspan’s legacy. The chairman was to extol the virtues of derivatives over the next 18 years and forever praise their ability to diffuse risk. This first widespread failure of a derivatives strategy demonstrated that when such a product is universally employed, it concentrates risk.

  The derivative strategy that came a cropper was portfolio insurance. It was the brainstorm of Mark Rubinstein and Hayne Leland, professors at Berkeley, who formed the firm of Leland O’Brien Rubinstein Associates (LOR).3 The basic concept was to insure investors against losses in the stock market.4 The thesis was fine, but the execution could be applied on a wide scale only after the introduction of financial derivatives.5

  Leland O’Brien Rubinstein’s success bred imitators—oodles of them. As with most investment ideas, success draws too many participants, and it ends in tears.6 A distinguishing flaw was the assumption of a “continuous market.”7 There had to be a buyer at a price linked to the previous price. It would not work if buyers for the “underlying” security disappeared. (The underlying is the physical item being delivered: corn, for instance, or the 500 stocks in the Standard & Poor’s index.) A derivative “derives” its price from the physical item. In the case of financial derivatives, the derivative derives its price from the price of a stock, bond, or currency. For example, a derivative gives the buyer the option to purchase a share of General Electric stock for $10. If GE stock is trading at $8 when the option is sold, the contract has no immediate value: why pay $10 when the stock can be bought for $8? If GE stock rises to $40, the option owner is owed (at least) $30 by the broker who sold the derivative.

  3 Peter L. Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (New York: Free Press, 1992), pp. 269–274.

  4 A simplified example: XYZ company’s pension plan wants to protect against losing more than 8 percent of its principal in any calendar year. The Treasury bill rate is 5 percent. All of its assets are invested in the S&P 500. The stock market falls 13 percent on the first day of the year. The portfolio insurer shifts 100 percent of the money out of stocks and into Treasury bills. At the end of the year, the 5 percent earned on the principal will leave the fund with an 8 percent loss for the year.

  5A futures contract on the S&P 500 was inaugurated in 1983. By buying (or selling) an S&P 500 futures contract, the insured would hold a position equal to that resulting from buying (or selling) the 500 stocks. Based on the actual asset mix and portfolio performance of the pension plan (our assumed purchaser of the product), LOR instructed the client to buy and sell the requisite number of contracts to meet the objective.

  6 If all pension plans set the line in the sand at an 8 percent one-year loss, it would be impossible for all the portfolio insurers to sell stocks at the same moment.

  October 19, 1987

  On August 25, 1987, the Dow Jones Industrial Average peaked at 2,722. This was a 43 percent rise since the beginning of the year. The DJIA suffered a 10 percent loss over the four days leading up to October 19, 1987. In lockstep with the mathematical formulas, each day portfolio insurers sold the S&P 500 futures contracts and bought Treasury bills. The stocks underlying the S&P 500 Index (or the S&P 500 futures contract) were sold.

  On Monday, October 19, 1987, sell orders for stocks overwhelmed

  On Monday, October 19, 1987, sell orders for stocks overwhelmed point drop from the Friday close. Markets were not continuous. The most basic of premises was wrong, and it was wrong largely because portfolio insurance overwhelmed the markets.

  It was impossible to calculate the S&P 500 Index. The comparative option contracts traded at as much as a 20 percent discount to the stocks; dealers refused to buy stocks; market makers would not answer their telephones; mutual fund shareholders could not sell because of the overloaded telephone lines; brokers sold their clients’ stock without telling them, often at a price far below the bid. So many had jumped into the product (Chase Manhattan Bank; Morgan Stanley; Aetna Life & Casualty; Exxon’s and General Motors’s pension plans) that a record number of S&P 500 index options were traded. The failure of portfolio insurance to deliver as promised was self-fulfilling.8

  7 From Bernstein, Capital Ideas, p. 285: “For the strategy to be fully effective, the investors without portfolio insurance must accommodate the investors with portfolio insurance, at all times and under all conditions. Changes in stock prices must be continuous—a stock must not close at $25 and open the next day at $22....The events of October 1987 shattered the underlying assumptions of how markets, and therefore, portfolio insurance would work in practice.”

  The result was that on October 19, the Dow fell 22.6 percent, and the S&P 500 dropped 20.5 percent. S&P 500 futures fell nearly 29 percent— cash selling (of stocks) could not keep pace with futures selling.9

  LOR’s business had seen its best days. Rubenstein claimed that “a one-day decline of 29 percent … wouldn’t happen in the life of our universe, which is 20 billion years. Indeed, it wouldn’t even happen if you were to live through 20 billion of those universes.”10 The calculations differed, but this was the general view of efficient market theorists, a group that suffers from innocence, self-absorption, and tenure. The strategy had been marketed as the culmination of theories produced by Nobel Prize–winning economists. The guild stuck to its models and assumptions of continuous markets, so an event that was impossible, given these assumptions, was dismissed as such.

  The stock market crash was a trial by fire for the new Fed chairman. He reassured markets that the Fed would supply unlimited funding to the banking system. This soothed nerves, and the stock market started to recover. Comparisons to 1929 were inevitable. The black cloud obscured the generally upward trend of stock market prices for the year: the S&P 500 rose 5.2 percent in 1987. The economy was growing. In 1929, it was slowing.

  Greenspan was generally lauded for his response to the market crash. The greatest criticism was of his September 4 decision to raise the discount rate from 5.5 percent to 6.0 percent, about six weeks before the crash.11

  Greenspan’s decision to raise the discount rate had been more than justified—it was redundant. Paul Volcker, in maybe the only comment the former chairman made about the Greenspan Fed, fully endorsed the September 4 rate decision.12 The fed funds rate—which is far more influential than the discount rate—was already rising on September 4. It would continue to rise afterward. The 30-year Treasury yield leapt from 9.0 percent in August to 9.75 percent.13 A stock market that had risen 43 percent between January 1 and August 25 faced a rash of complexities.

  8 Robert Sobel, Panic on Wall Street (New York: Dutton, 1988), pp. 440–479. 9 Richard Bookstaber, A Demon of Our Own Design, (Hoboken, N.J.: Wiley, 2007), p. 13, 10 http://www.derivativesstrategy.com/magazine/archive/1999/0799qa.asp. 11 Steven K. Beckner, Back from the Brink: The Greenspan Years (New York: Wiley, 1996),

  pp. 32–33.

  There is a tendency now to recall the entire Volcker chairmanship as an Arcadian paradise, but Alan Greenspan assumed office at a difficult time. Imbalances were rising. The balance of payments with foreign countries had increased from a deficit of $5 billion in 1982 to one of $147 billion in 1986.14 The federal budget deficit had risen from $127 billion in 1982 to $221 billion in 1986.15 Corporate and consumer debt were also rising.

  Lessons from the Crash

  Greenspan appeared before the Senate Banking Committee in February 1988. He thought that “[e]ven if that last surge in longterm [interest] rates had no
t occurred, the [stock] market would have topped out and come down anyway, and I find it difficult to perceive how actions of the Federal Reserve were material factors in the market.”16

  He may have been right. However, it is unfortunate that this real-world, real-time opportunity to understand the misleading promises of derivative manufacturers passed him by. Not only had the strategy failed, but the practitioners and apologists dismissed it. This was recreational mathematics in a rich medium. Greenspan had every reason to ban complex derivative strategies from his banks. He would serve as chief regulator of the financial system as it grew to a size far beyond the requirements of the economy it purportedly served. The strategies grew more inventive, impressive, exhilarating, perplexing, and finally unintelligible.

  The crash afforded Greenspan his first opportunity to open the money spigot, and he did so with relish. He received general support.

  12 “Volcker Hails Fed Rate Rise,” New York Times, September 11, 1987, p. D14.

  13 Steven K. Beckner, Back from the Brink: The Greenspan Years, p. 34.

  14 OECD.StatExtracts.

  15 Congressional Budget Office.

  16 Beckner, Back from the Brink, p. 62. This testimony was on February 24, 1988.

  During Greenspan’s 1987 nomination hearing, Democrats had warned Greenspan not to attempt an Arthur Burns money-printing effort to elect Republicans in 1988. If it hadn’t been for the crash, cutting the funds rate would have placed Greenspan in the dock. However, Democrats did not fault Greenspan for his efforts to calm the markets.

  The stock market crash punched a hole in the 1980s asset inflation. Rather than a bubble popping, it was more like an automobile tire with a slow, steady leak. The savings and loan crack-up caused a drain on credit. Commercial banks, too, incapable of restraining themselves during a splurge—any splurge—were about to reduce lending.

  When Citicorp Lends—We All Pay

  After the foreign loan mishap of the early 1980s, it did not take long for big banks to again drive themselves into penury. Real estate lending accounted for 60 percent of the net loan growth of the U.S. banking system between 1984 and 1989.17

  In the first quarter of 1990, real estate lending grew 20 percent in New York.18 Yet, by 1990, there was more vacant office space in midtown Manhattan than the total office space of Portland, Oregon; Tampa, Florida; and Seattle, Washington.19 Having divorced itself from any sense of reason, the financial industry was due for a douse of reality. In the recession that was now leaving the nursery, 25 percent of the jobs lost nationally would be in New York City.20 By 1991, 60 percent of the city’s residents claimed they would leave New York if they could.21

  The bellwether of ignorance, Citicorp, once again led the charge to the bottom. The chairman, John Reed, admitted: “We were warned about real estate two years ago, and we pooh-poohed it. Now I’m damned embarrassed because the critics were right and we were wrong.”22 By July 1991, Congressman John Dingell from Michigan stated that Citigroup was “technically insolvent.”23 Greenspan did not opt for a noninterventionist approach. Even if he had wanted to, the Continental Illinois precedent would have been difficult to contradict.

  17 James Grant, Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken (New York: Farrar Straus Giroux, 1992), p. 418.

  18 Ibid., p. 417.

  19Robert A. M. Stern, David Fishman, and Jacob Tilove, New York 2000: Architecture and Urbanism between the Bicentennial and the Millennium (New York: Monacelli Press, 2006), p. 24.

  20 Ibid., p. 28.

  21 Ibid.

  Greenspan might differ from Volcker in many ways, but one thing was the same: the Federal Reserve chairmanship had evolved into a brokerage operation for insolvent financial institutions. Whatever claims Greenspan might make (or Paul Volcker had made) about the stability and resiliency of the American financial system, former Fed Chairman William McChesney Martin would find it unrecognizably frenetic.

  Finance and financial institutions were more fluid than when the gold standard existed. Alan Greenspan explained the traditional reserve currency’s balancing properties in “Gold and Economic Freedom” (discussed in Chapter 2). The world bond market increased from less than $1 trillion in 1970 to $23 trillion by 1987.24 Without a gold standard, there was no ultimate settlement, so unredeemable currency and bond claims grew. Asset inflation and concentration of credit gave those who possessed “native cunning and access to leverage” an opportunity to apply their skills.

  The Panderer and His Masters

  Early in Greenspan’s term, the chairman of the House Banking Committee, Democratic Congressman Henry González of Texas, fumed about the “tremendous power” of the Fed. The institution should be “accountable.”25 Gonzáles had attempted to impeach Volcker. Such a campaign was in the tradition of grandstanding politicians in Washington. It also suggests a reason for the outsized prestige of the Federal Reserve. Were it not for Greenspan’s testimony before hectoring politicians, the man and his board might have been cast into the dull blur of other federal bureaucracies. As it is, the willingness of the Senate and Congress to shift blame from their mendacious and inflationary budgets has cemented their incumbency far more than their legislation has served the country.

  22 Grant, Money of the Mind, p. 430; Reed was quoted in “Citicorp Faces the World: An Interview with John Reed,” Harvard Business Review, November–December, 1990.

  23 Ibid.

  24 Peter Warburton, Debt and Delusion: Central Bank Follies that Threaten Economic Disaster (Princeton, N.J.: WorldMeta View Press, 2005), p. 3.

  25 Beckner, Back from the Brink, p. 111.

  Greenspan would be entreated to inflate by a phalanx of political interests—the executive branch as well as Congress, Democrats and Republicans alike. The inundation will not be discussed here in equal proportion to its influence. However, as an example of its constant presence, one can turn to Steven K. Beckner’s Back from the Brink: The Greenspan Years. The book serves as a catalog of unseemly intrusions.26 Greenspan’s weakness of character was only too apparent, but it should not be forgotten that he served the interests of politicians who used the loquacious chairman as an air-raid shelter.

  The Predators Crash

  After the 1987 crash, the stock market recovered, but easy liquidity did not. The deals grew larger, though, with riskier bonds to finance these monuments to braggadocio. In early 1989, Kohlberg Kravis Roberts paid $30.9 billion for RJR Nabisco Inc. This was a big number. It is difficult for an outsider to assess the efficiencies of such combinations, but they cause anxiety and disorientation. Sneaker jobs were going to Asia. This jumble of numbers and worries is often what we live by. The smorgasbord did not appeal to the tastes of either the public or the politicians.

  The temper in Washington was growing hostile.27 Kohlberg Kravis Roberts gathered 400 dealmakers and lawyers at the Pierre Hotel in New York to celebrate the RJR Nabisco LBO on lobster and Dom Perignon. The dealmakers from Drexel Burnham, Merrill Lynch, Morgan Stanley, and Wasserstein Perella and the lawyers from Davis Polk & Wardwell and Skadden Arps, Slate, Meagher & Flom were congratulated for making over $1 billion in fees. This did not include the junkbond sales and bank loans. Given the times, the dinner received publicity. It was also seen as being in poor taste. Predator’s Ball, a bestselling book about Drexel Burnham, encased Michael Milken’s already famous client parties in perpetuity.

  26 From this author’s unsystematic notes, see, pp. 111, 119, 141–145, 156, 163, 219, 231, 236, 243, 270, 272, 285–286, 291, 293, 294, 298, 302, 306, 310, 312, 313, 314, 315–327, 331–333, 348, 364, 366, and 370. This covers only the years 1987–1994.

  27 The term financial buyer was used to differentiate these deals from “corporate buyers” or “strategic buyers.” Corporations were being priced out of the merger business.

  Even as the borrowing bubble was peaking, it had already started to deflate. Integrated Resources, a financial services company that seemed to dabble in everything,
but specialized in selling tax shelters and absorbing Drexel Burnham issues, met its maker on June 13, 1989. That was the day when no bank would roll over its commercial paper. It was also the day that Michael Milken resigned from Drexel.28 The daisy chain that had bloomed from the X-shaped desk in Los Angeles was withering.29

  In fact, it started to gasp for water in late 1988 when Drexel Burnham Lambert agreed to settle insider trading investigations. Early in 1989, Michael Milken was indicted on 98 counts of fraud and racketeering. The market had been flooded with worthless paper: junkbond issues rose from $2 billion in 1980 to over $200 billion issued in 1988. In December 1989, KKR placed one of its companies into Chapter 11 proceedings—Hillsborough Holdings Corporation, the first bankruptcy filing by a large company owned by Kohlberg Kravis Roberts.30The LBO mystique was gone.

  The changing times were evident when Saul Steinberg spent $1 million at a Southampton summer party in 1989. This was half the cost of his daughter’s 1988 wedding at the Metropolitan Museum of Art’s Temple of Dendur, which had passed unnoticed. Southampton party guests told an inquiring press of their outrage. Other guests noted that the outraged looked mighty pleased at the party. Soon after, a bestselling book would immortalize the KKR and RJR Nabisco deal: Barbarians at the Gate. 31 Milken and Charles Keating were headed to jail.

  28 James Grant, Minding Mr. Market: Ten Years on Wall Street with Grant’s Interest Rate Observer (New York: Farrar Straus Giroux, 1993), pp. 262–266.

  29 Drexel Burnham Lambert Inc. filed for bankruptcy, on February 13, 1990.

  30“Chapter 11 for Kohlberg Kravis Unit,” New York Times, December 28, 1989.

  31 Bryan Barfrough, Barbarians at the Gate: The Fall of RJR Nabisco (New York: Harper, 1990).

  Greenspan Never Saw the Recession—Then Promotes His Foresight

  Meanwhile, Chairman Greenspan was a busy man. In a 1989 New York Times Magazine profile, Louis Uchitelle met the chairman in his office. He observed that Greenspan “has been Fed chairman for almost a year and a half, but the built-in bookcases are still mostly empty.” Uchitelle also noted that Greenspan’s desk was strewn with newspapers, reports, statistics, and “even a paperback novel.” 32 Senator Proxmire would probably not be surprised at his dishevelment.