Editor’s Note: The Sarbanes-Oxley Act of 2002, which President Bush signed into law on July 30, is designed to increase corporate responsibility. It is a step in the right direction, but it fails to address the central role played by Wall Street. Some CEOs and CFOs may go to jail, but, as usual, the people pulling the strings in Washington and Wall Street will get off Scot free.
As the world economy approached the New Millennium, crossing the Bridge to the 21st Century, a “New Era” was heralded: The unprecedented economic growth of the 1990’s was going to continue into eternity. The invisible hand of free markets, led by the revolution in information technology, seemed to promise no end to innovation, profits, and wealth for shareholders in the world economy and the United States in particular.
Today, however, the stock market is foundering, and the U.S. economy, mired in a recession accompanied by a falling dollar, rising energy and gold prices, and a continuing hemorrhage in the balance of trade, appears to be following the Dow. What has happened to change our outlook so abruptly? The answer is to be found in some fundamental realities about Wall Street, the United States economy, and human nature.
Socialists, libertarians, and conservatives have differing views on many economic questions, but they agree on one point: Greed drives the free-enterprise system. Socialists rail against the “unconscionable greed” that will lead, ultimately, to economic and social collapse; libertarians celebrate “unbridled greed” as the driving force of self-correcting markets; conservatives advocate “enlightened greed,” restrained by a social conscience. Greed, when practiced on the scale of Wall Street, is not simply the ordinary overindulgence in food, drink, and other comforts of life. It is more than the compulsion to squirrel away savings to secure a certain standard of living, overindulgent or not. What drives Wall Street is something else again: a craving for ever-increasing wealth; the power that comes with controlling markets and enterprises; and, particularly, the lust for luxuriating like royalty.
While other major commercial centers (including London, Paris, Tokyo, and Hong Kong) play key regional roles in directing the free-enterprise system, the acknowledged world capital is Wall Street. Here, prominent investment bankers and their entourages operate the capital markets that are the prime movers of the American and world economies. To these temples of financial power, Wall Street attracts the best and brightest—and greediest—people money can buy.
History attests to Wall Street’s achievements in financing the railroad, steel, and other great industries of the past. But Wall Street has also had its periods (the “Roaring Twenties,” for example) when its excesses impaired its credibility and ability to function. During the 20’s, a “New Era” mentality pervaded, and financial assets soared—particularly the U.S. stock market. This growth was fed by speculation, manipulation, and fraudulent accounting. The buoyant stock market drew excessive funds from American and foreign accounts, which had often been recklessly leveraged. When it became apparent that the inflated values of common stocks far exceeded rational values, the stock market collapsed. The Federal Reserve panicked and belatedly tightened the money supply, causing the banking system and the economy to collapse as well.
Inevitably, the socialists prescribed the solutions: the Glass-Steagall Act of 1933, which broadened the emergency-lending capability of the Federal Reserve Bank and its regulatory powers over holding-company banks; the FDIC, established to insure bank deposits and the soundness of national banks; and the Securities and Exchange Commission, established in 1934 to regulate the issuance of securities and the financial reporting of corporations and to prevent market manipulation. These innovations did restore order, but the socialists went on to create the Reconstruction Finance Corporation, the Works Progress Administration, and a host of other regulatory commissions.
The parallels between 1930 and the present—in the conduct of Wall Street and the current economic imbalances in the world economy—are scary. Wall Street investment bankers who set a value on tens of trillions of dollars of stocks and bonds have degenerated, once again, into shortsighted hucksters. Pressured by underwriters to maximize the market value of their securities, corporations overstate current earnings and supply unrealistically optimistic forecasts of future earnings. Analysts endorse these forecasts in order to support their companies’ related underwriting activities. The “Big Five” accounting firms (soon to be “Big Four,” with the demise of Arthur Andersen) certify balance sheets with undisclosed off-balance-sheet liabilities, “restructuring” write-offs and costly stock options that bypass income statements, and bogus revenues. The overall effect is to overstate real earnings and shareholder equity grossly. Prominent law firms sign off on these distorted statements, and the SEC observes all of this with hardly a murmur.
The results are disasters such as Enron, which created the fifth-largest market value in the world in a mirage of
creative accounting, and now the bankruptcy of WorldCom, which understated its costs by four billion dollars. How does that square with Wall Street’s role as
the pre-eminent securities market inter-
nationally, or the perception that the American securities market is the most transparent, best audited, and least manipulated in the world? What consequences does that imply for the continuing ability of the United States to consume beyond its means by financing a $300- to $400-billion trade deficit each year, sold to foreigners on Wall Street?
Congress (in thrall to campaign contributions) proudly accommodated the relentless pressures of the financial community by passing, in 1999, the Gramm-Leach-Bliley Act, which revoked the 1933 Glass-Steagall Act prohibitions against holding companies combining banking, insurance, and securities underwriting. Once again, the three most leveraged industries can merge here and abroad. Fortunately, the Basil Accords have required both American and international banks to maintain reasonable capital-to-liability ratios in order to create a more stable banking system. But the fact that major American banks hold $37 trillion in derivatives suggests that current capital-to-liability ratios are not adequate. Financial institutions engaged in too much leverage and speculation once again pose a serious risk to economic stability, as the collapse of Long Term Capital Management demonstrated.
Also contributing to bloated share prices in security markets is the lack of information available to individual investors when they are purchasing common stocks. It can be difficult to get more from a major brokerage house than simplistic descriptions of stocks, market prices, and “total return” (dividends plus appreciation) levels. Such vital information as earnings per share, book value, cash flow per share, net working capital per share, debt to equity, and coverage of obligations is usually not available. Thus, the sheep are herded into “momentum investing” (what goes up, goes up) instead of critical “value investing.”
Just as in 1929, the Federal Reserve Banks created to ensure orderly growth of the money supply have, instead, joined the stock market’s party. Excess growth of the money supply since 1997 has created a stock market bloated to dangerous levels not previously reached even in 1929. Although the stock market led the economy in the 90’s, it will be a retarding influence this decade—our much deserved hangover.
The most flagrant misrepresentation of performance data by brokerage houses has been the covert conversion of price-to-earnings data from price-to-actual-earnings per share to price-to-forecast-
operating-income per share (excluding
interest, taxes, restructuring allowances, and dilution of options). This makes bloated prices look more normal compared to the past. Deceptions of this nature have contributed significantly to the flow of funds to brokerage houses from banks, in exchange for stocks of dubious value.
As gullible investors, drawn in while the markets topped and sagged, contemplate their shrunken retirement savings, they may well turn into a dangerous political force. America may be headed for another crisis of confidence in the private sector, as happened in the 30’s: It is a wonder that enterprising attorneys have not yet launched class-action suits on behalf of individual investors against the major brokerage houses. The Merrill Lynch suit brought by the state of New York for conflicts of interest in analyst recommendations ought to be the tip of the iceberg—and the settlements should reflect the hundreds of billions of dollars that have been swindled.
Where have the regulators been while all this was taking place? The SEC is supposed to ensure that financial reports are representative and that security issuance and trading are subject to full disclosure. Also, insider trading is supposed to be promptly reported, and markets are not supposed to be subject to manipulation. Yet, typical of government agencies, the SEC has provided the appearance rather than the substance of oversight. Clearly, any faith in government regulation is misplaced, and investors must turn to the law for what meager satisfaction it may provide.
Wall Street’s lions have been gorging themselves. The deterioration of standards on Wall Street has led directly to the creation of Enron, WorldCom, and “dot-com” excesses that have seriously harmed the economy and diminished the savings they have solicited from average Americans.
The investment bankers and their collaborators are not the only ones who created the bogus values on Wall Street. Corporations, from penny-stock startups to Fortune 500 blue-bloods, have issued an avalanche of phony income statements, overstated assets, understated liabilities, and unreal forecasts of performance. Their CEOs and CFOs, and their auditors and attorneys, know what they are doing. It is an appalling indictment of contemporary morality that their check-and-balance functions do not function, despite the fact that it would require only one of the four to expose corporate fraud and deceit.
The relentless demand for impossible standards of profitability and absurd predictions originates with the corporate overlords of Wall Street. Their lust for commissions and huge gains on their underwriting, supported by their corporate subjects’ desire for appreciating stock options, is behind the Gross National Greed that drives the excesses of U.S. equity and capital markets.
If the free-enterprise system is to survive, this level of greed cannot be tolerated. In the best interests of the public, the laws of legitimate disclosure and stewardship must be tirelessly imposed and enforced on Wall Street and the corporations whose securities it trades. Given the scale of the rewards earned in capital markets, it is not unreasonable to expect that a comparable scale of punishment be inflicted on those who do not play by the rules.
The investment process is critical to the health of the economy; it is the engine of rising employment and living standards. Sound, long-term investments, not short-term speculations and misrepresented values, are needed to serve this vital role.
The Gross National Greed of investment banking must be subject to ethical and legal standards and to the creation of real value in the long-term interests of the general public. Otherwise, everyone will pay the price in yet another wave of regulation, confiscation, and perversion of the efficiency of genuinely free markets.