by John Brooks
But to the layman, the signs of recession late in 1970 were everywhere plain to see. In October, the Bureau of Labor Statistics reported that, with national unemployment at 5.2 percent of the work force, the figure for male black teen-agers in urban areas stood at 34.9 percent. At about the same time the tide of recession began spreading upward in the economic spectrum. It never did soak, or even dampen, the rich—corporate chieftains went right on drawing astronomical salaries, and banks in particular actually flourished because of continuing tight money—but in the autumn of 1970 the recession wave swamped the middle class. An organizer of the United Steelworkers told Studs Terkel, chronicler of the Great Depression of the nineteen thirties, “When a guy is cashing his biweekly check at the neighborhood bar, every check for the last few years has been $300, $400. Now he brings home $150 to $170.” A twenty-two-year-old described the effect of recession on the youth counterculture: “Most people with long hair have to work for dog wages. There aren’t many places that hire them, so they work at rip-off joints. You know, $1.75 an hour. It’s like being black.”
In October, the airlines, anticipating collective losses of at least $100 million on the year’s operations, were cutting back luxury services: sandwich meals now instead of steaks, fewer in-flight movies, paper towels instead of cloth ones, no more snacks of expensive macadamia nuts. The same month, the Department of Labor identified thirty-five separate major labor areas with “substantial or persistent” unemployment; the Council of Better Business Bureaus estimated that there were 400,000 currently unemployed executives; and large companies began making across-the-board cuts of executive and white-collar paychecks. The Norton Company of Massachusetts, to name one, shaved 15 percent from the salaries of 5,000 managers and white-collar workers, which for a person earning $25,000 meant a cut of about $72 a week. By November, in New York City, it was clear that the welfare rolls were being swelled faster by new applications from non-Puerto Rican whites than by those from blacks and Puerto Ricans. At the Professional Placement Center of the New York State Employment Service, the number of professional and managerial claimants for unemployment benefits had risen by more than 100 percent in a year, and there was talk of stockbrokers working as cab drivers, art directors taking jobs as layout artists, and accountants accepting sharp salary cuts and for the first time in their lives paying agency fees. That winter in Manhattan, for-hire limousines were in supply rather than in demand; for the first time in the memory of many opera patrons, there were empty seats at almost every Metropolitan Opera performance; many former Saks Fifth Avenue customers were patronizing Klein’s or Alexander’s, and many former taxi riders were riding buses and subways. In December, placement counsellors at colleges began telling seniors of a sharp drop in job offers, and warning them that the days when they could take their pick of starting jobs were over. Most large industrial companies began cutting their campus recruiting visits sharply, some cutting them in half. The advanced-degree job market became a small disaster area, with new Ph.D. holders taking jobs, when they could find them, at half the going rates of the year before. Urban private schools, used to watching affluent parents agonize over berths for their offspring, suddenly were competing among themselves for scarce applicants.
And so it went. There were no breadlines or applesellers, but bread was being eaten instead of cake, apples instead of baked Alaska. And the reaction of worried politicians to the deteriorating situation called forth more sardonic echoes of the past. As the year 1970 ran out with the gross national product down for the first time since 1958, and with industry limping along at three-quarters of capacity, the President, with the concurrence of Congress, began applying that old Herbert Hoover standby, the trickle-down theory of trying to save old jobs and create new ones through federal handouts to business. By the end of the year, Congress had voted the Lockheed Aircraft Corporation a $250-million loan guarantee in a financial rescue operation intended principally to save the jobs of 60,000 employees by saving the company from bankruptcy; the bankrupt Penn Central was on the way to a $125-million federal loan guarantee to keep its passenger trains running, and their employees working; a new governmental corporation, Amtrak, was being established to operate all of the nation’s intercity trains; and government shipbuilding subsidies were in the process of being greatly increased. It all looked like Hoover’s famous breadline for business, the Reconstruction Finance Corporation, all over again, with the difference that the R.F.C. had usually driven a harder bargain with its petitioners than the Nixon administration did now.
Week by week and month by month, new parallels kept appearing. In 1971, Nixon repeatedly rejected the idea of direct federally sponsored job programs, just as Hoover had done in 1930 and 1931. Week by week and month by month, the dollar grew weaker in the international markets. When the United States had finally been forced to abandon its pledge to redeem dollars with gold on April 18, 1933, it had been three and a half years after the beginning of the 1929 stock-market crash. This time, the triumph of political necessity over national honor came sooner. When the gold default of 1933 was repeated down to all but the smallest details in August 1971, it was hardly more than a year after the height of the 1970 crash.
History, in its economic aspect, seemed to have become a recurring nightmare from which the United States could not awake. But for Wall Street, the nightmare this time had a new dimension. In the second half of 1970, Wall Street itself, as distinguished from its hapless customers, came within a hair of plunging into irretrievable bankruptcy, and the American securities market into full-fledged socialism.
CHAPTER XIII
Saving Graces
1
If Wall Street can lay claim to special expertise in any particular field, that field is the raising and management of capital. Bringing together, presumably in an orderly and mutually beneficial way, companies that need new money to run their businesses and investors who wish to hire out some of their money at reasonable risk, is Wall Street’s work—the social justification of its existence. By and large, over the years, it has performed this function well. Yet in the latter nineteen sixties the capital structure of Wall Street itself became unsafe and unsound to a degree that, when hard times struck, was revealed as nothing less than a scandal. It was more than a case of a physician being unable to heal himself; it was a case of a physician habitually and systematically flouting everything he had learned at medical school, including the simplest rules of personal daily hygiene.
Matters had not always been thus. The celebrated post-1929 suicide victims had been for the most part customers rather than brokers. The brokers’ yachts were scarce by 1932, but their firms had come through that crisis still solvent, partly because most of them had been conservatively financed with the personal resources of careful Puritanical partners, partly because the brokerage business in those days had been of manageable size, and not least because the terrible drop in stock prices had occurred on such unprecedentedly high trading volume as to enable brokers to recoup on commissions much of their losses on stocks they owned. When brokerage failures did occur back in those days, it was usually a matter of outright fraud, as in the famous case of Richard Whitney and Company. But in the nineteen sixties, when the securities business had broadened to become mass business for the first time, brokerage houses financed themselves not by adopting the mass-business methods they understood so well and so often urged on others, but by merely adding new and dubious twists to the traditional methods of what had been, by the standards of American Telephone or General Motors, a cottage industry. Not until 1970, for example, did the first Wall Street firm raise money for its operations from outside by selling its own stock to the public, and it took a change in the New York Stock Exchange’s constitution to make such a sale possible. Like most bad business practices, Wall Street’s obsolete and unsound capital-raising methods worked well enough in good times; it required only a little misfortune to expose them as the jerrybuilt mechanisms they were.
That misfortun
e, utterly unanticipated, consisted of the simultaneous drop in stock prices and trading volume in 1969 and the first half of 1970.
Let us look, in brief and simplified form, at a brokerage firm’s typical capital structure in 1969-1970, as administered by the New York Stock Exchange and grudgingly but nonetheless leniently approved by the S.E.C.
The Stock Exchange rules imposed on such firms the requirement that the ratio between their aggregate indebtedness and their “net capital” be at no time higher than twenty to one, and the Stock Exchange through a system of surprise audits undertook to see that its members complied with this rule. And what was the nature and source of the “net capital” required under the rules? Its basic and soundest forms were the traditional ones—the cash investments of general partners, entitling them to stated shares in the profits, and the cash loans of other backers, entitling them to interest. But that was only the beginning, and, by the end of the nineteen sixties, only a small percentage of the capital of many firms consisted of such unassailable assets. There were other less substantial but still permissible forms of “capital” that, after the great expansion of 1967-1968, came to predominate over the traditional ones. One of these consisted of the loan of securities by an investor to a broker—a fair enough form of capital except that, unlike cash, the securities might abruptly decline in dollar value, thus abruptly reducing the amount of capital that they represented. Also qualified for inclusion as capital were a firm’s accounts receivable, which sometimes consisted of such birds-in-the-bush as anticipated tax refunds and possibly uncollectable cash debts from customers. Then there were secured demand notes. Anyone owning a batch of securities—no matter how volatile and speculative—could pledge them as backing for a paper loan to a brokerage firm and thus technically contribute to the firm’s capital. No money would actually change hands, nor would the investor actually give up the benefits of his loaned securities; there would merely be, for the firm, a cheering new capital entry on its balance sheet, and for the lender, the pleasure of regularly collecting interest on money he had never parted with and at the same time collecting dividends, were any paid, on his stocks. As if this were not a pleasant enough arrangement, under the terms of some such notes it was explicitly agreed that the lender would not have to part with any money or any securities, except in the all but unthinkable event that the brokerage firm should become insolvent, unable to meet its day-to-day obligations, or not in compliance with the net capital rule.
Shakiest of all, there were subordinated loans. Any securities-holding customer of a brokerage firm in need of additional capital could simply sign a paper headed “Event of Subordination Agreement.” In this magic instrument, the customer did no more than agree, in the event of the firm’s liquidation, to subordinate his claims to those of other customers and creditors; in exchange, he was allowed to go on collecting dividends on his stocks and simultaneously collecting interest on his “loan”—which, of course, had involved no actual money—while the brokerage firm was allowed to enter on its books the market value of the securities, less a reasonable discount, as new capital. Here, then, was “capital” that the beneficiary could never lay his hands on—unless he went broke, and even in that case the hands laid on it would be not his but those of his creditors.
The net of these perhaps rather abstruse ground rules is that the S.E.C. and the Stock Exchange allowed Wall Street firms to comply with the net capital rule—imposed for the protection of the firms themselves as well as that of their customers—with capital that was essentially a mirage. It was money that could not be seen, or rubbed together, or jangled in the hand, or, more to the point, used in the operation of a brokerage business; essentially, it was money that would become available, if at all, too late to do any good. Finally, contributors of the palpable and useful forms of brokerage capital, equity cash and debt cash, were entitled to withdraw any and all of their money at any time on only ninety days’ notice, whenever for some reason they didn’t like the way things were going. In 1969 and 1970 few investors in brokerage houses liked the way things were going, with the quite logical and rational consequence that there was an enormous and nearly catastrophic outflow of working capital from the nerve center of world capitalism.
Madness! the reader might understandably exclaim. And yet the reasons for such dangerous official permissiveness are not hard to find, and follow a certain logic of their own. As we have seen, the S.E.C. in 1969 wished chiefly to serve Wall Street—to avoid rocking the boat at a moment when almost everyone was happily making money. As to the Stock Exchange, it had logical reasons to treat its Rule 325, the one requiring a 1:20 ratio of capital to indebtedness, as a rule that was in effect at all times except when someone violated it. For the Exchange to stiffen the enforcement in 1967 and 1968 when things were going well, and brokerage capital was seldom a problem, would have been to play the role of spoilsport. Who, after all, was the Stock Exchange? The governors who made its key decisions were brokers. Conversely, when things began to go badly, a different reason, or excuse, for inaction came into play. If a member firm were found to be in violation of the capital rules and accordingly suspended from the privilege of doing business, the money and securities of the firm’s customers would automatically become frozen and unavailable until such time as the firm was restored to capital compliance. Widows and orphans by the thousands or tens of thousands would suddenly be separated, temporarily but firmly, from their stocks or cash—hardly an eventuality calculated to enhance Wall Street’s public popularity or leverage in Washington. So, when a member firm was found to be in capital violation, the Exchange was inclined to turn its back on its own rules, wink at the violation, and allow the firm to continue doing business while frantic efforts were made to find it more capital. Save the broker in order to save the customer: it was Wall Street’s version of the trickle-down theory. (Where were the customer’s yachts? Where, indeed, were the customers’ subordinated lenders?) And whether the real objective was in fact to save the customers or, as some suspected, to protect members of the club from embarrassment and loss, the situation illustrates very vividly what is wrong with the principle of self-regulation in a business that serves the public.
2
Capital troubles began to crop up in the backlash of the 1968 paperwork crisis, and one small firm, Pickard and Company, actually failed that year as a result of too much business too inefficiently handled. The Exchange, to its credit, was ready to deal with the plight of Pickard’s customers. In 1964, following the collapse of Ira Haupt and Company resulting from the infamous salad-oil swindle, it had set up a $25 million Special Trust Fund, paid for by subscription of Stock Exchange member firms, and reserved specifically for restoring the lost holdings of the unlucky customers of any member firm that should go broke. Pickard’s being the first member-firm failure since Haupt, the trust fund had never been drawn upon; now it was tapped for some $400,000, and Pickard’s 3,500 customers were reimbursed—or, in the rather attractive legal expression, “made whole.”
Well and good: an isolated case, everyone supposed, in which the machinery had worked exactly as planned. But in the late spring of 1969, when stock prices and trading volume began to sink in unison, the squeeze on brokerage profits was on in earnest, leaving the firms’ rickety capital structures increasingly exposed. Partners and backers, reacting to the bleak prospects, made things worse by availing themselves of the convenient ninety-day rule to pull out their money while the pulling was still good. (It may be noted that for a firm operating on the borderline of capital compliance, every dollar thus withdrawn meant that a debt reduction of twenty dollars was required.) In September, W. H. Donaldson—a principal in the powerful maverick firm of Donaldson, Lufkin and Jenrette that was about to force the change in time-honored Exchange rules that would enable it to raise money from outside Wall Street by selling its stock to the public—made some prophetic comments on the impermanence of Wall Street capital, and mentioned the arresting fact that probably more than 90 pe
rcent of all such capital was owned by men over sixty. In mid-October 1969, a certain Gregory and Sons went under. The Exchange promptly authorized the use of $5 million more from its Special Trust Fund to save the Gregory customers. At almost the same time, another firm—middle-sized Dempsey-Tegeler, which back in April had been fined $150,000 for record-keeping shortcomings—was forced by the Exchange to restrict its operations; it appears in retrospect that the Exchange knew the firm was not financially sound and was engaged in a furious effort to find it new capital to save it from bankruptcy—which is the terminus Dempsey-Tegeler would arrive at, in any event, the following August.
The trickle-down theory, then, was now in operation. But it was not working. That December, most brokerage firms omitted their often-lavish Christmas bonuses. Depression had come to Wall Street. A cheerless pall of nameless doom hung over the financial district through the 1969 holiday season; secretaries and clerks who knew nothing of subordinated lenders or secured demand notes were being affected along with officers and partners.
Early in 1970, as the continuing decline in prices and volume made the situation for brokers progressively worse, a wave of brokerage mergers arose—frantic, hastily arranged shotgun marriages dictated not by love but by the need for survival. During a dreadful March, there were two more member-firm failures and a quasi-failure: McDonnell and Company, in spite of high social prestige and close ties with the Ford family of Detroit, closed its doors (cost to the Special Trust Fund: $8.4 million); Baerwald and DeBoer went into liquidation (cost to the fund: about $1 million); and out in Los Angeles, the former hottest deal-maker of them all, Kleiner, Bell, where customers had chanted “Go, go, go!” as they watched the ticker, found the going so rocky that it simply withdrew from the brokerage business. And now for the first time it began to be evident that not just marginal firms but some of the conservative, well-established giants of brokerage were in bad trouble as well. On March 16, Bache and Company reported that for fiscal 1969 it had incurred the largest annual operating loss in the annals of American brokerage, $8,741,000. Shock waves followed the announcement; investors began to experience the chills of panic, and on March 23, Haack felt called upon to refute wayward rumors by stating that all of the twenty-five largest Stock Exchange firms were in compliance with the capital rules.
