WEBVTT - The Crash 0:00:00.320 --> 0:00:02.440 One of the things we all love about business stories 0:00:02.640 --> 0:00:05.800 are the humble beginnings, like when two buddies go from 0:00:05.800 --> 0:00:09.040 tinkering in their Palo Alto garage to creating the world's 0:00:09.080 --> 0:00:14.920 most valuable company, Apple. Sometimes everyday events even inspire something remarkable, 0:00:15.520 --> 0:00:17.600 like when a Swiss engineer takes a walk in the woods, 0:00:18.200 --> 0:00:21.000 marvels at the seeds that stick to his clothes, and 0:00:21.160 --> 0:00:24.160 ends up inventing velcro. The story we're about to tell 0:00:24.200 --> 0:00:26.920 you is a little bit like those, and it culminates 0:00:26.960 --> 0:00:31.280 with a three trillion dollar industry that's still growing. What's 0:00:31.320 --> 0:00:35.559 this We're talking about the exchange traded fund. We're going 0:00:35.600 --> 0:00:37.479 to trace how it came to be with some of 0:00:37.560 --> 0:00:39.519 the people who made it happen. We'll look at the 0:00:39.520 --> 0:00:42.479 state of things before it existed, find out where the 0:00:42.520 --> 0:00:45.800 spark came from, learn why the idea worked, and what 0:00:45.960 --> 0:00:48.240 it actually took for this financial tool to get where 0:00:48.240 --> 0:00:56.440 it is today. This is Trillions presents the et F story. 0:00:57.040 --> 0:00:59.760 I'm Joel Webber and I'm the editor of Bloomberg Business Week. 0:01:00.720 --> 0:01:03.680 Over the course of the next six episodes, with the 0:01:03.720 --> 0:01:06.320 help of Eric Baltunas, who's an e t F expert, 0:01:06.360 --> 0:01:09.560 and an analyst with Bloomberg Intelligence. We're going to document 0:01:09.800 --> 0:01:12.039 the story of the e t F. We'll hear from 0:01:12.040 --> 0:01:14.119 people who were there at the beginning. Will also take 0:01:14.160 --> 0:01:16.720 you on a few fuel trips, but mostly we'll be 0:01:16.760 --> 0:01:20.360 sharing the human stories behind an industry that's hoovering up 0:01:20.400 --> 0:01:26.080 trillions of dollars every year. So this all really begins 0:01:26.400 --> 0:01:41.240 when the stock market crushes on October nineteenth, Black Monday. 0:01:42.120 --> 0:01:44.800 If you have been away from your television set and 0:01:44.880 --> 0:01:47.000 haven't heard about the stock market, and this was it, 0:01:47.200 --> 0:01:55.400 the market declined to Practimately, I think that everyone, every 0:01:55.440 --> 0:01:57.920 amount and at this stage of the game needs to 0:01:58.200 --> 0:02:01.080 get their house in order, are ready to jump out 0:02:01.080 --> 0:02:04.480 of a window. And it was a pretty pretty sickening experience, 0:02:05.160 --> 0:02:08.520 almost like are we at the apocalypse opprestice right now? 0:02:09.000 --> 0:02:11.680 Being I'm Tom black Monday is now on the books, 0:02:11.760 --> 0:02:14.920 then the question is what will happen Tuesday and beyond? 0:02:16.639 --> 0:02:19.040 Even got a term black Monday, I mean that that 0:02:19.120 --> 0:02:21.280 sounds like a horror movie. This, of course, is our 0:02:21.320 --> 0:02:24.240 resident et F analyst, and for the purposes of the 0:02:24.320 --> 0:02:30.600 show are historian Eric Balt Noises were a great decade 0:02:30.600 --> 0:02:33.840 for the American economy. Modern finance was coming into its own. 0:02:34.440 --> 0:02:38.120 Two cities were especially interesting Chicago, where people who are 0:02:38.120 --> 0:02:42.880 trading futures contracts of commodities like corn or oil, and 0:02:43.000 --> 0:02:45.800 New York, where we've got the stock exchanges and people 0:02:45.840 --> 0:02:48.480 trading equities. Well, the market had been going up for 0:02:48.520 --> 0:02:51.760 a while, nothing goes up forever. There was probably a 0:02:51.760 --> 0:02:54.280 sell off that was gonna happen anyway, So the conditions 0:02:54.280 --> 0:02:56.520 were ripe for a sell off. And at the same 0:02:56.600 --> 0:02:59.160 time you had a build up of this hot thing 0:02:59.200 --> 0:03:03.040 called portfolio insurance, which was to use futures in order 0:03:03.080 --> 0:03:05.840 to heade your stock position. This portfolio insurance was created 0:03:05.840 --> 0:03:08.960 by the firm Leland O'Brien Rubinstein to deal with the 0:03:08.960 --> 0:03:11.799 big crash of the nineteen seventies. John O'Brien, who was 0:03:11.840 --> 0:03:14.720 part of the team that developed it, says portfolio insurance 0:03:14.720 --> 0:03:17.680 really started to take off once JP Morgan started doing it, 0:03:18.040 --> 0:03:21.079 but most people in the Wall street didn't understand what 0:03:21.240 --> 0:03:26.960 that was. Some big asset managers did, some big local 0:03:27.000 --> 0:03:30.040 dealers did, and they realized when the market went down, 0:03:30.120 --> 0:03:36.360 portfolio insurance required selling stock and buying bonds. O'Brien says, 0:03:36.360 --> 0:03:39.360 on the Friday before Black Monday, the market has his 0:03:39.440 --> 0:03:45.160 biggest drop since nine So all about portfolio insurance folks 0:03:45.600 --> 0:03:50.880 difficulty getting off enough sales of futures contracts to get 0:03:50.920 --> 0:03:54.160 down in the equity exposure to the level we should 0:03:54.280 --> 0:03:58.119 have had at the close of business on Friday, Act 0:03:58.160 --> 0:04:03.320 over seventeen. A couple of focus recognized this, so over 0:04:03.360 --> 0:04:06.520 the weekend they went short the US dock market and 0:04:06.600 --> 0:04:10.080 foreign exchanges until in the stock market opened on Monday 0:04:10.080 --> 0:04:13.320 at over nineteen there was a big drop, and right 0:04:13.320 --> 0:04:17.839 away portfolio on jurors had to sell more features contract 0:04:18.120 --> 0:04:21.000 and more of that got transmitted to the New York 0:04:21.080 --> 0:04:26.159 Stock Exchange, and they specialists on the exchange saw every 0:04:26.200 --> 0:04:29.279 major firm spending all of its runs to all of 0:04:29.320 --> 0:04:31.960 the posts, selling all of the docks, and the sci 0:04:32.600 --> 0:04:36.280 and the specialists didn't understand that this was all a 0:04:36.320 --> 0:04:39.760 mechanical things and they thought, you know, World War three 0:04:39.760 --> 0:04:41.960 had broken out somewhere and they didn't know about it. 0:04:42.080 --> 0:04:46.200 So they just dropped all their bids and went to launch. 0:04:46.240 --> 0:04:48.279 You went to the doctor or went to the bedroom 0:04:48.320 --> 0:04:53.720 where just basically wouldn't trade. So the monket just you 0:04:53.760 --> 0:05:01.640 know collapse, Uh, And it was all mistake a big 0:05:01.680 --> 0:05:05.039 mistake that now has to be cleaned up. In terms 0:05:05.080 --> 0:05:07.760 of government official at the time, it was probably the 0:05:07.800 --> 0:05:10.359 scariest time of them in my sixteen years at the SEC. 0:05:10.640 --> 0:05:14.520 That Monday and into Tuesday. This is Howard Kramer. During 0:05:14.560 --> 0:05:17.279 the crash, he was Assistant Director of the Division of 0:05:17.320 --> 0:05:20.960 Market Regulation at the U S Securities and Exchange Commission, 0:05:21.440 --> 0:05:25.200 or the SEC. I had oversight over all of the 0:05:25.279 --> 0:05:28.960 nation's securities exchanges, so that included both the stock exchanges 0:05:28.960 --> 0:05:31.400 and the options exchanges. He says he has a few 0:05:31.440 --> 0:05:34.320 sharp memories from that day. On the afternoon of the crash, 0:05:34.520 --> 0:05:37.680 Kramer went over to the Commodity Futures Trading Commission to 0:05:37.760 --> 0:05:40.960 talk about what was going on. Yeah, pretty distinctly remember 0:05:41.080 --> 0:05:43.679 being in the room and you know, as the stock 0:05:43.720 --> 0:05:46.760 market was tanking and thinking, you know, these these were 0:05:46.800 --> 0:05:51.039 commissioners who have experienced mostly in agricultural products and futures, 0:05:51.040 --> 0:05:53.560 and here we are discussing what's happening with the stock market. 0:05:54.440 --> 0:05:58.120 Another one was being in with some other senior staffers 0:05:58.360 --> 0:06:02.240 and one of them, Shares, coming down and trying to 0:06:02.240 --> 0:06:05.719 find out what was happening and then saying that he 0:06:05.880 --> 0:06:07.600 needed to call the White House. So they needed to 0:06:07.600 --> 0:06:11.200 call the White House. So they basically asked us to 0:06:11.240 --> 0:06:15.560 clear out of the room, and I did. It was 0:06:15.640 --> 0:06:19.279 so bad that the SEC decided to make a task 0:06:19.320 --> 0:06:23.120 force and immediately for the next few months study what happened. 0:06:32.160 --> 0:06:34.080 And that's what they do in the form of a 0:06:34.200 --> 0:06:40.240 massive report called October Market Break. David Ruder, who is 0:06:40.240 --> 0:06:42.440 the chairman of the SEC at the time, says the 0:06:42.480 --> 0:06:46.120 goal of the report was factual. The goal was to 0:06:46.480 --> 0:06:49.680 say what had happened. The goal was not in an 0:06:49.720 --> 0:06:54.400 advance to plan some result from the report. But the 0:06:54.480 --> 0:06:57.960 idea was to create a factual reconstruction of what happened 0:06:58.360 --> 0:07:02.920 and then to make suggestions based upon that report. And 0:07:03.520 --> 0:07:06.200 it was a long, arduous process. I'd say for the 0:07:06.240 --> 0:07:10.280 next three months through early January, a bunch of us 0:07:10.320 --> 0:07:13.160 had two jobs, which was, you know, investigating what happened 0:07:13.160 --> 0:07:15.680 and writing to report up and doing our day job. 0:07:15.840 --> 0:07:19.480 Did you get paid double for that? No, No, we 0:07:19.480 --> 0:07:22.880 didn't get paid double, uh I said. But from Thanksgiving 0:07:22.920 --> 0:07:25.000 a New Years the only day I took off with Christmas. 0:07:25.440 --> 0:07:29.160 Literally my wife still remembers that. Um No, it was. 0:07:29.400 --> 0:07:32.280 It was pretty intense period. So this report ends up 0:07:32.320 --> 0:07:35.800 being eight hundred and forty pages. It was thicker than 0:07:35.840 --> 0:07:38.840 the Manhattan phone Book, for sure, it was. You know, 0:07:39.120 --> 0:07:42.240 obviously we we sent a number of copies off the Congress. 0:07:42.800 --> 0:07:45.280 You know. It was available for a couple more years, 0:07:45.280 --> 0:07:48.760 and eventually it became a collector's item. I have two 0:07:48.760 --> 0:07:50.920 in my office. If anybody wants to bid for it, 0:07:50.920 --> 0:07:53.240 I'm ready to do it on eBay. Before Creamer could 0:07:53.280 --> 0:07:55.760 sell anything on eBay, we borrowed one of his copies 0:07:55.800 --> 0:08:02.320 to see it for ourselves. So it says October market break. 0:08:02.720 --> 0:08:04.760 It really is like a phone book. I mean it's 0:08:04.880 --> 0:08:08.080 that's exactly that. The feel. It's just all right, Joe, 0:08:08.120 --> 0:08:09.480 I'm gonna flip through it, just so you get an 0:08:09.520 --> 0:08:11.160 idea of how big this is. Right, So this may 0:08:11.200 --> 0:08:17.160 take a few seconds hanging there, still going. You're like 0:08:17.200 --> 0:08:24.520 halfway it is going. That was not quite halfway. It 0:08:24.560 --> 0:08:31.320 gets more dramatic as you keep going. Wow, I see 0:08:31.360 --> 0:08:40.280 some shirts. Wow, let's hear it drop. Yeah, take your 0:08:40.280 --> 0:08:43.040 pick of Harry Potter books to Harry Potter books side 0:08:43.040 --> 0:08:45.880 by side. That's about the dimensions. Let me go more 0:08:45.960 --> 0:08:50.320 high brow here. This is Warren Pace Squared. Oh yeah, 0:08:50.520 --> 0:08:54.600 nailed it. This thing. Yeah, Like my mom's five ft 0:08:54.679 --> 0:08:56.560 and she has to use this like little thing in 0:08:56.600 --> 0:08:59.360 the car. This is like what you could use if 0:08:59.360 --> 0:09:00.520 you were like an all even year old and you 0:09:00.600 --> 0:09:02.440 stole your parents car and you need to see you 0:09:02.440 --> 0:09:05.440 over the steering wheel. I mean it literally could be used. 0:09:05.440 --> 0:09:08.360 It's like a booster seat. Yeah. Could you imagine reading this? 0:09:08.760 --> 0:09:10.520 I will say the ends a lot of charts, Like 0:09:10.559 --> 0:09:13.120 I think the last two pages is charts and numbers, 0:09:13.840 --> 0:09:17.320 but I mean there is a lot of stuff, some footnotes, right, Yeah, 0:09:17.640 --> 0:09:19.880 And you're saying like one page of this is a 0:09:20.000 --> 0:09:22.760 huge piece of landscape here, I mean it's a big 0:09:22.800 --> 0:09:26.240 big I'm also thinking somebody was on a typewriter doing this, Yeah, 0:09:26.320 --> 0:09:30.040 I mean they had to be. What would it take Eric, 0:09:30.400 --> 0:09:33.320 This is a huge report. I can't imagine how long 0:09:33.360 --> 0:09:34.920 it would take you to read it. But what would 0:09:34.920 --> 0:09:37.280 it take you to be able to actually, like plat 0:09:37.320 --> 0:09:41.040 through this. I would probably need illegal substances to get 0:09:41.080 --> 0:09:43.600 through this thing. If not, okay on the legal side, 0:09:43.840 --> 0:09:47.199 a lot of coffee, a latte, and some were very 0:09:47.280 --> 0:09:52.400 quiet because the littlest distraction, the milk, anything that a 0:09:52.559 --> 0:09:54.559 noise in the attict would be like oh, let me 0:09:54.600 --> 0:10:09.360 go check that out, because I am not so what 0:10:09.400 --> 0:10:11.679 was in this big report we've been talking over. They 0:10:11.720 --> 0:10:14.160 just broke down what program trading was, They broke down 0:10:14.200 --> 0:10:16.600 what portfolio insurance was, They broke down what happened that day. 0:10:16.679 --> 0:10:19.200 That was the first part of the report. The second 0:10:19.240 --> 0:10:22.800 part gave suggestions about how a future crash could be avoided. 0:10:24.600 --> 0:10:27.520 But meanwhile, in downtown New York, you had the American 0:10:27.520 --> 0:10:30.960 Stock Exchange and this is an exchange that was in 0:10:31.120 --> 0:10:34.880 third place in trading. It had fallen down. The American 0:10:34.880 --> 0:10:37.080 Stock Exchange wee we'll call AMEX from here on out, 0:10:37.280 --> 0:10:41.440 was basically an exchange that was looking for a winner. 0:10:42.320 --> 0:10:46.120 And that's where Nate Most and Steve Bloom we're working together. 0:10:47.280 --> 0:10:50.600 These are market nerds. Okay, these are not like salespeople. 0:10:50.800 --> 0:10:55.319 They're not They're not portfolio managers. They are They're into derivatives, 0:10:55.320 --> 0:10:58.560 they're into data, they're into the exchange. So these market nerds, 0:10:58.800 --> 0:11:02.320 Nathan Most and Stephen Bloom are kind of an unusual pair. 0:11:03.160 --> 0:11:05.520 Most is seventy four years old at the time and 0:11:05.559 --> 0:11:09.400 he's the vice president of new Development at AMS and 0:11:09.440 --> 0:11:13.520 Bloom is just fresh from Harvard with a PhD in economics. 0:11:14.240 --> 0:11:16.520 Nate died in two thousand four, but we found it 0:11:16.520 --> 0:11:18.760 our reporting that he made a big impression on those 0:11:18.800 --> 0:11:22.559 he worked with. Arthur Levitt, who was running Amyx in 0:11:22.559 --> 0:11:25.480 the nineties, says he was blessed to have inherited Nate 0:11:25.520 --> 0:11:28.000 Most who at the time was trying to create products 0:11:28.040 --> 0:11:32.040 and trading mechanisms that would give AMEX a competitive edge, 0:11:32.480 --> 0:11:36.839 and to the extent to which PTS became a reality, 0:11:37.440 --> 0:11:41.960 I give of the credit to Nate. I can remember 0:11:42.360 --> 0:11:45.320 saying to him that if this is something he believes 0:11:45.360 --> 0:11:48.520 and it wants to do, he has my full support 0:11:48.720 --> 0:11:50.840 to go ahead and do it. And Nate Most had 0:11:50.880 --> 0:11:53.880 this eclectic background. He'd served in the Navy as a 0:11:53.920 --> 0:11:57.160 submarine engineer during World War Two, after where he worked 0:11:57.200 --> 0:12:00.560 as a trader for Pacific Vegetable Oil and then became 0:12:00.559 --> 0:12:04.000 president of the Pacific Commodities Exchange for a time. Oh 0:12:04.040 --> 0:12:08.480 he was great, he was wonderful. He was a tall man, 0:12:09.200 --> 0:12:12.760 and he was kind of not very he was kind 0:12:12.760 --> 0:12:16.480 of aw shucks almost. This is Kathleen Moriarty, who played 0:12:16.480 --> 0:12:18.520 a major role on the legal side of the story 0:12:18.800 --> 0:12:21.120 and worked quite a bit with Nate Most. I remember 0:12:21.160 --> 0:12:22.960 one time I was in a meeting with him and 0:12:23.040 --> 0:12:26.880 some Goldman people, and these guys who were probably like 0:12:26.880 --> 0:12:29.080 in their thirties looked at Nate and he had thick 0:12:29.120 --> 0:12:32.080 black glasses, and it was clear that they thought he 0:12:32.160 --> 0:12:34.959 was like somebody who didn't really know much of anything. 0:12:35.040 --> 0:12:36.719 So he went up to go to the men's room 0:12:37.080 --> 0:12:39.400 and they looked at each other and they said, oh, 0:12:39.480 --> 0:12:42.040 he's not a rocket scientist, and I said, actually, he 0:12:42.160 --> 0:12:45.760 is a rocket scientist. Yeah, he was literally a rocket scientist. 0:12:45.880 --> 0:12:48.760 The guy had a PhD in physics. And what's more, 0:12:49.080 --> 0:12:51.040 he's got the help of Stephen Bloom and Steve was 0:12:51.080 --> 0:12:53.600 his assistant. Steve was much, you know, much younger. He 0:12:53.679 --> 0:12:56.400 was probably, you know, somewhere around my age at the time, 0:12:56.520 --> 0:12:58.640 and you know, somebody who was, you know, at a 0:12:58.760 --> 0:13:02.079 very sharp mind for numbers and did a lot of 0:13:02.120 --> 0:13:06.480 the assistance and kind of secondary lifting for Nate. So 0:13:06.480 --> 0:13:08.320 they were a good team. They worked very well together. 0:13:10.240 --> 0:13:12.360 So you've got these two smart guys who have their 0:13:12.360 --> 0:13:14.760 work cut out for them and their roles at Amex, 0:13:15.280 --> 0:13:18.160 which has Levitt puts it, the animates was kind of 0:13:18.360 --> 0:13:22.560 and had been kind of a backwater exchange struggling for 0:13:22.679 --> 0:13:27.439 relevance and gradually losing listings to the New York Stock 0:13:27.520 --> 0:13:32.040 Exchange across the street. And no matter what we tried 0:13:32.080 --> 0:13:36.480 to do to compete against New York, the stature and 0:13:36.640 --> 0:13:41.280 status and prestige of New York managed to whittle away 0:13:41.360 --> 0:13:46.280 the listings that were the lifeblood of exchange. Here's Creamer again. 0:13:46.400 --> 0:13:49.800 To stay relevant, it had to continue to develop new products, 0:13:50.200 --> 0:13:54.439 particularly new options products or or options like products. Steve 0:13:54.480 --> 0:13:57.480 and Nate were behind that development initiative of the AMEX, 0:13:58.040 --> 0:14:02.160 so let's fit in pretty nicely into their sweet spot. 0:14:02.360 --> 0:14:04.959 I trying to come up with a product to stay 0:14:05.000 --> 0:14:09.560 ahead of of their competitors that may have some investor appeal. 0:14:09.880 --> 0:14:11.800 And what Kramer is referring to is a section in 0:14:11.880 --> 0:14:15.000 chapter three of the Market Brake Report with his suggestion 0:14:15.360 --> 0:14:18.400 for a market basket trading instrument that could be used 0:14:18.440 --> 0:14:21.480 instead of the futures to hedge and would be something 0:14:21.480 --> 0:14:25.560 that the SEC could regulate. So the market Brake Report 0:14:26.040 --> 0:14:29.280 makes its way to AMEX, and most in Bloom read 0:14:29.320 --> 0:14:33.040 through the whole thing. Bloom calls it riveting and one 0:14:33.120 --> 0:14:37.520 particular part especially caught his eye. When Bloom read that paragraph, 0:14:37.880 --> 0:14:39.480 you know, it was like a light bulb went off, 0:14:39.520 --> 0:14:41.800 you know. He told me that he ran into natemost 0:14:41.840 --> 0:14:45.080 office immediately and basically said, here's an opening we could 0:14:45.120 --> 0:14:47.200 drive a truck throw. We didn't feel like it was 0:14:47.240 --> 0:14:50.400 a panacea to what we were trying to address, but 0:14:50.480 --> 0:14:54.320 we felt it was. It was a novel idea, a 0:14:54.400 --> 0:14:57.480 panacea or not. Most in bloom go with it, and 0:14:57.600 --> 0:14:59.880 Kramer says, it's best that they or someone in the 0:15:00.000 --> 0:15:03.200 marketplace would take up the idea because it wasn't a 0:15:03.240 --> 0:15:07.280 regulatory proposal, so we were hoping that they would take debate, 0:15:07.360 --> 0:15:10.120 so to speak, and and run with it. And uh 0:15:10.360 --> 0:15:27.600 them X did. Next time, on Trillions Presents, most in 0:15:27.640 --> 0:15:32.320 bloom share their idea with maybe the most influential investor 0:15:32.480 --> 0:15:35.680 of all time, Jack Bogle, and I said, However, Nathan, 0:15:36.520 --> 0:15:39.680 Mr mos Nate, they proposing you sent me last week 0:15:39.720 --> 0:15:45.000 doesn't work. It has these three flaws and you're gonna 0:15:45.000 --> 0:15:46.560 have to get them fixed before you can never do 0:15:46.640 --> 0:15:53.280 anything with it. Thanks for listening to Trillions Presents Until 0:15:53.320 --> 0:15:55.760 next time. You can find us on the Bloomberg Terminal, 0:15:56.160 --> 0:16:00.280 Bloomberg dot com, Apple Podcasts, and whever else you Snip 0:16:00.280 --> 0:16:06.360 podcast Trillians Presents is produced by Jordan Bell. Francesco Levy 0:16:06.720 --> 0:16:21.280 is the head of Bloomberg podcast Back, Oh, one more 0:16:21.480 --> 0:16:25.120 tiny little Thing, here's any strike for you. I have 0:16:25.160 --> 0:16:26.800 a question when we send this back to him, would 0:16:26.800 --> 0:16:31.440 you buy it on e Bay? No, I'm not that 0:16:31.680 --> 0:16:33.520 I'm in deep, but I'm not that in deep.