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May Day

Tuesday, April 30, 1975. The day before what came to be known to people in financial services as May Day. I’m not sure if it was sunny or socked in with San Francisco fog. I had a lot on my mind. I do recall that investors had been in a good mood all spring. The Nixon impeachment nightmare was over, the Vietnam War was behind us, and the market was moving again; the Dow was up nearly 50% since late December. I’m sure I was as hopeful as anyone else. But I’d seen too much to believe the worst was over.

I was about to turn 38 in a couple of months. The Dow had been flirting with the magic 1,000 mark for the last 10 years, first breaking that milestone on November 14, 1972. At the moment it was hovering just above 800. So to say I was a tad skeptical of the rally’s staying power would be an understatement. On the other hand, if you’d told me then that not until December 21, 1982, would the Dow finally break through 1,000 for good, I might have said to hell with it and found another line of work. In fact, I had been right on the precipice of that decision for some time. Who starts a brokerage firm in the middle of a two-decade stock market slump? This was my third go at starting a business since I had set out on my own, shortly after finishing Stanford Business School. Part of me wondered, How many chances does one guy get in life?

What’s more, I was in a deep trough myself just then, carrying a six-figure debt. I owed money to Crocker Bank for a business loan I had used to buy out one of my partners. I also had a sheaf of personal loans that wound up in my pocket when I got divorced. I was now married again, but I had no assets to speak of. Helen and I were living with our baby, Katie, in a small apartment in Sausalito. Helen was selling real estate, while I was a year into launching my firm, an experiment in discounted stock trading made possible by the Securities and Exchange Commission’s test of deregulated commissions. I was bound for parts unknown.

That Tuesday, I had one overriding question. The answer would make or break my plans, as deregulation was about to become the law of the land after a one-year test period. What would Merrill Lynch do? Founded in 1914 by the legendary Charles Merrill, with a vision to bring “Wall Street to Main Street,” Merrill Lynch was the undisputed king of the retail brokerage market, and a billion-dollar-plus underwriter. It had branch offices from coast to coast, an army of thousands of highly motivated commissioned brokers, and a slogan known to everyone who watched TV or read the newspaper: “Merrill Lynch is bullish on America.” Charles Merrill had built his firm on the idea of opening up the world of investing to the middle class. It was a goal I admired. He was the first to experiment with salaried brokers back in the 1940s, addressing the serious conflict of interest that I had disliked for years (they backtracked from that model in the early ’70s under Don Regan’s leadership to incentivize its large herd of brokers). And the firm was hugely successful. Everybody said to me, “Wait until Merrill Lynch decides to go into your business. You are going to be crushed.”

I was worried, but Merrill was an entrenched member of the Wall Street establishment. It was still beholden to its many commissioned brokers, and its highly profitable investment banking and research businesses. It couldn’t just chuck all that out the window. Still, the more I thought about it, the more I was certain that Merrill would have to lower its commissions at least a little in response to deregulation. In which case, I feared, I’d be dead in the water as soon as I launched my business. No way my little firm could compete with an industry giant like Merrill.

All that was on my mind when I arrived at 120 Montgomery Street that Monday morning, early as usual (I liked to be at my desk by 6:30 a.m. when the market opened in New York); I took the elevator up to the 24th floor and the small office the handful of us occupied. I picked up my copy of the Wall Street Journal, and there on the front page was the news: “Merrill Lynch will raise securities brokerage fees on most transactions under $5000.” Was it true? “. . . will raise securities brokerage fees . . .”

Unbelievable. Here I’d been afraid that Merrill would lower its fees and meet my commission cuts and steal my opportunity. Instead, it had taken advantage of deregulation to raise its prices for the average guy and drop them for large institutions. Once I got over my shock, I was beaming. I saw an opportunity, and I meant to take full advantage of it. It had been a long road, with lots of bumps along the way. But on that day, Charles Schwab looked like it had a real chance in the marketplace. I remember saying to myself, I’ve got a hell of a business.

I have loved the idea of investing since I was a kid and my dad first showed me stock tables in the local paper. The idea that stocks captured a little bit of the magic in our economy and, if you worked at it, you could participate in that . . . well, that caught my imagination. That was exciting. Today, I remain more convinced than ever that investing is the individual’s path to financial freedom. It is how people can participate in a growing economy, beyond just earning a paycheck. I’m an optimist. And investing has always seemed to me to be the ultimate act of optimism. You’ve got to have confidence that the money you invest today is going to grow; otherwise, you might as well stuff it under the mattress. You have to believe tomorrow will be better than today.

But back in the ’70s when I was starting Schwab, I knew investing was deeply flawed. And I thought investors deserved better. Access to the markets came with outrageously high costs—average commissions and spreads could eat up nearly 10% of an investor’s money! Mutual funds, which pooled investors’ money together to be invested by a professional money manager, often carried 9% sales loads. That meant you needed to earn 9% on your investment before you’d break even. So much of those high costs were claimed to cover the “advice” that you were getting. But was it good advice, or just the price of entry? Wall Street had controlled commissions from its very first day under a buttonwood tree in 1792, where its founding members had established the New York Stock Exchange and agreed to do business only among themselves, and to never negotiate commissions.

So in a real way, Charles Schwab was born of my own frustration. I was an independent investor. I was passionate about the market. I did my own stock research. I believed in taking charge of my own financial destiny. I loved the thrill of the chase. The last thing I needed was some broker’s questionable advice about what to buy, and when to buy or sell. And I resented paying for services I wasn’t using. I was also deeply frustrated. For I had come to believe that the brokerage business had a nagging problem with conflicts of interests. I knew that the Wall Street big brokerage firms that were also investment banks—despite their so-called Chinese walls—couldn’t easily put the interests of individual investors first. The same was true for commissioned salespeople, many of whom made their living by trading in and out of stocks—not by building up their clients’ portfolios. Not their fault: it was just how the system worked.

But a new day had arrived. After years of mounting pressure for reform, the Securities and Exchange Commission (SEC) had begun a bold experiment aimed at dismantling the century-old Wall Street cartel. Under the old system, fixed brokerage commissions were held in place by a web of regulations that carried the full weight of law. If you made a trade, you paid a high price, and the price was fixed. Or maybe not, this being Wall Street. Small traders had zero leverage, but big traders were getting bigger and had plenty of leverage, and lately they’d begun to use it. They had worked out an elaborate system of special favors, hidden discounts, side deals, and mutual back-scratching—anything to lower the cost of trading. Take, for example, the four-way ticket, a crazy system that broke commissions up into pieces, with the proceeds spread around to provide some benefit to the large institutions making the trades. In a four-way ticket, an institutional investor such as a pension or a mutual fund, would buy 10,000 shares of a stock, for example, with a commission that might have been, let’s say, $1 a share. One-fourth of that $10,000 commission would go to a research firm, who would provide proprietary research back to the investor; another quarter would go to reimbursing the investing institution for travel, under the auspices of “education”; another fourth went for entertainment such as a night out at a game or club, or a fancy dinner. And the last fourth would go to the brokerage. The same was true for a larger transaction of 100,000 shares. Only in that case there would be a $100,000 pie to be divided.

By the early 1970s, the system had become unwieldy. Something had to give. Institutions didn’t like it, the SEC didn’t like it, and Congress got involved. Bottom line: the power of the big traders was growing; the New York Stock Exchange was buckling under enormous pressure. Change was inevitable.