Bad Stock Market Medicine

Bad Stock Market Medicine

Sheehan Op-Ed in the Washington Times
December 18, 2002

In response to high profile corporate-accounting scandals, such as Enron and Worldcom, lawmakers and regulators moved swiftly to enact measures aimed at shoring up investor confidence in the stock market. These measures are based on the faulty presumption that more draconian regulatory scrutiny of corporations and Wall Street will cure what ails the stock market. This flawed regulatory prescription ignores the true causes of market weakness as it weakens the financial system and undermines legal standards. The great bull market of the late 1990s was the result of rapid credit expansion at the Federal Reserve. Loose credit fed into asset prices by lowering the cost of capital and overstimulating investment in speculative Internet and telecom ventures. When the investments failed to generate expected profits, and the entire structure moved from boom to bust as investors were forced to re-allocate their capital more rationally. Instead of addressing the root cause of the collapsing financial bubble, regulatory policies have moved in the direction of treating two symptoms of the problem: aggressive corporate accounting and conflicts of interest on Wall Street. The government's knee-jerk reaction to accounting scandals was the Sarbanes-Oxley Act, which Congress passed into law last summer. Sarbanes-Oxley criminalizes even minor accounting mistakes, and holds the chief executive officer liable if a restatement of accounting results becomes necessary. Thus, a CEO could be prosecuted for a forecasting error committed by an employee. The new law is similar to previous laws mandating that accounting be checked by independent auditors as well as the Securities and Exchange Commission. Unfortunately, the law promotes moral hazard by continuing to encourage investors to rely on a government bureaucracy to enforce laws, as opposed to having investors fully absorb the risk of their investment decisions. With disastrous results, investors trusted the SEC to ensure the accuracy of corporate financial statements and to detect fraud. But the agency stymied investors seeking access to its company files, subjecting them to a cumbersome administrative process under the Freedom of Information Act. Besides offering a false sense of security, the new accounting law will likely hurt the competitiveness of our financial markets. Sarbanes-Oxley prohibits companies from making loans to employees, a privilege that was egregiously abused at Worldcom. Yet this prohibition is particularly inappropriate for European companies, which routinely provide loans to their employees as a form of compensation. European companies are expected to comply as a precondition to trading their stock in the United States. For this reason, Porsche, the German automaker, has already canceled plans to list on the New York Stock Exchange. An equally misguided response to the deflated bubble comes from New York Attorney General Eliot Spitzer, who has filed lawsuits against Wall Street securities firms charging them with publishing optimistic stock research. Mr. Spitzer seems not to realize that Wall Street analysts were under intense pressure to be optimistic from their customers. During the boom, Wall Street faced insatiable demand from fund managers, day traders, and hedge funds for dot coms and telecom stocks. Investors shunned Wall Street analysts who were overly skeptical of Internet stocks. Merrill Lynch, for example, fired its Internet analyst Jonathan Cohen in late 1998 because investors hated his bearishness on Amazon.com. The firm replaced him with a more bullish competitor, Henry Blodget. New York's chief prosecutor is currently trying to force investment banks to subsidize independent research not influenced by investment banking considerations. This is effectively a tax scheme estimated to cost $1 billion to $2 billion over five years. The end result will be an inflated cost of raising capital, particularly for smaller companies. Yet it will not produce more balanced research. Independent research firms tended to be just as bullish on the overheating new economy. Justice may also become a casualty of the New York politician's crusade. Mr Spitzer is suing brokerage firms under an antiquated 1924 state law, the Martin Act. Under this odd provision, defendants can be found guilty without intending to commit fraud, though intent is ordinarily a vital element of culpability under our system of justice. Moreover, Mr. Spitzer is assuming that a conflict of interest exists when an investment bank publishes favorable stock research on a banking client. This widespread practice was not considered illegal or improper at the time. In fact, the federal government had been promoting greater integration of stock brokerage and investment banking as a way to improve efficiency in financial services. Mr. Spitzer's suit undermines a bedrock of the U.S. legal system, the protection against retroactive punishment. It is unfair and unjust to penalize investment banks for violating legal standards in 1999 that were not invented by Mr. Spitzer until 2002. The government's various regulatory maneuvers moves are intended to improve corporate governance and boost the stock market. However, until root monetary causes are corrected, the stock market will remain anemic. Regrettably, regulators are fueling the misconception that people lost money in the stock market because companies lied to them or Wall Street cheated them. In reality, investing is risky, and positive returns are not guaranteed. To the extent that the political class fosters false expectations among the investing public, it does society a disservice.