The Go-Go Years (44 page)

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 percent 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.

Whether or not Haack knew it at the time, this was quite wide of the truth, as subsequent events would more than demonstrate. Facts were only spottily available; Wall Street was swept by confused alarms, and many firms in trouble were bald-facedly concealing the truth from the Stock Exchange. Perhaps Haack's statement should be taken as an expression of hope. His job, he clearly felt, was to spread reassurance and to ward off
panic reactions. Again, in mid-April 1970, answering an urgent query from Senator Edmund Muskie, Haack wired from Wall Street: “THE EXCHANGE'S SPECIAL TRUST FUND IS NOT NEAR DEPLETION… SITUATION WITH RESPECT TO OPERATIONAL AND FINANCIAL PROBLEMS OF NYSE MEMBER FIRMS HAS VASTLY IMPROVED.” In fact, five Stock Exchange firms were at that moment in liquidations that would end up costing the Special Trust Fund $17 million of its $25 million total; another member firm, Dempsey-Tegeler, was in its death throes, and its liquidation would eventually cost the trust fund over $20 million; and, worst of all, Hayden, Stone and Company, an eighty-four-year-old giant not far from the core of the Wall Street Establishment, with some 90,000 brokerage customers and a major share of the underwriting business, had lost nearly $11 million the previous year and was now losing money at a rate in excess of a million dollars a month. Hayden, Stone's affairs were shortly to erupt into the first phase of the crisis that almost brought Wall Street low for good.

3

At the end of May—at just about the time of the White House dinner that got credit for turning the market around—Lasker and some of his fellow governors of the Stock Exchange decided that the time had come to form a special committee to maintain surveillance over member firms' financial affairs. This was normally the work of the Exchange staff, and in particular of the Member Firms Department; but the governors were dissatisfied with the way that work was being done. The situation had become chaotic. It was increasingly evident that some firms were exaggerating, if not actually falsifying, their capital figures in their reports to the Exchange; at governors' meetings there would be talk of $40 or $45 million being required from the trust
fund in liquidations already under way, but nobody was sure. The figures were guesses. It was Robert L. Stott, Jr., a well-known floor specialist, who came to Lasker and suggested that a committee of governors be formed forthwith. Responding enthusiastically, Lasker appointed to the new committee—formally named the Surveillance Committee, but usually thereafter called the Crisis Committee—himself; Ralph DeNunzio, executive vice president of Kidder, Peabody and vice chairman of the Exchange; Stott; Stephen M. Peck, senior partner in Weiss, Peck and Greer; Solomon Litt, senior partner in Asiel and Company; and Felix George Rohatyn, a partner in Lazard FFelix Rohatyn réres and Company.

The chairman of the committee was Rohatyn, and it was he and Lasker, working in tandem, who would bear the brunt of its work over the months ahead. Rohatyn had been born in Vienna in 1928, and he and his Polish-Jewish parents had arrived in the United States as refugees from Hitler in 1942, after an interim stay in France. He had graduated in 1948 from Middlebury College, in Vermont, with a B.A. in physics, gone directly to Lazard, and never left again except for a spell of military service during the Korean war. As a young acolyte making the transition from natural science to the intricate and unnatural science of corporate finance, Rohatyn at Lazard had had the good luck to become a protégé of one of the leading masters of corporate deal-making, the French-born, publicity-shy, tough old wizard of Wall Street, André Meyer. Under such Cordon Bleu tutelage, sous-chef Rohatyn flourished. A compactly built man with a pug nose, heavy brows, full lips, and a slightly receding chin, he had an eager face and easy smile that made him at forty-two seem more like a student. But his appearance was deceptive. “Nobody has a record quite as spectacular as Felix's,” a partner in a rival investment-banking house said of him in 1970. The record consisted of having become one of Wall Street's most ingenious experts in corporate acquisition and reorganization. That is to say, Rohatyn had become, like his mentor, a master merger-maker, and one of the firms for which he arranged intricate, multimillion-dollar acquisitions was the
Lazard client International Telephone and Telegraph, on whose board of directors he sat.

In 1972, Rohatyn would come to national prominence, of a sort, as the banker for I.T.T. who the previous year had had a series of private meetings with then Acting Attorney General Richard G. Kleindienst to argue, on public-policy grounds, for a favorable settlement of the Justice Department's antitrust suit against I.T.T. Disclosure of those meetings involved Rohatyn in considerable controversy, since Kleindienst would later deny, for a time, that he had had anything to do with the settlement. (It was never alleged that Rohatyn had any knowledge of or involvement in the famous I.T.T. financial commitment to the Republicans for their 1972 national convention.) Whatever the facts of that matter, Rohatyn in 1970 was quite possibly the most brilliant, and certainly among the most dedicated and energetic, men in Wall Street at a time when Wall Street badly needed brains, talent, and energy to save it from its own folly. Rich enough at forty-two, married to a daughter of the well-known author and Union-with-Britain advocate Clarence Streit, beginning to be spoken of as heir apparent to Meyer as boss of Lazard Fréres, Felix Rohatyn in 1970 was riding the crest.

The Surveillance Committee started out by meeting once a week, for lunch on Thursdays, in a committee room on the sixth floor of the Stock Exchange building. Always present, besides Rohatyn, Lasker, and their committee colleagues, were two representatives of the Exchange staff, President Haack and Executive Vice President John Cunningham. According to Rohatyn and Lasker—both of whom later talked to me at length about the committee and its work—its first job consisted chiefly of trying to exercise due diligence as to use of the trust fund in current liquidations, and of trying to set up an early warning system as to other firms that were heading for trouble. It quickly became clear that the Exchange staff men really knew remarkably little about those other firms' financial condition. To their horror, the committee members began to see that weakness was the rule rather than the exception. Brokerage firms that the Exchange had supposed to be above reproach were revealed, under even
superficial investigation, to be walking zombies, carrying assets on their books that did not exist and never had existed. “It was like a nightmare,” Rohatyn said later. “You pushed here, you pushed there, at random, and wherever you pushed, you found softness.”