this writing, the United States is attempting to recover from a liquidity panic
of a breadth and depth unprecedented in our financial history. Much of the
financial chaos has resulted from some intrinsic difficulties in our financial
system as to the accurate determination of the value of enterprises and,
consequently, of interests therein, i.e.
“securities.” Most of these intrinsic difficulties are of long standing,
but the recent development of new securities instruments seemingly unmoored to
underlying assessable values has exponentially compounded the traditional
of the early methods of valuing an enterprise was to liken it to a debt
instrument, such as a bond, paying interest at a stated rate at predictable
intervals. The question as to what
the value of a predictable stream of future payments might be worth, in the
case of a bond, could easily be determined by simple calculations amounting
essentially to inverting the stream of future bond coupon payments and reducing
it to a single amount one would pay for such an income stream to yield a single
value called the “discounted present value” of the bond payments. Also, because
the “discount rate” or interest rate to be paid on a bond could be “risk
adjusted” by raising or lowering the required rate to account for varying risk,
the “discounted cash flow method” became the preferred method for bond
financial industry recognized that the “discounted cash flow method” also could
be applied to value a stream of anticipated future dividends from a
corporation, for example, to yield a risk adjusted valuation for the operating
enterprise. Such a measure was a far more accurate measure of what an
investment in a company or enterprise was worth to the investor than, for
example, the original cost or even depreciated cost of its assets – which
in practical terms would not be relevant until liquidation, or the “market
value’ of the enterprise.
contrast, “market valuation” of a large operating enterprise is inherently
difficult, since purchases and sales of very large enterprises are rare and
heavily negotiated and dependent upon special circumstances. Furthermore,
trying to value a huge enterprise via the alternative market valuation method
produced by daily trades of relatively small volumes of stock on an emotionally
driven securities exchange may not tell you much about what the whole
enterprise is worth.
this discounted present value valuation method veered into abstraction,
however, was when it was applied, not to a discounted stream of future
dividends, which are after all concretely measurable
style="mso-spacerun:yes"> on a cash on cash basis, but
to a discounted stream of future
company earnings, some or
none of which might be distributed or distributable as dividends.
style='mso-bidi-font-weight:normal'>Earnings, while existing for tax
purposes, are essentially abstract non-cash algorithms, subject to manipulation
through the application of concepts of taxation and accrual accounting
which became ever increasingly complex as income taxation of enterprises
began to provide an ever increasing share of governmental revenues.
market crash of 1929 and the great financial depression which
followed gave rise to the perceived need for more government regulation
of the financial markets. In addition to a great number of banking regulatory
laws passed between 1932 and 1940, the Securities Act of 1933 and the Securities
Exchange Act of 1934 were enacted principally to provide some transparency to
the financial markets by requiring most large enterprises raising capital from
the public to register their “public” shares with the Securities and Exchange Commission
(“SEC”). Thereafter, the securities acts required such registered enterprises
periodically to provide full financial disclosures in the form of financial
statements to the SEC and the investing public, including holders of their
compensate for the inherent abstraction and manipulability of the “earnings”
and other financial information provided by SEC-registered enterprises in such
periodic financial filings, the securities acts required that registered
companies hire outside “Certified Public Accountants” to certify as to the
soundness of the accounting methodology used to generate the financial
information filed. The obvious flaw in this creation of a new class of
accountants to police the SEC registered enterprises was that such accountants
thereby became accountable to the investing public for the defalcations of the
very clients which paid their fees. Thus, a suboptimal
solution to correct for the valuation abstraction of the “earnings” concept
helped to lead to the liquidity panic facing us today – a panic caused in
substantial part by the inability of investors and markets to determine the
true value of
enterprises and instruments relating thereto.
2. Emergence of New Models
for Corporate Governance and Management Compensation._________________________
United States, having converted virtually its entire industrial capacity to
production of war material, emerged from World War II the indisputable world
industrial leader. Rapidly converting its productive capacity to production of
consumer goods, U.S.–based industries sold vast quantities of consumer
goods and industrial equipment of every kind in the U.S. and abroad.
this process of economic expansion, a new breed of war
seasoned managers emerged. As the economy and profits boomed, more and
more of them began to subscribe to the economic philosophy of Milton Freedman
and the “Chicago School” of economics. The University of Chicago had built the
bomb, after all. Chicago’s economists were probably correct in thinking that,
if the government could just manage monetary policy, industry could function
well without much regulation.
that this thinking comports well with the idea that mathematical concepts and
algorithms, such as “earnings,” essentially are constructs to be manipulated by
trained managers. As this new class of financial managers came to dominate
American businesses by the late 1960s, commentators like John Kenneth Galbraith
began to write books and articles pointing out that businesses were being run by
an infrastructure of managers largely insulated from ownership
parallel trend was that the record profits generated by postwar industry began
to be siphoned into vast funds of pension monies and investment trusts held for
the benefit of American workers and managers. Relatively new financial
instruments, such as mutual funds, money market funds, variable annuities,
hedge funds and private equity funds, began to be used as investment vehicles
by the industry and government trustees entrusted by the work force with
stewardship thereof. Such funds were in fact managed by members of the new
class of financial managers who began earning huge fees based on the increasing
size and volumes of enormous sums managed which grew as American industry
burgeoned and the stock market continued to climb.
the late 1980s, these fund managers began to worry that American industry,
which by now faced massive competition in the world markets from foreign-based
companies, might not be able to continue to grow fast enough to justify the
ever growing fees they were earning – mostly in secret since fund
disclosures tended to be marginal at best and industry practice was to bury all
of the fees generated as deeply as possible in any required disclosures.
such as Nell Minnow, who purported to be looking out for the pensioners and
retirees, began publicly to castigate American managers for being too stogy,
not earning enough for the shareholders, and not being aggressive enough in
their financial management. She even began taking out ads in publications like The
Wall Street Journal identifying the underperforming management teams by
name. If only these managers were as dependent on company performance for their
livelihood as the poor shareholders, maybe they would manage better and
generate more money for investors.
course the poor shareholders were not really the people most immediately
concerned, since most investments were by then held in funds by fund managers
who held the investments in their “street names.” “Shareholder democracy” had
become a paper tiger, but fund managers could make or break a company’s stock
price. They were the constituency to which corporate boards of directors and
their appointed business officers and executives really were accountable.
for the fund managers and financial industry, industrial managers loved the
idea of making what their counterparts in the financial management arena were
making. They promptly began granting themselves stock options, warrants,
incentive shares and huge incentive bonuses for managing businesses the returns
of which were not increasing in real terms.
however, could be increased in order to justify the new compensation schemes.
During the period of the “dot-com bubble” of the 1990s, this increasingly was
accomplished by a number of subterfuges, many of which were virtually
undetectable until a company literally ran out of cash. “Virtual” sales and
accruals could create an illusion of increasing “earnings” in a hollowing out industrial infrastructure in
which little investment in American innovative productive capacity was being
made by U.S.-based industries. Much of this “creative accounting” did not
violate the “generally accepted U.S. accounting principles” applicable at that time.
result was an enormous shift of corporate ownership from the former owners to
the newly capitalized managers, who now were being compensated better than all
but the most aggressive investment bankers and hedge fund operators.
good deal of this compensation was actually financed by substituting debt for
the disinvested equity transfers to managers. Funds sent abroad to purchase
foreign made consumer goods were being lent back to the U.S. financial system
and could be borrowed by American businesses at fairly low interest rates. The
executives also helped to finance these equity transfers to themselves
by effecting massive disinvestment in U.S. based productive infrastructure and
moving productive operations abroad.
was particularly advantageous for these U.S. companies to operate in the
emerging economies on the Pacific Rim, which could be counted upon to supply
and finance plant and equipment as well as to furnish attractive labor
contracts in exchange for the latest American technology accompanied by little
or no capital investment by the U.S.-based companies.
workers in the U.S complained that their jobs had been eliminated, the
invariable answer was that automation and foreign competition were to blame.
The managers neglected to point out that it was cheaper to automate overseas
when your foreign partners financed both the labor force and the new investment
required, whereas in the U.S., new investment might require that some of the
billions being looted by management from U.S. companies in the form of
executive compensation might have to be diverted to investment or reinvestment in
wealth and job creating venture here in the United States..
investors in the U.S. were not deluded by this, and, during the late 1980s and
throughout the 1990s, flocked to invest in their own industrial operations in
a day of reckoning as regards all the abstraction and misdirection in our
financial system was fast approaching.
us now fast forward from the great depression and the creation of the
securities regulatory model, through the post war boom and the increasing
abstraction of the “earnings” concept, and the shift of ownership and control
from investor owners to fund managers and company managers who increasingly
“managed” for personal gain, to the Enron crisis of the new millennium and its
progeny, including our current liquidity panic.
you may recall, was a company trading in and brokering energy futures related
securities and derivatives which turned out to have been highly speculative,
all the while producing glowing financial reports indicating stellar and
ever-increasing “earnings.” These financial reports were
audited by the large and well-respected public accounting firm, Arthur Andersen.
Enron’s reported “earnings” were revealed to have been illusory all along only
when Enron literally ran out of cash. Millions of investors lost everything.
the aftermath, Arthur Anderson, which had in fact been auditing Enron’s financial
statements in accordance with then acceptable accounting standards, but which
also had been making large fees as a business consultant to Enron, was sued,
found criminally liable at one point (its convictions were later reversed on
appeal), suffered numerous private investor lawsuits and was forced out of
the main, however, the central problem presented by the Enron situation and its
purported resolution was that neither Enron nor its accountants really had
strayed far from the existing accounting rules and standards. True, Enron
management had taken enormous financial risks, but most Enron executives
probably had not realized how risky the company’s position really had become.
style="mso-spacerun:yes"> Arthur Andersen, it turned out, had made
a real mistake in trying to act as both auditor and consultant. There were some
eventual convictions of Enron executives and some evidence was developed that
at least some of the Enron managers really had behaved fraudulently. Primarily,
though, Enron and its accountants had been playing by the rules as they
understood them in a rapidly developing and expanding market comprised of new
financial products nobody fully understood.
any event, remediation clearly was indicated and once it was revealed that
Enron had participated in a great number of undisclosed off-book
class=GramE>investments which had added greatly to its financial risk,
there was pressure for stronger, more inclusive oversight of corporate
management. For one thing, the remaining large public
style="mso-spacerun:yes"> accounting firms had no intention
of being forced out of business the way Arthur Andersen had been for
defalcations of corporate management in hiding behind accounting rules by
failing to disclose important risky investments to auditors and the public. If
the accountants were going to avoid being blamed for the failure of corporate
managers, there needed to be a law making company managers directly and
personally liable for the accuracy of their books. The SEC completely agreed.
The SEC had been demonstrated to have exercised ineffective oversight over a
major company and did not wish to be embarrassed again.
a new financial oversight law was passed,
Act of 2002," Public Law 107-204, 116 Stat. 745, United States Code (2002)
Sarbanes Oxley required, among other things, that companies form audit
committees from amongst the members of their boards of directors and that this
committee and certain corporate officers should sign off upon and be personally
liable for the contents of the financial statements of the company. One
intention of Sarbanes Oxley was to give responsible corporate officers and
board members incentives to disclose off-book risks they might otherwise seek
to avoid mentioning to auditors, the SEC and the investing public. An
unintended consequence was that Sarbanes Oxley let board members not on the
audit committee essentially evade liability for faulty financial statements.
yet another attempt to tighten financial regulation, the accounting profession,
with the active collaboration of the SEC, in 2007 mandated compliance with
Financial Accounting Standards Board (“FASB”) Statement No. 157 “Fair Value Measurements”, which became
effective for entities with fiscal years beginning after November 15, 2007.
This so-called “Mark to Market” rule was designed to make sure that where the
values of assets held by enterprises changed in value, the balance sheet
valuation would be altered to
reflect such new valuation, rather than historical costs. Originally used to
regulate the collateral needed to maintain loans on margin trading accounts,
mark to market accounting had been used by the Enron management
style="mso-spacerun:yes"> to value seldom traded derivative assets
by marking them to a hypothetical market created by computer modelling. FASB
157 was designed to prevent this by requiring that financial products be marked
to actual trades.
lang=EN style='mso-ansi-language:EN'>Consequences of Sarbanes Oxley,
style="mso-spacerun:yes"> FASB 157, Glass Stegal Repeal and The
Commodities Futures Modernization Act of
were significant market developments which had been
unforeseen at the time Enron drove the adoption of Sarbanes Oxley and FASB 157.
One was that the technology bubble had been replaced by a housing bubble in
which easy mortgage lending practices designed to promote individual home
ownership created huge stocks of home mortgages which were not retained by the
lenders, but were instead “securitized” –
style='mso-bidi-font-family:"Microsoft Sans Serif"'>i
style='mso-bidi-font-family:"Microsoft Sans Serif"'>.e.
style='mso-bidi-font-family:"Microsoft Sans Serif"'>, bundled up into
trust-like funds which were in turn sorted into tranches in accordance with
their perceived risks. Such tranches of risk-sorted debt were further
subdivided into vast numbers of snippets of these funds of bundled mortgages
and sold, primarily to institutional investors seeking higher than typical
returns, all over the world.
Ironically, the very lenders who had made the risky mortgages in the
first place and then securitized them and sold the fragments off to “hedge”
their risks, then rushed to buy back their own foam..
this froth of derivative shards from imprudent lending, new instruments called
“credit default swaps,” many not discernibly tied to the underlying bundles of
dubious credit instruments, were created and sold.
style="mso-spacerun:yes"> These new products were sold primarily
to institutional investors, without anyone having a clear idea where they were
or who had them. The investing public in turn purchased shares in the
institutions and funds holding such incalculable investments and so
participated in the indeterminable and unregulated, but massive, market risks
these new derivatives and swaps were “securities” in the traditional sense of
the word. Where were the regulators? Where was the SEC? Shouldn’t someone in
the government have been regulating these new assets?
so, but the fact was that, by the turn of the millennium, the government by
statutes had proscribed itself from doing so, thereby relegating the SEC, the
banking authorities and virtually every potential government regulator
style="mso-spacerun:yes"> to the sidelines as the real
estate bubble burst and the financial markets here
style="mso-spacerun:yes"> and abroad began to implode.
major mistake the government made was to heed the plaintive cries of merchant
bankers that they were missing out on all the great money the investment bank
mangers, corporate chieftains, insurance fund managers, and hedge fund and
private equity fund managers were making. They claimed the
style='color:black'>Glass-Steagall Act, ch. 89, 48 Stat. 162 (1933) (codified
as amended in scattered sections of 12 U.S.C.
style="mso-spacerun:yes"> (1982)), which originally was enacted
during the depression to prevent commercial banks from engaging in underwriting
functions and likewise to prevent investment banks from accepting commercial
deposits, was unfair to them. It was unfair, they claimed, because, as amended,
bank competitors could compete for deposits using an ever
expanding variety of investment vehicles, while commercial bankers
remained severely constrained in the permissible scope of their activities.
result? Glass-Steagall was repealed on November 12, 1999, and the separation of
powers and risks in the U.S. financial industry effectively ended.
the government made during this period was to enact the Commodity Futures
style="mso-spacerun:yes"> Modernization Act of 2000
DeVinne'>, which amended
Section 1a of the Commodity Exchange Act (7 U.S.C. 24
style='mso-bidi-font-family:DeVinne'>1a), effectively removing credit default
swaps and most other derivatives from the scope of virtually all
style="mso-spacerun:yes"> federal and, via preemption, state,
regulation. This act specifically excluded the U.S. Securities and Exchange
Commission from regulating what clearly were newly emerging and highly
leveraged and risky securities and their securities markets.
the turn of the millennium, the housing bubble had replaced the dot-com bubble
as massive amounts of housing was sold and resold for ever
higher prices financed through more and more leverage. This enabled citizens to
draw money out of their newly overvalued and over-financed homes and spend it
on (mostly) foreign made goods.
people spent their houses, newly deregulated commercial banks lent madly in the
booming housing markets and eagerly participated in bundling of the mortgages
into securitized funds in turned dissected into derivatives sold worldwide
which in turn spun off
new instruments called credit default swaps – housing
bubble foam which not easily tied to anything, but “worth” trillions of
their enthusiasm, the commercial banks, which had sold themselves on the
virtues of diversification of risk via laying it off on the new unregulated
markets via securitization, and the creation of risk allocating derivatives and
credit default swaps, were enticed by the tremendous “earnings” being generated
from the frothing bubble and began investing heavily in their own instruments,
thus negating any possible hedge of their mortgage risk.
result of all this ferment is now evident. The housing market contracted once
people had spent their houses and that fund of cash to fuel the
consumption-based economy was exhausted. People could no longer sell their
overpriced houses and over-leverage themselves into a yet more overpriced home
against which they could keep borrowing and spending. Because the bundled and
derivative housing debt instruments had become so abstracted while being sold
worldwide without any regulatory oversight, no transparent, regulated market existed
for these instruments. As more and more mortgages went into default and
consumer spending plummeted, FASB 157 required that the financial industry
“mark to market” securitized mortgages, derivatives and credit default swaps
for which there was no centralized regulated market because the government, at the urging of the financial industry, had
legislated that there could be no such market.
result of the lack of a market for these instruments resulted in the
now-conservative accounting industry, still haunted by the spectre of the
Arthur Andersen collapse, electing to treat every sale of such an instrument as
making a “market” requiring the revaluation of entire portfolios of this foam.
is small wonder that the liquidity panic occurred. No institution wants to sell
an instrument for less than its face value lest its entire portfolio be subject
to revaluation. If nothing sells, and at this writing nothing will sell without
a steep discount, no market for the now called “toxic investments” will develop
and the downward valuation spiral will continue.
style='font:7.0pt "Times New Roman"'>
Failure of Securities Regulation.
style='mso-bidi-font-family:DeVinne'>Effective July 22, 2010,
style='mso-bidi-font-weight:normal'> the massive Dodd-Frank Wall Street
Reform and Consumer Protection Act (“Dodd Frank Act”) was enacted. This act
addresses in a piecemeal fashion some of most obvious consequences of the
former lack of regulation of a financial industry gone wild generating
phantom, profits from essentially non-substantial instruments
unconnected to ventures truly creating wealth. However, the regulatory scheme
that created the Securities and Exchange Commission remains marginalized.
Dodd Frank Act’s new provisions purport to regulate the structuring of
derivative instruments, dealers in such instruments, and the facilities in
which such instruments are executed, cleared and reported. However, it is still
possible to trade such instruments outside the regulated markets subject
primarily to regulation of the extent such off-market securities can be
leveraged by debt. Such regulation is split between the Commodities Futures
Trading Commission and the S.E.C.
private equity funds hedge funds and even Ponzi schemes operating outside
regulated markets , such as that apparently
perpetuated by the prominent former securities regulator Bernard Madoff, remain
largely outside regulatory grasp, subject to such provisions as the
style="mso-spacerun:yes"> “bad actor” and anti-bailout rules of
the Dodd-Frank Act.
is ironic that as, beginning in 2000, as the financial industry was being
unified so that insurers underwriters, commercial bankers, securities
investment bankers all were allowed almost seamlessly to perform the same
functions, no attempt was made to unify the regulatory scheme governing the
financial industry, in approaching the solution in a multifaceted way, the Dodd
Frank Act represents a
fractionalized, missed opportunity to enact a simpler, more global
solution to oversight of the financial industry taken as a whole.
piecemeal regulatory approach, fundamentally and conceptually unaltered by the
Dodd Frank Act, clearly has to date been totally ineffective to prevent abuses
and irresponsible judgment by an investment community having herd mentality
seeking ever higher returns from an abstract conception of “earnings,” which remain a game-able set of algorithms
untied to real returns.
accounting reform has been a disaster. Sarbanes Oxley exonerated most corporate
managers from responsibility for bad accounting. The flawed application of FASB
157 underscored the absurdity of the so-called “efficient market” theory which
attributes god-like prescience to our current system of determining the market
value of a company by reference to the isolated daily trades by emotional
financial managers of a few thousand or even a few million company shares on an
exchange, or, increasingly, to the trade of some mathematical construct
disguised as a derivative or swap where no regulated exchange exists, or,
presently, can exist.
style='font:7.0pt "Times New Roman"'>
style="mso-spacerun:yes"> Financial Industry Regulation.
regulation as we know it has failed to evolve to deal with valuation problems
inherent from its inception and with the unification and diversification of
financial institutions and investment vehicles.
there is a recent precedent for comprehensive federal legislation governing
aspects of the entire unified financial services industry, combining elements
of federal mandate and industry self-regulation. Ironically, to date Title III
class=GramE>of the USA
Patriot Act of 2001, passed on October 26, 2001, virtually without debate in
the wake of the terrorist attacks of September 11, 2001, to deter and track
money transfers by terrorists has been the first and only comprehensive federal
regulation to deal with the reality that the financial industry
style="mso-spacerun:yes"> in the United States was effectively
unitary, with financial institutions ranging broadly from insurers
style="mso-spacerun:yes"> to brokers to banks to
style="mso-spacerun:yes"> pawn shops performing overlapping and
often identical economic functions.
the Patriot Act only attempted to coordinate regulation of a small part of this
unitary financial industry – that dealing primarily with money transfers
- and otherwise did nothing to synchronize the regulation of the many
unregulated or inconsistently regulated players in this unified financial
industry for the benefit of financial markets increasingly spinning beyond
Dodd-Frank Act Congress had an opportunity to follow the conceptual path of the
Patriot Act and develop an overarching regulator scheme for the entire
financial industry, but it failed to do this, following instead the well-worn
path of industry accommodation and fragmentary regulation.
the U.S government can develop a comprehensive way to regulate all players in
the markets from banks and insurers to investment banks, brokers, hedge funds,
private equity funds and other managers of investment vehicles and financial
and securities instruments, financial industry regulation will remain where it
is today, fragmented, marginal and ineffective to deal with the financial
tsunami which engulfed the world, and has yet to subside.