Eagle on the Street

  To the public, whether before Congress or in interviews with the press, Shad repeated over and over a handful of cherished aphorisms, each time as if they were new revelations. The one he repeated most often was “America has today by far the best securities markets the world has ever known—the broadest, the most active and efficient, and the fairest. Last year, securities transactions in America amounted to about $40 trillion, about nine times the gross national product. By the highest conjecture, securities frauds amount to a fraction of one percent of such transactions, most of which are executed over the telephone in reliance on the other party’s word.”

  Over and over again, Shad implied a key reason the markets worked so well was that most human beings were trustworthy enough to honor their word. Shad also argued that fraud was not systemic on Wall Street, so there was no need to become hysterical about the relatively small incidence of insider trading his SEC was uncovering. Perhaps on the Wall Street where Shad had worked before heading to Washington—in the world of men’s clubs and Ivy League degrees and quiet wealth—honor and trust were exalted, even enforced. If such a culture had ever existed broadly in the financial world, as opposed to what went on in the exclusive suites and clubs where Shad worked and socialized, it was fast eroding in that January of 1983, under the ancient pressures of speculation and greed.

  The Securities and Exchange Commission had been created precisely because the country had learned, in the devastating financial panics of the 1850s, the 1870s, the 1890s, and the 1920s, that when there were large sums of money to be made, the people who controlled the financial markets could not be trusted to police themselves. Shad seemed to accept the necessity of the commission’s role, but not all of its assumptions about human nature. Shad often said that if new laws or regulations were passed, 99 percent of the people would follow them and the 1 percent of the people they were aimed at would find new ways to break the law. He didn’t believe new laws and regulations would raise the general standards of conduct. Above all, he embraced freedom of choice for investors. Yet in his genuine enthusiasm for innovation and efficiency, he seemed unable to see that lax discipline, in the face of vast temptation, could bring out the worst in people, threatening rather than strengthening, the markets to which he was so devoted.

  There were people Shad respected who warned, late in 1982 and early in 1983, that ominous change was occurring on Wall Street. The takeover free-for-all between Bendix and Martin Marietta was one signal. Trading in stock index futures, the new financial instruments whose birth had been ensured by the regulatory deal cut by Shad and Philip Johnson in the summer of 1981, was perhaps an even more obvious sign, since debate in Washington over whether to allow stock futures had been conducted in the same ideological and even moral vocabulary so often used by the commission chairman. “In my judgment, a very high percentage—probably at least 95 percent and more likely much higher—of the activity generated by these [stock index futures] will be strictly gambling in nature,” the investor Warren Buffett had written to Congress at the height of the debate in 1982. Shad admired Buffett; during his first months at the commission, he had invited the Omaha investor to brief commission staff about certain insurance issues, partly to acquaint the bureaucrats with the wisdom of an accomplished capitalist. In his warning to Congress about stock futures, Buffett had concluded, “In the long run, gambling-dominated activities … are not going to be good for the capital markets.”

  Gambling—that was a loaded word in the Mormon community where Shad was born, a word of sin. Shad was adamant that the constant wagering he engaged in, since it didn’t involve casinos or large sums of money and was driven by competitiveness and a pure quest for excitement and fun through risk taking, wasn’t really gambling, at least not in the sense that a Mormon might think of it. During the critical congressional debate over whether the SEC should accede to the creation of stock futures, Shad took a similar position—he didn’t think that trading stock futures would lead to widespread gambling, at least not in the sense that Buffett meant. Some increased speculation would be good for the financial markets, he thought. But in Shad’s view the private choices of investors, whether speculative or prudent, were best left alone by the government. To enact the laws that authorized stock futures, Congress had to use the prerogatives of the federal government to preempt certain state antigambling statutes that otherwise would have prohibited such speculative trading. Still, Shad had no basic moral or economic objection to stock futures. And he did not think stock futures would alter fundamentally the way the stock market worked.

  About that, at least, it turned out that Shad was wrong.

  Early in 1983, in a pit on the floor of an obscure commodities exchange in Kansas City, Missouri, the first stock index futures contracts changed hands amid great fanfare and ceremony, all of it mustered in the hope that a new era was at hand. It was, but unfortunately for those gathered in the pit, little of the massive wealth generated by trading in stock index futures during the 1980s would find its way to Kansas City.

  The futures industry had been headquartered for decades in Chicago, and there stock futures trading would flourish. That was appropriate in a way, since it was the conservative economists at the University of Chicago, the ones Jack Shad had so admired, who had helped to invent stock futures in the first place. On Wall Street, too, futures trading would soon generate tens of millions of dollars in fees and commissions annually as new products proliferated and grew in popularity. Some on Wall Street came to believe that futures trading contributed to the great bull market already under way that winter. Since the previous August, when the economy’s recovery from recession finally seemed assured, the Dow Jones Industrial Average had raced from the mid-700s past 1,100, an increase of about 50 percent in only half a year.

  Later, in 1987, when the market crashed and the politicians in Washington fretted over what to do about it, there was a great deal of public talk about whether stock futures were good or bad for the country. The trouble was that few in Congress or at the White House understood what stock futures were or how they had changed the financial markets. Bemused economists in Chicago said that that was typical of Washington, that federal regulators and legislators were often years behind in comprehending innovation in the industries they supervised. In the case of stock futures, the problem was compounded by the conflicting ideological assumptions that different factions carried to the debate. It was a peculiar facet of the futures business that ever since its birth, a century earlier, people had been trying to outlaw the industry on what boiled down to moral grounds.

  The conflicting American impulses of religious rectitude and boyish abandon visible in a man like John Shad were evident, too, in the tangled history of stock futures. The futures markets were born on the hardscrabble midwestern plains of the nineteenth century in a spontaneous attempt to quell the effects of what were then commonly called acts of God—violent storms, howling tornadoes, and devastating droughts. The seasons and the weather formed a repeating, treacherous economic cycle for farmers, who depended on rain at the right time and in the right amount to eke out sustenance for their families, many of them recent migrants from the more comfortable East. In the spring, a farmer went deeply into debt to buy seed, fertilizer, and other supplies for planting. If the weather cooperated, he profited. At harvest-time late in the summer, he hauled his crop to market, sold it at the prevailing price, paid off his debts, and stashed away the profits. Next spring, he began again. But if the weather failed, he was ruined. If it rained too much and there was a bumper crop, plummeting prices caused by the oversupply prevented him from earning enough to pay off his debt. If it rained too little and his crop failed, he might not have enough to sell to pay back his spring borrowings. Every year, then, the farmer, often an austere and deeply religious man devoted to the land, involuntarily gambled on the weather.

  In Chicago and Kansas City and other Midwestern cities, a free-market answer to the farmer’s predicament sprang up. Fly-by-night spec
ulators and profiteers came west and offered to make deals with the farmers. In the spring, at planting time, a farmer might contract with a speculator to “presell” the crop he would harvest later. The farmer would get the speculator’s cash, receiving the prevailing market price for wheat or whatever crop was to be planted, and he would agree to deliver the goods at harvest-time. The speculator was betting that crop prices would rise so that he could make a killing. The deal between the farmer and the speculator involved what economists came to call risk transfer. The risk of bad weather was shifted from someone who couldn’t afford to bear it, the farmer and his family, to someone perfectly willing to gamble, the speculator.

  As time went on, the speculators started to swap crop contracts. The modern futures market in Chicago actually began in loose, raucous crowds of speculators who gathered in the mud near the railroad depots where the crops came in. A rough system of market pricing developed, and slowly the speculators began to build institutions for themselves, places some of the farmers’ organizations denounced as casinos. There was always tension between the farmers and their unruly financial partners in the cities—mainly because the farmers rightly suspected the speculators of manipulating crop prices in their unsupervised marketplaces. For a hundred years, price manipulation and crop-cornering schemes were virtually commonplace in the agricultural futures pits where trading took place. Scandal and corruption on Wall Street prompted the SEC’s creation during the 1930s, but the futures markets received no such vigorous oversight, though they continued to prosper and grow in importance. Despite futures scandals, one reason there was little push for federal regulation was the low involvement of small investors in the futures markets and the success of futures traders—who opposed federal regulation—in political fund-raising. Until 1974, when a particularly outrageous series of scandals led to the formation of the Commodity Futures Trading Commission, the Chicago futures exchanges were supervised by a small, ineffective office in the federal Agriculture Department.

  It was a diminutive, wiry, palpably energetic speculator named Leo Melamed who changed everything. The only child of Polish immigrants, Melamed had started out as a clerk at the Chicago Mercantile Exchange, then a lesser institution known in part for its trading in egg futures. He went broke in the pits three times before he rose to power at the exchange, winning a seat on its executive board and building a coalition that eventually transformed the Merc into one of the world’s most important financial institutions. Melamed was an erstwhile science fiction writer; he eventually published a thriller in which characters named Rafflo, Nan Nan, and Slib Fru jetted between planets dubbed Qalm, Quut, and Usma, indulging themselves with morsels of Zamotian fruit. His writing was original, but back on planet Earth, Melamed demonstrated a remarkable talent for taking other people’s ideas and turning them into money.

  Free market economist Milton Friedman provided him with the breakthrough that ended the cycle of boom-and-bust that had defined Melamed’s career. In 1967, Friedman became convinced—correctly, as it turned out—that the international monetary system was about to undergo revolutionary changes as the prices of foreign currencies became subject increasingly to free market forces. Friedman wanted to gamble on his analysis, and he asked a Chicago bank to let him make a down payment of $30,000, borrow $270,000, and then sell short $300,000 worth of British pounds, meaning that Friedman would profit if the price of British pounds declined. The bank refused. For one thing, Friedman was asking the bank to lend him 90 percent of the purchase price—in the stock market, ever since the crash of 1929, individual investors had been required by the federal government to put up 50 percent of the purchase price in cash, in an effort to quell dangerous speculation. As it happened, about three weeks after the bank’s rejection, the price of pounds plummeted so steeply that had Friedman been allowed to borrow the money to place his bet, he would have more than doubled his original investment. Friedman vented his frustration with the Chicago futures-market officials he knew, urging them to take advantage of the upcoming volatility in the currency markets by establishing new futures products based on the world’s major currencies. Leo Melamed was among the few who listened to him.

  In theory—and theory was the Chicago School’s specialty—Friedman’s proposal traced back to the economic idea that underlay the alliance between speculators and farmers a century earlier: risk transfer. What was the difference between a farmer worried about changes in the weather and a giant, multinational bank concerned about fluctuations in the value of the dollar in Japan, where the bank might have huge loans outstanding? The price of the dollar relative to other currencies was just as unpredictable as the weather. Melamed, sensing that he had stumbled onto a potential bonanza, began to work with Chicago School economists and officials of the Chicago Mercantile Exchange, which had long been dwarfed by its rival, the Chicago Board of Trade. Melamed and his competitors came up with futures not just for foreign currencies, but for Treasury bonds, Treasury bills, corporate bonds, mortgage-backed securities, and, finally, stocks. A pension fund, for example, could hedge against a drop in the overall stock market by “preselling” some of its stocks through the use of stock index futures.

  They found it was theoretically possible to transfer any economic risk imaginable.

  By 1983, when stock futures began trading, it was hard sometimes to recall the original impulse—the eagerness of speculators and drifters heading west to make fast money gambling on the weather—that gave birth to the futures markets in the mud down by the railroad tracks. The approval and supervision of so many new financial products by regulators in Washington during the Carter administration and in the early Reagan years had produced a blizzard of well-reasoned papers and briefs written by lawyers and economists, all designed to justify financial futures on theoretical grounds. The once-humble idea of risk transfer was extended and expanded and contorted into charts and graphs until it began to resemble some philosopher’s ontology of the universe. When he flew into Washington to testify before Congress or the CFTC, Milton Friedman liked to talk about theories of capitalism. He didn’t digress into why he personally had wanted to wager $300,000, several times the annual salary of a college professor, on the future price of British sterling, or what exactly he planned to do with all that money if his bet paid off.

  Yet the terms of Friedman’s proposed bet on the price of the pound told exactly why financial futures were booming in Chicago, and why they might eventually effect the way the stock markets on Wall Street worked. The key was leverage.

  That winter of 1983, most financial regulators in Washington, including Shad, weren’t sure that stock index futures would ever become popular. Large institutions that owned a lot of stocks—university endowments, pension funds, and mutual funds—tended to view the Chicago futures exchanges as seedy hotbeds of speculators. Why would these big traders abandon the venerable New York Stock Exchange? The answer, it turned out, was that they could buy more with less, just as Milton Friedman had proposed to control $300,000 worth of sterling with only $30,000 in cash.

  Stock index futures were contracts containing promises about the future. As with stock options, every contract had a date on it: an exact day, month, and year sometime in the future guaranteeing the delivery of the financial value of stocks for a price negotiated in the present. The “index” part of the contract referred to the basket of stocks to be delivered. The Standard & Poor’s 500, made up of stocks of five hundred big U.S. corporations, would eventually become the most popular basket. The S&P 500 futures contract promoted by Leo Melamed succeeded because it took less cash to buy the stock future in Chicago than it did to buy the corresponding five hundred stocks in New York. Instead of the 50 percent down payment required of individual investors in the stock market, a speculator in the futures markets was required to put up only about 10 or 15 percent in cash. Stock futures traders got more bang for the buck than anyone in the stock market, just as a home buyer with $20,000 on hand can buy a bigger house if the required
down payment is 15 percent rather than 50 percent.

  During the stock market crash of 1929, highly leveraged speculation by individual investors not only contributed to the steepness of the market’s fall, but also wreaked financial devastation on thousands of the middle class who seemed to think, as they borrowed and borrowed to buy stocks, that the market could only go up. A deep skepticism about the uses of debt never left the generation that witnessed the crash and lived through the Great Depression. John Shad was one of them—even as he maneuvered with Phil Johnson at the CFTC to unleash trading in stock futures, he expressed concern to Federal Reserve Board Chairman Paul Volcker about the relatively low down payments required of stock futures investors. Volcker was worried as well, but there was a part of him that just didn’t want to get involved with the futures markets. The Federal Reserve already had to regulate the size of the nation’s money supply, assure the safety and soundness of the banking credit system, and oversee the use of borrowed money in the stock market. Volcker was afraid that if the Fed was seen as a kind of universal financial safety net, prepared to protect people against even the most outrageous speculative losses in the futures markets, then it would only encourage more and more speculation. Volcker’s thinking was that if a tightrope walker knows he has a net underneath him, he is encouraged to take all sorts of foolish chances on the wire.

  So, despite the misgivings, a new market for stock futures was born. Shad heralded the freedom of choice for investors, believing that restrictions on innovation would do more harm than good. Like so many other complex issues, it was for Shad a simple equation of costs and benefits.

  Inauguration of stock futures trading sealed off Jack Shad and the SEC from regulation of one of the fastest-growing sectors of the country’s financial markets, since the original deal between Shad and CFTC Chairman Johnson precluded the SEC from supervising stock futures trading. That meant the markets in Chicago were regulated by Johnson’s CFTC, while the stock markets in New York—increasingly influenced by the stock futures trading—continued under the supervision of the SEC. Those who had opposed this act of regulatory segregation warned that the SEC should protect investors from abuses arising from the trading of any financial product, including stock futures, that directly affected the stock market.