How the Government Subsidizes Stocks

0:00My topic today is how government subsidizes stocks. And I'll race to that conclusion in my 30 minutes this morning. The title kind of gives my hand away. I should have picked something a little more mysterious, like Jim Grant's phrase this morning, the suspension of disbelief, because that's really what I'll be getting into today. Another alternate title was unpalatable conduct. The relevance of that will shortly become clear. The questions I'm going to look at this morning are why and how is the government in the securities industry, what is it that they protect and does that affect market values. This third question I think will probably have to Wait to the panel tomorrow because it's a pretty big topic.

0:56As you can see, I mean subsidy in the title in the broadest possible sense and not really direct cash support. Specifically, I mean the government's indirect support of the securities industry. The form of subsidy, excuse me, the form of subsidy is protectionism, capturing a customer base that might not otherwise be available to them. The often stated rationale of the Securities and Exchange Commission is investor protection. There's a big difference between the motive of protection and the motive of protectionism, a big difference. Securities regulators seem to have won the propaganda battle by virtue of their steady drumbeat of press releases.

1:45This, I think, echoes Tom Villarenzo's point just a few minutes ago that Congress likes to create the perception of crises. They say, we protect you. We protect you, the little guy, the average investor. So if you, a member of the general public, are reading about how the SEC busts day trading firms, Sometimes flaky brokerages, how it punishes banks and other large institutions for managing earnings. If you read yesterday's paper about the Maytag case, you'll tend to think that there's a lot of hanky-panky out there and you'd be right some of the time. But what is the protection offered by the SEC? Does it over-protect? Does it under-protect? Does it create false hopes? What does it do?

2:36On net are they helping or hurting? They say they want to root out fraud, which undermines confidence and upsets smoothly functioning markets. So Congress awards the SEC very wide discretion to punish those people who upset markets. The frauds are only one part of this total, the total group that upsets markets. In some ways, there are people who upset markets who are not committing fraud. The SEC has a vision of the market that if you violate that vision of the market, you are in effect committing a crime.

3:21Ultimately, I guess this is the point I really want you to go away with this morning. Are the laws that govern securities markets geared to specific credible rules against fraud or are they geared to enhancing the securities industry's ability to attract investors? Again, that grant phrase, suspension of disbelief, I think, is pertinent here. If they do protect the industry's position and reputation, then that has some important implications. Do SEC rules create any kind of artificial preference for stocks as against other things? Are they in effect a branch of the Federal Reserve System promoting confidence in securities, Like bank regulators create confidence in banks or SNLs or farm credit with the same kind of disastrous results we've seen in those industries in the 80s, with potentially the same disastrous results.

4:27Artificial preferences for things like securities or other financial instruments are going to affect their public values. Public Values. So these are the questions that everybody is asking these days, not just Austrians. Is the confidence of investors out of sync with expectations? The SEC itself thinks so. They do public surveys on this and they are worried that public expectations are out of line. Arthur Levitt pretty much agrees with Alan Greenspan that there is such a thing as irrational exuberance. The aura of protection and safety for average investors may put them in over their head.

5:16Just to give a down-home example, my wife is attracted to stocks that are ready to split, and I try to tell her that's really not going to affect the value of the stock Because everybody knows it's going to split, so that's taken into account in the value of the stock. So she makes money, and I look like a curmudgeon for telling her that it's not going to work. So a large segment of investors are feeling pretty supercharged today. The cash that flows into retail brokerage accounts is turning into, if not, hot money, kind of pseudo-hot money, the kind that turns on a dime. Let me make just a side point here about asset values and that will be the only thing I'm going to say about that right now.

6:04For years mutual funds have been taking market share from banks, which is good in some ways because mutual funds are better competitors than banks. Banks were very slow off the mark for a long time. Is there any way to really know whether this is a healthy development? Banks value assets differently than securities markets, should all of the assets, excuse me, should all of the asset values that we observe be public market values trading in securities markets, or is there any room for bank lenders doing complex, subtle, private valuations, perhaps channeling the ghost of JP Morgan to figure out what the true value of this thing really is.

6:52Like I said, I want to reserve those questions for the panel tomorrow. The modern SEC though is like any other government agency that has industry cooperation and sponsorship. In some ways, it is the marketing arm of the industry that it regulates. That's no surprise given what we know about other government agencies. The industry does not want investors to believe that the market could be rigged or biased in any way Just like the FDA doesn't want its regulators, its food companies, to believe that processed food is tainted. Now, they preach that they want to make the market fair for the little guy.

7:41We live in the new era of democratic capital. Everybody gets a piece of the action. We're all investors now. Stock trading, which was kind of a naughty thing to do in the 20s, is kind of a nice thing to do here in the 90s. And the chaperone between investors and firms is the SEC. No dirty dancing. Their central activity is to regulate business speech between firms and investors. They ban insider trading and other wicked sounding practices. They promote disclosure and transparency. While at first these communications regulations sound innocuous and popular, kind of like consumer protection, they have very bad effects.

8:32By painting with far too big a brush, they undermine the very trade in information that they're supposed to protect. In some cases, but not all, insider trading is appropriate. There is such a thing as property rights in intangible things, and that seems lost on the SEC. In some cases, transparency is appropriate. Other times, it's not. There are business secrets that are proprietary, disclosures that are not cost effective in situations where investors could care less whether they get various facts. Earlier this year, the SEC was burdened by the problem of selective disclosure.

9:22Did anybody read the papers yesterday about Maytag, by any chance? Thank you. You'll know what I'm talking about. Let me explain. Executive managers are sitting on very valuable assets. They are banned from using inside information themselves, whether their corporate board would permit them to use it or not. It sort of depends on the charter they have and what state they're in. It's possible that firms could experiment with allowing some of their executives to trade, Trade. Just like in days of old before these practices were banned. So firms create valuable property, tangible and intangible. Who is it that assigns the right to use those? Jonathan Macy at Cornell University, a fairly prominent law and economics professor once said that banning insider trading is like a rule that says throw money out the window of corporate headquarters. In this In this instance, instead of throwing it out the window, executives reveal it strategically to favorite analysts hoping to either delay contrary opinion or hoping for a good response.

10:48So, how does the SEC approach this? This is instructive. There are a few options. They can recognize reality that some information is too complex to be synthesized by average investors or they can let firms experiment with assigning rights to the use of those intangible assets at the same time while not undermining the public participation in their stock or they can simply say to the public, okay, folks, this is obnoxious, bribing analysts It biases outcomes, but it happens all the time, so you should watch yourself. I think the last option is the more honest.

11:35Instead, they continue down the path of threats and punishment. Here are the words of a current commissioner talking about making rules that deal with the problem of selective disclosure. In drawing bright lines by rulemaking, we always run the risk of legitimizing conduct that falls just below the line, conduct that we may still find unpalatable. And given a compelling set of facts on this selective disclosure case, we are not averse to testing our legal theories in this area through an enforcement action. In other words, if we don't like it, we have the power to stamp it out, so watch it. And wouldn't that make Chairman Mao blush, am I? So the question is, do you think that this outlook improves the quality of corporate information or not, independent of what you think about CEOs who give tips to friendly analysts?

12:33Let's talk about the Maytag case for a second and the papers yesterday. Let me recount the facts here. Individual investors bought about $2.3 million on Maytag stock on Thursday. Institutional investors, not sure how many, the Connected View and some others, were dumping their stock on Wednesday, the day before. The news came out on Friday, so the individuals got soaked. Here's my take. See, if you agree with this, we'll have a show of hands. Thursday, a lot of swaggering little guys with high capacity internet connections thought they could outsmart or outguess the institutions, buying on rumors one day before earnings.

13:22So, one question is, who buys long term in the days before earnings are announced? Correct me if I'm wrong, I don't know if anybody who considers themselves a long term investor would buy under those circumstances. Since they were short-term investors trying to be big shots, how many people here think they got that they deserved in the sense that they took a fair gamble and lost? Could I just see a show of hands? We're all in agreement then. Well, some of you don't agree. How many do not agree with that? Okay, I've convinced them. So none of you then, I have another question here, none of you would agree in the affirmative.

14:07How many of you think that the law should intervene to make absolutely certain no divergence of information should ever occur again between institutional investors and these new hot shot internet investors? And I don't think we need to spend a lot of time on that. Last month the SEC redefined materiality yet again. In the past, accounting firms argued convincingly, I think, that misstatements or errors that were small as a percentage of earnings were irrelevant. And that's a good rule, I think. Don't sweat the relatively small stuff. Now they say you cannot hide behind a fixed numerical test.

14:54If we say 5% we might mean 4%. At 4% watch out too because we might mean 3% or 2%. In other words, it's material when we say it's material. Now this attitude arose in the wake of CUC, a conglomerate that lied to its accountants, The accounting firm thought it was an immaterial error and it would have been had the company not lied to them. But the result is that this fraud now, the rulings based on this fraud expand the scope of SEC powers and impose more costs on firms. The rule is now, sweat the small stuff.

15:40They even have really bizarre issues with internet distribution. The fine-tuning mentality is really beyond the pale. If you just go to some of their speeches on their website, I can refer you to a couple of them. They'll make your hair curl or straighten or grow, depending on your reaction. The reaction, 70 million people in the country have internet access, which is only 20% of households, and that's just not good enough for the SEC. They split hairs over when information is disseminated, when it's published, when it's available, at what time, if it's on the website, is it published, If Dow, Reuters, Bloomberg don't have it, does that mean it's not published?

16:32Fortunately, I have come up with what I consider to be the best and final technical solution to this problem to make sure that investor information in future generations is equal everywhere. It's like the V-chip. I call it the 10K chip. Everyone gets a wireless receiver and storage device implanted in their brain at birth. Later in life you can upgrade to the 10KAR, which is what? It's the 10K doubler chip that allows you to receive not only the 10K but annual reports with graphics and video. So other modifications are possible too. You can have it Buffettized. It'll select out the five or six things that Warren Buffett looks for.

17:26Anyway, the possibilities are endless here and I'm advising the Gore campaign this year. So watch for it. So back to the main theme. This issue, investor protection or industry promotion, is a bit confusing. There is a chicken and egg quality to it. In some high-profile cases, in the Michael Milken case, for example, the situation was totally unprecedented and unique. The establishment reacted to Drexel's extraordinary success by what? As Tom DiLorenzo was mentioning earlier, The late business historian Robert Sobel from Hofstra University told me the thing you have to remember about Drexel is that they had no friends on Wall Street, so Drexel is a very long and complicated story, not enough time to get into it, not enough time to get into it, not enough time to get into it, not enough time to get into it, not enough time to get into it, But in the end, the SEC was the instrument of the hostility of the industry, the public and the Congress.

18:45Now, banning Michael Milken from securities markets for life to protect the average investor should sound a little far-fetched, I think, to this audience. But remember, the head of the SEC at the time was very vicious, compared him to a mafia kingpin. and rationalize their actions against him by referring to the needs and the desires of small investors. Other lower profile issues the SEC deals with can be ambiguous. Earlier this year the floor traders were in trouble and I can't remember...

19:30The floor traders were in trouble. They charged a commission to their customers. Depending on the way the commission is structured, it can resemble profit sharing. That can bias the floor trader's decision on who to deal with and slide down the slope here. Commissions begin to look like bribery. This seems to be a common pattern in SEC enforcement. Traders and others become the victim of a new law applied to a conventional or aggressive practice. I'm going to go a little out on a limb here. There's some things I don't quite understand about the member exchange system, but I want to throw this out.

20:15Maybe someone can let me know. Well, traders who show utter indifference toward clients who basically act like computers showing no favoritism, that seems to me like a way of widening participation. My point here is simply to throw out a subtle case where the marketing effect of this SEC action against the floor traders is what is operative rather than the protections offered to investors. I want someone to explain to me why a floor trader cannot or should not distinguish between a good customer and a bad customer. Every other agent develops good relations.

21:02Why should new low-volume customers get the identical treatment of older, more reliable, high-volume customers? Customer relations seem to be a fact of life. Why not just let the new customers know the score? Again, correct me if I'm wrong on this interpretation. So also over the last year, there's been talk of regulation of electronic trading. One of the key features of electronic trading is that counterparties can simply bypass the member exchanges and trade anonymously and in large volume. Member exchanges fear disintermediation, which is just a big word for the money going someplace else. In the interest of market transparency, the SEC wants electronic exchanges to reveal information, but institutional investors do not want their positions known.

21:59That disclosure rule would push institutional investors back to the member exchanges or the phones The law that invokes the gospel of transparency. We want to furnish the public with the full size of the best buy and sell orders, denying the reality of the power of institutional investors and their ability to get what they want.

22:35The rule here clearly squashes electronic exchanges and benefits an SEC constituent, namely the member exchange. The market is not made better by regulation that promises protection, but more often lures the unwary. The fears of the little guy are not answered, but hijacked for special interests. These examples that I've just gone over show that the member exchanges benefit, the connected investment banks benefit, and the Congress benefits. It's a matter of the pork barrel politics that serves special interests. It's not clear that overall that reasonable investors or the amorphous investment community are better off by banning electronic exchanges, banning selective disclosure, banning floor traders with customer relations and banning or eliminating an investment bank like Drexel.

23:37One thing is clear that after these regulations that the money does flow. The stock exchange, the stock market makers and the investment bank trading units benefit from trading The more that trading is perceived to be fair, the more the general public will trade in stocks. That much is easy to understand. What is more complicated for the public to get is that fraud is defined not in the context of property rights, but in reference to the economic policy of wide, deep, liquid securities markets. If you violate that policy, you've committed fraud. The SEC and the member exchanges define healthy markets in a special way that serves their interests.

24:25They have the right to attract wide participation in the stock market and ensure its continuance by voluntary means. But wide participation is not the standard for evaluating the market. Markets with less participation are not imperfect, they're not inferior, they're not in need of correction. The member exchanges do not have the right to create or hijack an agency, especially an agency with extraordinary power to find and eradicate unpalatable conduct. No market can live up to the level of perfection demanded by the SEC. To create a false perception of fairness in order to attract capital is a public disservice.

25:15One foundation stone of a credit structure supported by, in Jim Grant's words, this suspension of disbelief. The alleged benefits of investor protection looked at in this light I think are far more sinister than the average investor realizes. And that's the end of my main remarks and I have a few minutes and I'd be willing to take a question or two, I don't want to be too long a question or two, but I also want to just throw out a couple of questions, a pop quiz for amateur stock market historians, just to see if anybody in the room knows this.

26:03So if you have a real pressing question, please interrupt me. I've got about five minutes. One obvious question is how the SEC started, what was the experience in the 20s and 30s, and what did the Congress really intend at the time, did the agency start out of hand, did it get out of hand, what happened? Were they answering the problems of speculation, fraud, how much fraud was there really? So let me throw out these questions to you. Does anyone know, excuse me, does anyone know

26:49what the widest held securities in the world were in the 20s? And in particular in the U.S. at the beginning of 1929. These were very popular, let me give you a couple of hints. They were wildly popular securities held by the most prestigious universities and investment banks and the stock investing public. Some also came in a novel form. These were the first B-share, class B securities. And it was a worldwide conglomerate, had lots of different interests. And as a foreign stock, think on that for a second. Let me go to the next question. Question. Does anyone know who was on the cover of Time magazine when the market crashed in 29?

27:40Was it a figure of hope, anguish, irony? In the few years that followed the crash and the real pain of the depression started appearing, the blame was directed toward speculators. The causes of the crash were not understood and speculators were the first targets of public outrage, but that actually subsided. Why did it take almost four years, October of 1929 to May of 1933, for the Securities Act of 1933 to be signed into law? What was Congress doing all that time? Securities laws had been on the back burner since 1918 in the Wilson administration, so it's very curious.

28:28So anyone has or to guess about what the wide securities were, who was on the cover of time, why the Congress reacted finally in 1933, no one knows. Well, I'll tell you, it was Kruger and Toll Securities, Ivar Kruger, the famous match king, Swedish match king, was on the cover of time that week. and in 1932 he committed suicide or was shot depending on who you believe and for the year before the Securities Act there were 300 articles in the New York Times on Ivor Kruger, on his empire collapsing, there were five books written about him and testimony before Congress, the Congressional Committee put out a report called Stock Exchange Practices in 1933 and 250 pages of it were devoted to the Kruger scandal and so the question is did he commit a fraud?

29:37Well I guess you're just going to have to come back next year and find out. I have a question. I was hoping you would talk to me about this. Could you give me a few words about how you came to this and how you came up with the contract for this?

30:12In his book, Economics and the Public Welfare, where he talks about, I think it was U.S. Steel, stocks getting, their stock was getting hammered for one reason or another, and they wanted to convey to the public that there was no reason to be worried about the condition of their company, and instead of saying that, they went out and said, we have a lot of confidence in our company, we personally are going to take on more risk, we're going to buy more stock, we're going to buy stock and put it in our own personal portfolios. And so that's the classic kind of example where they signal the outside participants in the stock market that they are confident in the future earnings of the company and they buy stock following waves of pessimism.

31:20I think that's a perfectly legitimate thing to do. ______________________________________________________________ Well, right, I mean there are times when there is such a thing as illegal, unauthorized insight trading, I don't know if I'm an executive and I've got an offshore account and I'm secretly buying up shares. I'm basically stealing company property. I'm not saying that there aren't serious cases where insider trading shouldn't be punished.

32:06I'm just saying that there are times when it's appropriate. The SEC has a very, very broad brush and they will go after it in a lot of different ways whether or not it makes economic sense, as in my first example. That to me makes perfectly good economic sense and if they go after something like that, they shouldn't. There are other examples where they've gone after people, you know, arbitrageurs, Ivan Boesky, people like that, and tried to hook them for insider trading when it didn't really even apply. yes

33:17The idea that if you are advantaged in any way, whether you have a fiduciary duty to the company, if you can move the market in mysterious ways, if you can upset it, you've violated this policy.

33:47The policy of having a wide deep liquid securities market because you undermine confidence and so they're willing to go after anybody who say overhears a couple of lawyers in a bar talking about the merger offer next week. They will go after that person even though that person has happened before. Yes, Tony.

34:39Yes, some economists would argue that who is it really harming if you're a long-term holder and insiders are buying up, you know, it's irrelevant to you, if they're buying up on good information because they think things are going up, if they're selling on bad information because they think things are going down, if you're in it for the long I think I just add to those comments that trading by an insider, per se, is not wrong. I think I just answered those comments that trading by an insider, per se, is not wrong.

35:32This guy or half of Boehm-Garrison's corporation and they want to sell for personal use, or they want to buy and further invest in it, this is a very normal thing to do. Right. It's for the basis of some future information. Right, or it's timed around earnings announcements. It is persistent, and I think that even if you were able to define it very carefully, it still would persist, it would be throughout the market, always, anyway.

36:21I work for a company, I'm not allowed to inside trade, a week before earnings, a week after earnings, but I don't know what our earnings announcements are going to do to the stock. I have no idea how people react to what we're going to say. It's not clear to me at all, but I'm in 401k plans and stuff like that, and so I can move money around that way, but those are long-term holdings, and I've got an advantage. I know a little bit more I know when when to buy and when to when to sell but that's that's just the nature of the market and take one more question before for Lunch, Burt? I want to just give a comment to you about what you think the parents and members of the car are of the period of fraud.

37:09When you talk about what is not, I think you need to look at the big picture. I want to just give a general outline of what you think those kinds of criminal fraud are in the period of fraud. Well, remember I was mentioning the... I can't obviously be exhaustive, but let me give you an example. Well, you know, I'm not a lawyer, so I can't get disbarred for this. Well, in the case of... I would say the rule of, you know, material misrepresentation is a pretty good principle.

37:54Faking trades, in the case of this floor trading scandal, was actually triggered by a real scandal. The Oakford Corporation was just giving blank tickets to the floor traders. The floor traders were just trading on their own account and then going back and sort of backdating the documents to make it look like the client initiated the trade Yeah, like I said I'm not a lawyer I don't know the penalties whether double or triple damages or being banished from the securities industry for life.

38:41I'm not sure about the proportional punishments for things like that, but if it's bad, it's bad on some scale, and then you would calibrate the appropriate punishment. But let me think on that, because I don't know, like I said, material misrepresentation and faking money. faking, faking trades, things like that. I mean, there are genuine cases of securities frauds and there are subtle and complex securities frauds. You know, Michael Milken was alleged to have done and still is alleged to have done by many people a very subtle form of securities fraud.

39:37So, one more, last one, I'm hungry.

39:59Are you talking about silicon graphics? Compact, okay. I'm not familiar with the Compaq case but it sounds almost like the silicon graphics where the silicon graphics executives were actually putting out really positive reports for months and months at the same time they were getting internal reports about how sales were down so they were actually putting out disinformation it's one thing so you can say okay if they just kept silent and not said anything and did not answer questions from analysts and analysts would say we think there's something rotten in Denmark here, so we can't recommend the stock, they're not telling us the truth, but the fact that the Silicon Graphics executives actually gave out this information about how rosy things were going to be, I think there's a genuine case of, and at the same time we're selling their stock, I think that the crime is only one part insider trading, I mean what What they did was give out disinformation in order to sell their stock at a good price

41:11before it was going to go down, when they put out other information. So I think that would, you know, if I were an attorney and I were suing someone on the basis of that, a reasonable lawsuit I would think would say you were putting out disinformation, putting out one thing doing another. Thanks.