Investigations by Congress in 1912, 1932 and 2002 revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. A comparable effort is needed now in the face of the worst credit crisis since the Great Depression.
A trio of former SEC chairmen and a solo performance on the part of a former high-ranking Fed official are making for some interesting music and a much-needed counterpoint to the current chorus of conventional thinking. In a recent Op-Ed piece in The New York Times, William Donaldson, Arthur Levitt, Jr. and David Ruder write: “In 1987, a presidential task force was established to investigate the Black Monday crash. Today, we need a similar exhaustive, bipartisan and impartial examination to explore a series of possible business and regulatory failures”. The former securities regulators invite an examination of:
…apparent conflicts of interest on the part of the credit ratings agencies; the failure of banks and other lenders to adopt sound lending practices; the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages; the sale of high-risk securities to investors for whom they were unsuited; the breakdown (or absence) of adequate risk management systems among the top financial services firms; and the failure of regulators to recognize and take early action to deal with the problems that have grown to today’s magnitude.
We would add to that list for investigation the alarming failure of too many boards to effectively oversee risk and the role that excessive compensation played in rewarding CEOs for taking on levels of risk that would run up the price of shares and boost their pay in the short term but which ultimately proved to be unmanageable over the longer run. As we predicted some years ago, Titanic-sized CEO compensation has proven to be the most corrosive force in the modern American boardroom. It will continue to be associated with mishaps, scandals and failures in the future, as it has been in the past, unless it is checked by a healthy injection of common sense and sound judgment around the director’s table.
Valuable as a review of the SEC’s role would be, we have expressed the view that a more comprehensive inquiry regarding the actions of all the players in the subprime ordeal, and what changes are necessary both in the regulatory system and in corporate governance practices, is more appropriate. Back in January, in Time for Tough Questions About Subprime Solutions -and Their Potential Dangers, we suggested that Congress needed to get to the bottom of what was happening and why. We concluded by noting:
The issues of subprime bailouts, foreign investment and the failures that brought American capitalism to this troubling state are far too important to be permitted to escape scrutiny or unfold by stealth or default, which is the current mode of operation. Those actors have too often entered the room when no one was paying attention and waltzed out with most of the silverware in their pockets.
Vincent Reinhart, who was director of monetary affairs at the Fed until last year, has called the Bear Stearns bailout “the worst policy mistake in a generation.” We, too, have had our reservations about that rescue and the lack of transparency associated with it. As we said shortly after the deal was announced:
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster.
In a later posting we noted:
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision…places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy.
The causes of the worst crisis in America’s capital markets since the Great Depression, and the unprecedented decisions of the Fed in dealing with it, along with the role other public and corporate actors have played in this saga, call out for serious analysis and national discussion. Congress has acted before in the face of momentous challenges to the stability of the market and public confidence in its functioning. A special subcommittee of the United States House of Representatives was formed in 1912 under the legendary chairmanship of Louisiana Congressman Arsène Pujo to examine the influence of the “money trust” and the growing power of Wall Street titans like J.P. Morgan.
In 1932, in the wake of the Crash of 1929 and the ensuing economic depression, the United States Senate Committee on Banking and Currency (as it was called then) began to consider the need for reforms. Its landmark work, spearheaded by committee counsel Ferdinand Pecora, produced the first securities laws of 1933 and 1934 and created the SEC.
More recently, as a result of a series of accounting scandals and widespread failures in corporate governance, efforts by Congress under Senator Paul Sarbanes and Representative Mike Oxley led to the creation of omnibus boardroom reforms known as the Sarbanes-Oxley Act of 2002.
A wide-ranging inquiry into the causes and lessons of the subprime credit implosion, similar in scope and heft to the Pujo, Pecora and Sarbanes-Oxley hearings, needs to be conducted, and soon. We also think it is important to include in that review the governance of the Federal Reserve System and the reforms that are needed to bring it into line with 21st century levels of public confidence, independence and accountability. We pointed out earlier, for instance, that at the New York Federal Reserve, which played the leading role in the Bear Stearns bailout, Jamie Dimon of JPMorgan Chase, the Fed-assisted purchaser of Bear Stearns, was a director. Richard Fuld and Jeffrey Immelt, CEOs of Lehman Brothers and GE, both big players in the capital markets, were elected by the New York Fed directors to represent “the public.” That, we find to be a bit of a stretch. It’s a throw back to the cronyism of the New York Stock Exchange before it was faced with a wave of demands for reform after the pay scandal involving former CEO Richard Grasso. It is simply not possible for any player in the Fed system to maintain credibility regarding its important public mandate while at the same time maintaining what is an essentially privately structured, club-like governance system. It is time for a serious rethinking about to whom and for what the Federal Reserve System is accountable, and how its governance practices need to be more aligned with its public mission.
Comprehensive investigations by Congress in 1912, 1932 and 2002 (and these were not one- or two-day affairs, as recent hearings on some aspects of the subprime debacle have been) revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. Their enactment paved the way for a restoration of public confidence and enabled significant periods of growth and expansion.
It is important that the opportunity to understand more completely the causes of the subprime crisis, and the vulnerabilities that led to it, not be lost. Only then will the full spectrum of necessary reforms both in the boardroom and in the regulatory arena become clear. In that respect, basic logic if not sound public policy principles counsel that the package of regulatory changes proposed recently by the Bush Administration was premature. More needs to be known about the specifics of the failures at all levels that created the current problem before the correct solution can be adopted. Uppermost in any such legislative review is the question: How exactly was one company, Bear Stearns, allowed to become so critical to the functioning of the market that only by preventing its failure through a massive intervention of the federal government could the collapse of the entire financial system be narrowly averted, as U.S. officials have asserted in testimony before Congress.
Not even in the unfettered era of J.P. Morgan’s trusts, or at the height of the rail-riding Great Depression, was the American public presented with the frightfulness of that prospect.