WSJ, Oct. 17, 2002
Did Washington Set the Stage
For Current Business Turmoil?
Seeking Growth, Policy Makers Made
Free Markets Freer, Shot Down Naysayers
By JACOB M. SCHLESINGER
Staff Reporter of THE WALL STREET JOURNAL
On an unseasonably warm February morning in 1987, three bank executives
squared off against the Federal Reserve board in a crowded hearing room in
Washington, D.C. Their mission was to persuade the Fed to start tearing
down the half-century-old regulatory walls between the business of banking
and the business of selling stocks and bonds.
Paul Volcker, the Fed's gruff chairman, was leery. He worried that easing
the limits set by the Glass-Steagall Act of 1933 posed dangers: lenders
recklessly lowering loan standards in pursuit of lucrative public
offerings; banks marketing bad loans to an unsuspecting public.
Thomas Theobald, then vice chairman of Citicorp, countered that three
"outside checks" on corporate misconduct had emerged since the financial
shenanigans of the Roaring Twenties had led to Glass-Steagall. He cited "a
very effective" Securities and Exchange Commission, knowledgeable
investors, and "very sophisticated" rating agencies, according to a tape of
the hearing.
Mr. Volcker remained hesitant, but most of his colleagues thought it was
time to free the markets from the restraints of Glass-Steagall.
The erosion of that landmark law was one of many steps that added up to a
free-market sweep of Washington over the past quarter-century. Policy
makers transferred onto the shoulders of investors more of the
responsibility for steering financial markets and policing wrongdoing.
Republicans and Democrats joined forces to loosen federal control over
crucial economic sectors. Along with banking, they unshackled
telecommunications and energy.
From the 1930s to the 1970s, Washington embraced an ever-greater role for
the federal government. But the economic stagnation of the 1970s convinced
politicians in both parties that the pendulum had swung too far. By the
decade's end, Democrat Jimmy Carter launched the modern deregulation
movement by freeing up the airline and trucking industries. His successor,
Ronald Reagan, even more enthusiastically embraced the wisdom of markets
over bureaucrats.
The reforms, the officials believed, would unleash innovation and raise
living standards. Those good things did happen. Deregulation and low
interest rates spurred a burst of technological investment that accelerated
the growth of the economy and slashed the unemployment rate. But the
savviest policy makers knew they were making a choice "between economic
growth with associated potential instability, and a more civil ... way of
life with a lower standard of living," as current Fed Chairman Alan
Greenspan recently put it.
Now, with corporate corruption on the upswing and the stock market on the
downswing, the trade-offs are all too apparent. Deciding not to meddle, the
Fed let the stock-market bubble expand and pop to devastating effect. The
Telecommunications Act of 1996 cleared the way for highfliers such as
WorldCom Inc., which imploded after the biggest accounting fraud ever. The
airline industry, having never really learned to cope with deregulation,
slid into a series of slumps including a particularly devastating one now.
The decision in the 1990s not to regulate the arcane financial instruments
known as over-the-counter derivatives made it tougher to uncover accounting
tricks favored by Enron Corp. And it is now obvious that investors, and the
stock analysts who advised them, weren't up to the task of making sure that
corporate executives kept their priorities and books straight.
In short, it's clear in hindsight that the marketplace's own "checks,"
touted by Mr. Theobald 15 years ago, weren't enough to prevent the upheaval
roiling the business world today.
Blame for business's recent troubles has been assigned to everyone from
greedy executives to naive investors. But there were singular moments when
Washington also made decisions with serious consequences. Here are five:
Chipping at Regulation
The morning that Mr. Volcker played host to Mr. Theobald and his fellow
executives from J.P. Morgan & Co. and Bankers Trust New York Corp. was a
bit of a landmark. It was only the third time in the secretive Fed's
74-year history that it had held a public hearing with outside witnesses.
The bankers were seeking permission to sell certain securities. They
weren't asking to sell stocks, just municipal bonds, commercial paper and
securities backed by mortgages and credit-card receipts. Still, their pleas
carried great symbolic value because they represented an assault on
Glass-Steagall.
The triumvirate of bankers faced the five Fed governors across a large oval
table, their lawyers and lobbyists watching from behind.
Mr. Volcker, the Fed chairman, brandished a copy of a 1934 letter to
shareholders from the chairman of the National City Bank of New York,
Citicorp's predecessor. In his rumbling voice, he read: "I personally
believe the bank should be free from any connections, either directly or in
any way, which might be taken by the public to indicate a relation with any
investment banking house."
Why then, Mr. Volcker asked, was the lender back in Washington begging for
permission to sell securities?
"The world has changed a hell of a lot," Mr. Theobald responded.
"But the law hasn't," Mr. Volcker barked. Citicorp was portraying its
petition as so "innocuous," so "sensible," that "we don't have to worry a
bit," Mr. Volcker complained. "But I guess I worry a little bit."
Having tamed double-digit inflation that plagued the late 1970s, the
cigar-puffing Mr. Volcker was one of Washington's towering figures. A
former undersecretary of the Treasury during the Nixon administration, he
was appointed to his Fed post by President Carter. A Democrat, when it came
to regulation, he was a pragmatic believer. But President Reagan had
surrounded him on the Fed board with free-marketeers.
One of the Reagan appointees, Martha Seger, spoke up, challenging the logic
of Glass-Steagall. "I don't think farm banks in Iowa or Michigan went under
because they were underwriting or speculating in securities," she said.
"Thank you," Mr. Theobald interjected.
J.P. Morgan president Dennis Weatherstone explained that rapid market
changes were putting banks at a "competitive disadvantage." Their clients
were expecting new types of credit "they can readily get from our
investment bank competitors," he said.
Nearly three months later, the Fed governors reconvened, this time in
private, to vote. Though Mr. Volcker acknowledged the law was obsolete, he
continued to fight. If a subsidiary was to be allowed to sell securities,
it should have a name separate from the bank, he said. And in any case, he
argued, it was the job of Congress to be making such important changes. The
Fed's board approved the bankers' application 3-2, with Mr. Volcker voting
against, according to minutes of the meeting.
That summer, the Reagan administration appointed Mr. Greenspan to succeed
Mr. Volcker. The new chairman, a campaign adviser to Mr. Reagan in 1980,
continued to chip away at the walls between banking and investment banking,
and in 1997, banks were given permission to acquire securities firms
outright. By the time Congress repealed Glass-Steagall in 1999, the law was
pretty much obsolete anyway.
J.P. Morgan Chase & Co. and Citigroup, Citicorp's successor, were free to
both lend money and underwrite securities for Enron, WorldCom and others,
and they aggressively did so as they pushed to create diversified financial
behemoths. But now the banks face questions about whether they extended
risky loans in order to chase lucrative investment-banking deals with
borrowers. J.P. Morgan said Wednesday that it was forced to take a charge
in the third quarter of $834 million for loans, largely to telecom and
cable firms. Citigroup and J.P. Morgan also have been sued by WorldCom
investors alleging that they had a conflict of interest in lending money to
the company and selling its bonds.
"The real problems have revolved around either bookkeeping or dodgy
off-balance-sheet deals, all of which had nothing to do with the repeal of
Glass-Steagall," says Mr. Theobald, now at a Chicago private-equity firm.
Mr. Volcker, 75, heads a global accounting-reform panel. He thinks the
changes to Glass-Steagall, though inevitable, came without sufficient
deliberation by policy makers. "Markets are absolutely indispensable," he
says. "But I don't think they are God."
Starving the SEC
In May 1994, SEC Chairman Arthur Levitt told a congressional panel that he
"would walk on hot coals" for a larger, more stable source of funds for his
agency. Since the early 1980s, he told legislators, the value of public
offerings had jumped nearly 1,800%, while the SEC staff had grown just 31%.
But Mr. Levitt's budget campaign faltered, thanks to a clash between two
fiery lawmakers with very different ideas about the role of market regulators.
Mr. Levitt's idea was to fund the SEC with fees paid by companies
registering stock offerings. At the time, the SEC simply collected the fees
and shipped the money -- an amount double the agency's annual budget -- off
to the Treasury.
Mr. Levitt had an ally in Rep. John Dingell. The veteran Democrat had
inherited his Detroit-area seat from his father, an ardent New Dealer who
backed the creation of the SEC in 1934. The year before Mr. Levitt offered
to do his coal walk, the younger Mr. Dingell had pushed a bill through the
House that would have allowed the SEC to keep more of its fees. But it had
stalled in the Senate.
This time, he tried an entirely different tack. Mr. Dingell persuaded the
House to pass a bill cutting the SEC budget for 1995 to $59 million from
about $270 million in 1994. He wanted senators to believe that unless the
SEC was allowed to keep its fees, it would go belly up.
But Mr. Dingell hadn't factored Sen. Phil Gramm into his strategy. "Don't
threaten me," the Texas Republican warned when asked about Mr. Dingell's
ploy. "I may take you up on your offer."
A conservative economist with a deep skepticism of government, Mr. Gramm
had spent the 1980s on the front lines of the war against federal spending.
"Unless the waters are crimson with the blood of investors, I don't want
you embarking on any regulatory flights of fancy," Mr. Gramm once told Mr.
Levitt, according to a new book by Mr. Levitt.
Mr. Gramm thought self-funding would make the SEC too powerful. He
dismissed the idea that it was starved for funds, writing to colleagues
that with "a 145% growth in SEC funding since 1986," the SEC's budget "has
grown faster than inflation, faster than the U.S. economy, faster even than
the federal budget."
Throughout the summer, Messrs. Dingell and Gramm played parliamentary
chicken with the SEC budget. The new fiscal year began Oct. 1 without full
funding. At the SEC, Mr. Levitt curbed travel and scaled back inspections.
Ten days later, Congress put the agency back in business with an
appropriation of $297 million -- a 12% increase.
But Mr. Levitt and Mr. Dingell's victory was shallow and short-lived.
Though the SEC had gotten more money, the self-funding notion was dead,
leaving the agency at Congress's mercy. A month later, the Republicans won
control over Congress, and Mr. Gramm took over the Senate committee setting
SEC funding.
In 1995, Mr. Gramm won his committee's approval for a 20% funding reduction
in the SEC's budget. Ultimately, he didn't have his way and the budget
wasn't cut. Still, his counter-offensive changed the way Washington viewed
Wall Street's overseer.
From fiscal 1995 to 1998, the SEC's work force and budget stayed about
constant, adjusted only for inflation. In 1997, Mr. Levitt sarcastically
noted to a House panel that SEC funding was below that of the Sportfish
Restoration program, but lawmakers didn't nibble.
During those years, the number of corporate SEC filings grew 28%. Investor
complaints rose 20%. The value of initial public offerings rose by a factor
of 12. The agency cut back on reviewing financial filings, examining just
11.9% of the statements filed in 1998, down from 18.5% in 1995. It
conducted its last thorough review of Enron's books in 1997.
It took the WorldCom bomb to revive Washington's backing of the SEC. In
July, Congress authorized a 69% budget increase. But with the overall
budget frozen in Congressional gridlock, the agency has only gotten a
fraction of its new funding -- and may have to cut its expenses to pay for
the new accounting oversight board Congress created.
Mr. Gramm, who is leaving the Senate to join the big Swiss investment bank
UBS Warburg as a vice chairman, hasn't changed his mind. With self-funding,
"you would lose accountability," he said recently.
Ramping Up Telecom
"How'd you like that telecom act?" a senator asked Reed Hundt, head of the
Federal Communications Commission, shortly after it became law in early 1996.
"I've studied it a lot," Mr. Hundt said.
"Then you know we put everything in there," the senator said, laughing, and
"then we put its opposite in." The Senator slapped Mr. Hundt on the
shoulder and walked away, according to the former FCC chairman's memoirs.
In spirit, the sprawling Telecommunications Act of 1996 discarded the
pro-regulation philosophy of the 1934 Communications Act, which had treated
the telephone industry as a monopoly. Just as the breakup of AT&T Corp. had
created competition in the long-distance business, the new act aimed to
unshackle local markets, giving consumers cheaper phone, video and computer
services.
But Congress worried that overnight deregulation would let the regional
Bells smother new rivals. It instructed Mr. Hundt to spend six months
writing a whole new web of rules governing the $100 billion market.
At the FCC's aging eight-story headquarters near Georgetown, staffers spent
months swapping complex economic models and arguing endlessly over the
meaning of the word "cost." Lobbyists and telecom executives besieged the
FCC with nearly 1,300 visits, phone calls and letters, as well as filings
totaling 17,000 pages.
A wisecracking antitrust lawyer who went to prep school with Al Gore and
law school with Bill Clinton, Mr. Hundt liked to joke that his appointment
to the FCC was "just a coincidence. The truth is that I got the job because
I have the same birthday as Alexander Graham Bell."
But Mr. Hundt, who believed that telecom needed a good shake-up to stir
competition, had serious adversaries in Mr. Bell's namesakes. That spring,
Bell Atlantic Corp., which serviced Washington, bused FCC staffers to its
Baltimore switching facility to demonstrate the technical difficulties of
opening its network to new competitors, a tour that included opening
manhole covers to reveal the complex tangle of underground cables that
would somehow have to be unbundled.
Long-distance carriers, meanwhile, encouraged Mr. Hundt to stand his ground
so they could go head-to-head with the Bells and capture a piece of the big
business of serving local customers. In June, Bernard Ebbers, president of
long-distance provider WorldCom, spent two days prowling the FCC's halls
making his case. The new rules, he wrote to Mr. Hundt, were "so important
to WorldCom and the future of telecommunications competition."
On Aug. 8, 1996, the FCC released its 682-page "interconnection order"
setting the rules for opening local markets and tilting the playing field
toward telecom upstarts. Weeks later at a press conference, Mr. Ebbers
announced WorldCom's $14.4 billion acquisition of MFS Communications Co.,
an innovative Nebraska local service provider that had swallowed UUNet, an
Internet pioneer. The acquisition, Mr. Ebbers said, had been "encouraged"
by the new telecom law and the "absolutely fabulous" FCC rules.
It was precisely what Mr. Hundt had hoped for. "Within three years, there
were 6,000 Internet providers, 250 new competing local telephone companies,
a half-dozen new long-distance companies, dozens of new equipment vendors,"
he wrote in "You Say You Want a Revolution," published in 2000.
Yet opening the telecom market to competition turned out to be a painful
process. In the past two years, telecom stock prices have plummeted.
WorldCom's bankruptcy filing in July was only the most recent of two dozen
by publicly traded telecom firms this year. Accounting scandals have
bloomed at WorldCom, Qwest Communications International Inc., Global
Crossing Ltd., and Adelphia Communications Corp.
In the wake of the debacle, there has been plenty of finger pointing. The
Bells insist that Mr. Hundt's rules made it too easy to enter the market,
causing severe overcapacity. Announcing a round of 11,000 layoffs last
month, Texas-based SBC Communications cited "regulations that force us to
sell our product below cost." Telecom upstarts blame the Bells for
sabotaging deregulation with yet-to-be-resolved court fights.
Mr. Hundt makes no apologies. Now a consultant at McKinsey & Co., he
brandishes graphs showing how telecom's share of the economy has grown as
consumer prices have plunged. "The 1996 telecom act produced the greatest
consumer benefit of any law within a generation," he says. "I'm happy to
claim whatever credit I can get."
The Fed: Party On
As Fed members took turns giving their assessments of the economy at their
September 1996 meeting, most focused on their fears of impending inflation.
Lawrence Lindsey, at 42 the board's youngest member, had something
different on his mind: soaring stock prices.
"Last night, one of the TV news magazines had a story about people who won
the megabucks lotteries, millions of dollars -- and ruined their lives," he
said, according to a transcript of the meeting. "The TV show reminded me
that we have been having a string of what appears to be good luck. ... Our
luck may be running out."
With the bull market shifting into high gear, and the Dow Jones Industrial
Average poised to break 6000, Mr. Lindsey fretted that Wall Street had
developed "a gambler's curse." He thought the Fed should consider reining
in the market. Popping the bubble might have unpleasant effects on the
economy, he acknowledged, but "I think it is far better that we do so while
the bubble still resembles surface froth."
Most officials ignored Mr. Lindsey's views of what he called the "economic
party." But after a coffee break, Mr. Greenspan agreed it was a problem "we
should keep an eye on." Still, he worried aloud that the Fed's limited
options for damping the market -- raising interest rates or making it
harder for investors to borrow by raising margin requirements -- would
cause a recession. The Fed didn't end up raising rates that day.
Partly encouraged by the Fed's inaction, the Dow kept marching upward. It
crossed 6300 the day before the Fed reconvened on Nov. 13. By then, more
members were concerned. Thomas Melzer, president of the Federal Reserve
Bank of St. Louis, talked of "speculative excesses" and wondered if "by
moving now, we might be able to avoid a bigger accident." Still, they left
interest rates alone.
At an American Enterprise Institute dinner three weeks later, Mr. Greenspan
used carefully chosen words to raise the question of whether "irrational
exuberance" was boosting stock prices. Wall Street took note. With traders
worried that the Fed would try to drive down shares, the Dow industrials
fell 145 points before recovering some losses by the close. Investors
bitterly complained that Mr. Greenspan had overstepped his role in
criticizing the market.
A few board members congratulated Mr. Greenspan at the Fed's December
meeting for taking some air out of the bubble. Mr. Lindsey, however,
remained skeptical that a single speech would do the trick. "I think that
... 1997 is going to be a very good year for irrational exuberance," he said.
Mr. Greenspan replied, "I will make another speech." His colleagues laughed.
The Fed never did openly target the stock market. And Mr. Greenspan never
gave a speech forcefully declaring that he thought shares were overvalued.
Though the Fed did end up raising rates -- once in 1997 and throughout 1999
and early 2000 -- the central bank explained the moves as an attempt to
pre-empt inflation, not curb stocks. Mr. Greenspan's respect for market
forces made him reticent about second-guessing investors, "many of whom are
highly knowledgeable about the prospects for the specific companies," he
said in 1999 at the Fed's retreat in Jackson Hole, Wyo.
When Mr. Greenspan returned to Jackson Hole this past August, the Dow had
retreated some 3000 points, or 26%, from its January 2000 high of 11723. He
defended his earlier decisions, arguing that pricking the bubble might have
caused a recession. Meanwhile, the plunge in stock prices has contributed
mightily to the current U.S. economic slump.
Mr. Lindsey left the Fed in early 1997 and, a year later, sold all of his
personal stock holdings, he said in a 1999 speech. Now an economic adviser
to President Bush, he says it's too early to tell whether leaving the
bubble alone was the right choice: "Economic historians will be debating
this issue for decades to come."
Bullying Brooksley Born
Meetings of the President's Working Group on Financial Markets, formed in
the wake of the 1987 stock-market crash, were usually staid, scripted affairs.
Not so on April 21, 1998. A crowd of regulators watched in silence as
Robert Rubin stared across the table in the Treasury Department's ornate
conference room at Brooksley Born, head of the Commodity Futures Trading
Commission. Mr. Rubin, President Clinton's venerated Treasury Secretary,
curtly informed her that she had no right to pursue her plan to explore
whether more regulation was needed of the market for over-the-counter
derivatives.
Mr. Greenspan, sitting to Ms. Born's right, chimed in with a warning that
she risked disrupting U.S. capital markets.
Messrs. Rubin and Greenspan were used to getting their way, but Ms. Born
didn't flinch. The career litigator declared that, as head of an
independent agency, she could go right ahead. "It was really unpleasant,"
says one attendee.
Ms. Born's thinking made her the odd person out among the others in the
room. The value of the OTC derivatives market had grown fivefold to $29
trillion in the six years since regulators had last considered regulating
the financial instruments. They derive their value from price shifts in
underlying assets, such as the interest on a bond, the value of a currency
or the price of a barrel of oil. Multinational corporations, for example,
use derivatives as a hedge, to protect themselves against sudden swings in
the value of the dollar.
Mr. Rubin was a former co-chairman of Goldman, Sachs & Co. whose major
political achievements included making Wall Street and business executives
comfortable with Democrats and persuading President Clinton to balance the
federal budget. He took seriously Wall Street's complaints that even the
threat of regulation could void pending transactions. Mr. Greenspan
believed that innovative derivatives were making the economy more efficient
by providing companies with a hedge against financial fluctuations.
And yet Ms. Born worried that leaving derivatives unregulated also carried
huge risks. Over-the-counter derivatives were traded directly between
companies, away from regulated futures exchanges. Because they weren't
subject to rules that applied to other securities, little was disclosed
about the transactions. That made it easier for traders to take big risks,
or fraudulently manipulate deals. Derivatives had contributed to some
spectacular blowups, including the bankruptcy of Orange County, Calif., and
the demise of 233-year-old Barings PLC, which went belly up in 1995 after a
rogue trader lost $1 billion in unauthorized derivatives trades.
In early May, Treasury and Fed officials circulated word to worried
financial lobbyists that they had persuaded Ms. Born to back down. They
were mistaken. Just days later, the CFTC released a "concept release"
raising 75 questions about the way the OTC derivatives market was
regulated. Treasury and the Fed received no advance notice.
The CFTC paper didn't propose new regulation. It just suggested that it
might be needed. But that was enough to make Messrs. Rubin and Greenspan
fear that the market would be destabilized if people read the paper to mean
that derivatives had been sold illegally. Within hours, joined by SEC
Chairman Levitt, they rushed out a statement saying they had "grave
concerns" about the study.
Wall Street went into lobbying overdrive, as leading derivatives
underwriters such as J.P. Morgan, heavy derivatives users like Enron, and
nearly a dozen financial trade groups pleaded with the Fed and Treasury to
stop Ms. Born. They then asked Congress to block the study.
In late July, Mr. Greenspan told the House Banking Committee that Ms. Born
was trying to pick a fight with the capital markets. "If somebody says to
me, 'I'm contemplating punching you in the nose,' I don't presume that that
is a wholly neutral statement," he said.
Ms. Born, sitting at the table with Mr. Greenspan, said he had distorted
her plan. She explained that she was merely asking, "Do you think you need
a punch in the nose?"
"You don't intend to punch Dr. Greenspan in the nose, do you Ms. Born?" New
York Democratic Rep. John LaFalce asked.
Even a financial meltdown that fall, triggered by bad derivatives bets made
by the Long-Term Capital Management hedge fund, didn't help Ms. Born's
cause. A month after the Fed brokered a bailout of LTCM, Congress passed a
six-month moratorium on proposing or adopting derivatives regulation that
lasted until Ms. Born's term expired. In late 2000, Congress passed a bill
stating that OTC derivatives in most cases weren't subject to regulation.
Enron used derivatives to mask balance-sheet problems. Revelations that
rival energy traders used derivatives for similar controversial
transactions have prompted investors to lose confidence in the largely
unregulated energy-trading sector, causing a loss of some $200 billion in
the market value of a dozen energy companies over the past year. Congress
now is considering a bill to tighten oversight of energy derivatives.
Ms. Born, these days practicing law in Washington, says that if she had
succeeded four years ago, regulators would have been more likely "to detect
misuse of derivatives by entities such as Enron."
But Mr. Greenspan still believes in the value of an unregulated derivatives
market. Those instruments, he said in a speech in September, "have
effectively spread losses from defaults by Enron, Global Crossing" and
others, cushioning the blow to the economy. "So far," he insisted, "so good."
Louis Proyect
www.marxmail.org