Once upon a time, in both New York (before 1933) and London (until about 1980), there was a financial services business with very little regulation. Common law principles of theft and fraud deterred the worst crooks, and for the rest, the overriding principle was "caveat emptor" -- let the buyer beware. The buyer of financial services was expected to know the reputation of the seller, and to act accordingly as a prudent man should. If a financial services industry participant gained a reputation for shady dealing, his career among thoughtful clients and top tier business partners was finished. As the great J. Pierpont Morgan testified before Congress in 1913, questioned by Samuel Untermyer:
Untermyer: "Is not commercial credit based primarily upon money or property?"
Morgan: "No sir. The first thing is character."
Untermyer: "Before money or property?"
Morgan: "Before money or property or anything else. Money cannot buy it...because a man I do not trust could not get money from me on all the bonds in Christendom."
It was a very different world, but one in which small investors, provided they dealt with a reputable house, had considerably more protection than they have today.
For illustrations of where regulation can fail, consider some of the scandals of the last couple of years:
-- Mutual fund late trading, in which hedge funds traded with major mutual fund groups on a short term basis at closing prices that were already out of date in the light of post-closing events. Public pension funds pulled more than $4 billion in investments from Putnam Investments, one of the leading fund groups implicated, in one week in November 2003, after which Putnam's chief executive Lawrence Lasser was forced to resign. A satisfactory market based outcome, in other words, in which regulation played no part since "late trading" had not been thought of when the regulations were drafted.
-- The ImClone insider trading scandal, in which Sam Waksal, chief executive of ImClone was jailed for 7 years for insider trading -- for knowledge of a Food and Drug Administration ruling that should never have been issued, since it delayed by 2 years the availability in the United States of Erbitux, a drug effective against advanced and generally fatal colo-rectal cancers. Waksal appears to have been one of the few entrepreneurs of the 1995-2004 period who created something of lasting and important value.
-- The Martha Stewart case, in which Stewart is being prosecuted, not for insider trading, since she had no fiduciary relationship with ImClone Systems, but for propping up the stock price of her own company, Martha Stewart Living Omnimedia, by protesting her innocence of insider trading. So far, stockholders in Martha Stewart Living Omnimedia have lost through the adverse publicity several thousand times the amount of Martha Stewart's non-insider traded gain.
-- Ray Dirks, the analyst who exposed the 1973 Equity Funding insurance swindle -- and was prosecuted by the SEC for telling his clients of his own analysis before he told the market -- is again in trouble, and possibly facing final ejection from the market. He is accused of "pumping" (whatever that means) penny stocks to retail investors. The fact that the principal stock he is accused of "pumping," Transmeridian Exploration, is currently selling at three times the price at which he recommended it is of no importance, it seems.
-- Enron, in which middle management was enriching itself illicitly at stockholder expense, illegal under any financial system since and including the South Sea Bubble of 1720. Meanwhile top management was losing money for stockholders, certainly, but through derivatives trades of such complexity and elegance that not only could regulation not have prevented them, but top management itself was completely unaware until close to the end that the entire edifice was a house of cards.
-- Fannie Mae, the huge government-sponsored home mortgage corporation, lost over half its capital in 2002 through similar derivatives trades, reported "off balance sheet" and therefore hidden from all but the most knowledgeable and conscientious investors -- who, if they sold the stock short, lost their shirt. Fannie Mae's stock price has substantially risen since the event, nobody appears to have lost their job, and Fannie Mae's credit rating remains AAA.
-- Parmalat, the Italian food company, which slid into bankruptcy after it was revealed that the company had concocted a fictitious bank account, with a balance of more than $4 billion, thus creating an entirely spurious solidity in its income statement and balance sheet, all of which had been audited according to Internationally Accepted Accounting Principles by the major international auditor Grant Thornton. Even the simple rules, that a publicly traded company must publish an audited balance sheet and that bank statements must be verified by the auditors, were no help there, it seems.
Even when no illegality has occurred, investors still get fleeced. Companies such as Cisco and E-Bay have paid out more in value to their management in stock option profits than their reported earnings, all of it without affecting the income statement -- after management remuneration, the two companies have run at a substantial loss since their inception and, taking one year with another, continue to do so. The Financial Accounting Standards Board is attempting to rectify this problem -- but the timetable for the implementation of new accounting standards slips further and further back, as the tech sector lobby puts pressure on its favorite senators, who in turn put pressure on the FASB.
Even more important than stock options, the total of "extraordinary items," costs debited directly against capital and not passing through companies' income statements, has rocketed in the last few years. In the middle 1980s, it averaged around 5 percent of reported earnings for the Standard and Poors 500 as a whole, now it averages around 40 percent. Of course, the frequency of corporate restructurings has increased, so one would expect a greater level of one-time write-offs. Nevertheless, when the S&P 500 is considered as a whole, these items are not "extraordinary" at all, but occur on a regular basis in every quarter. Hence around 40 percent of reported S&P 500 earnings are "water" in the sense that they do not represent value to stockholders; combine this with the stock options problem and you can see that S&P 500 reported earnings of just over $50 are about double the true level that actually accrues to stockholders and could potentially be paid out as dividends. Thus the stock market currently trades on around 45 times true earnings.
Regulation is useless, far too slow to catch up with the various fraudulent schemes, and the stock market boomlet of 2003-04 has brought back all the scams and gullibility of the bubble years. As the pace of trading in the market has grown ever faster, the traders ever younger and more aggressive, and the rule-makers ever more hopelessly in arrears, investors are increasingly considered as "marks," existing only to be defrauded under some illicit new scheme. Any distinction between high quality houses and bucket shops has been lost, as practices are shaved to the minimum legally necessary, rather than raised to preserve the institution's good name. Every now and then the authorities move in, whether or not an explicit law has been broken, and a trader or market participant is given a swingeing jail sentence. Alternatively, the trial lawyers hover greedily in the wings, seeking carrion wherever they can get it.
The randomized threat of imprisonment or bankruptcy greatly increases the risk and unpleasantness of the securities business, and makes it less and less likely that the honest and conservative will enter it. For the "sporting-minded," of course, the rewards are sufficient to make the risks worth it.
This type of environment has been seen before; lovers of old Broadway musicals will recognize it as that of Damon Runyon's classic "Guys and Dolls," based on the career of New York crime kingpin Arnold Rothstein, whose life as the "Thomas Edison of crime" (as one reviewer called him) is lovingly set out in a new biography ("Rothstein" David Petrusza, Carroll and Graf Publishers, $27.)
Rothstein ran a huge gambling empire, enormously profitable, generating revenue from intermediating pretty well every illicit activity in New York, and making sure that none of his business partners ever knew what his real game was. His "fix" of baseball's 1919 World Series was Enron-esque in its complexity, involving no fewer than three teams of gamblers placing bets and attempting to bribe the Chicago White Sox players; it was also Enron-esque in its collapse, causing disaster to Chicago players and innocent bystanders but allowing Rothstein himself the remain at liberty with a substantial overall profit. Over and over again, laws were passed attempting to curb his activities, but they merely caused him to change his style of operations, moving from a fixed gambling casino in Manhattan to mobile "action" in its major hotels, and making another huge fortune from the onset of Prohibition, by which he gave Meyer Lansky and "Lucky" Luciano their start in life.
Recognize it? Investing in today's stock market is like playing poker with Arnold Rothstein -- you may even win in the short term, but in the long run it's an intrinsically unprofitable activity. However, just as you were unlikely to profit from hoping that the New York legal system would curb Rothstein, so investors are unlikely to gain a fair deal through regulation, when the ethical standards of the market are so low, and the profit opportunities from chicanery so enormous.
There will come a reckoning, and it will be both financially painful and psychologically shattering for those investors who have trusted a system corrupted by the easy money of the 90s. Eventually, the huge wave of Fed-created liquidity that is sustaining the markets will dry up, the poker game will end, the Rothsteins will vanish and investors will be left with only losses. Needless to say, the backlash against Wall Street that this will cause will be enormously politically powerful, and even more economically damaging.
The solution is not to write off capitalism as a hopeless casino where crooks get rich and the suckers get fleeced, it is to recognize that regulation cannot in reality protect investors if they deal with financial institutions driven by their trading desks to exploit every angle for a fast buck. Before the regulatory wave of the 1930s in the United States and the 1980s in Britain, for those investors who made sure to deal with top quality institutions: J.P. Morgan, the First National Bank, Kidder Peabody and the Boston money managers (or Schroders, Rothschilds, Hill Samuel, Warburgs, Hambros), their money was both safe and earned a decent return. Only investors dealing with "bucket shops" entered the world of Damon Runyon and Arnold Rothstein and lost their money.
As Morgan would have told you, regulation is absolutely no substitute for character.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long 90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica press, April 2004) -- details can be found on the Web site greatconservatives.com.
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