Markets Don’t Run on Money, They Run on Trust

Dear Holman,

OK, so you, Alan Greenspan, and I were all Cassandras and “everybody” knew they were participating in a bubble. I guess it was everybody’s dumb cousin Ernie who was staying in the market, then, because somebody was driving that bull (in both senses of the term) and it wasn’t just day traders.

Even Greenspan started to believe that some of that exuberance might have been rational, after all. In 1997, just eight months after his original warning, Fortune magazine said that Greenspan had gone from taking away the punch bowl to spiking the punch. But regardless of who predicted what when, bull markets are bucking broncos, and eventually they are going to leave anyone who tries to ride them in the dust.

I led off yesterday with an acknowledgement that anyone who invested in the companies that have toppled should have expected some problems. I hope that establishes my credentials as a capitalist who believes in the long-term efficiency of the free market. But that does not put me on the side of the Panglossians who think that everything is for the best in this best of all possible market economies.

I want to talk about what is less free and less efficient than it should be and what needs to change. The reform proposals I support are not regulatory restrictions on the market; they would remove the obstacles that keep the market from optimal efficiency. The playing field does not have to be precisely level, but it would be nice if it weren’t sometimes perpendicular.

Markets don’t run on money; they run on trust. And trust depends on the reliability and completeness of the information. I enthusiastically endorse what you refer to as Elliot Spitzer’s ambulance-chasing. He went after the Wall Street analysts for failing to disclose their conflicts of interest. Their firms were getting fees from the companies they were evaluating and—surprise!—companies that paid fees tended to get more enthusiastic recommendations. I wouldn’t mind so much except there was no way to tell which recommendations might have been influenced by financial ties. I’ll bet that the Wall Street Journal has some kind of rule that reporters and columnists and book reviewers have to disclose any possible conflicts of interest. Why shouldn’t the analysts? I hope your response is not going to be “everyone knows” again. Sophisticated institutional investors who do their own research might take analyst recommendations with a barrel of salt. But retail investors who log on to just get a list of strong buy/hold/sell recommendations without any context and do not have any way to evaluate their objectivity.

And yes, I’ll shed a tear for George Soros, but not because he came too late to the game of musical chairs that was the dot-com bubble and got caught without a place to sit when the music stopped. I’ll shed a tear for him because he and I were both investors in an old-technology company, Waste Management, when it announced a then-record $1.7 billion restatement in 1998. The SEC is now suing the CEO, CFO, general counsel, and other top management of the era for “perpetuating a massive fraud that lasted five years.” How caveat does the emptor have to be when a public company’s audited financial reports wildly overstate assets (assigning inflated values to depreciated property), understate expenses (by not reporting them), and, in that classic dodge carried to extremes by WorldCom, categorize operating expenses as capital expenses?

The whole reason we have rules in place for public companies is so that there will be enough checks and balances and enough consequences to make sure that any natural human tendencies to lie and steal are countered by incentives to prevent, catch, expose, and minimize their effects. If your daughter asks you to invest in her lemonade stand, you can make a judgment based on the invaluable information you already have about her trustworthiness and business judgment. But if you are going to invest in someone you don’t know, we try to make up for your inability to get that kind of information. We limit public companies’ liability and protect their privacy and liquidity. We make them tell you a lot about their business, and just to make sure they are telling the truth, we bring in some outsiders—auditors and boards of directors—to double check. We need to make sure that the incentives we have in place make it clear to corporate managers, directors, and auditors, who are supposed to be so good at cost-benefit analysis, that it is not worth it to try to lie. Yes, there will always be people who will commit fraud anyway, but when it rises to the level that it has this year, we need to take another look at the systems we have for prevention and punishment to make sure they don’t need to be recalibrated.

There have been a lot of low points this year, but the lowest have to be these:  First, the revelation that the Enron board of directors waived the conflict-of-interest rules so that the CFO could enter into the special-purpose entity deals that brought the company down (but, on the other hand, the CFO made $30 million). Second was Arthur Andersen’s approval of WorldCom’s switching of billions of dollars of expenses from operating to capital, just in time to support an enormous debt offering. And third, when Deutsche Asset Management voted its Hewlett-Packard shares against the merger with Compaq, the managers got a call from their investment banking side, asking them to meet with HP executives. After the meeting—and a new million-dollar fee—DAM switched its vote. And this was upheld by the Delaware “we’ll do anything to keep America’s corporations paying taxes here” chancery court.

If we can’t count on the board, the auditors, the analysts, or the shareholders to recognize, prevent, or respond to management abuses, then it is time to make some changes.