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February 1998 Volume 16, Number 2 Is the Market Too Big to Drop by Jeff Scott

It's time to start thinking of the stock market as a giant S&L. Money continues to pour in, despite a bounty of evidence that the extraordinary gains of the last few years cannot be enjoyed in the near future. The perception has never been stronger that the stock market is the right place to be for your long-term investment needs. The investment philosophy of "buying on the dip" has proved a winner, partly due to genuine economic growth and accompanying profits. Many other investment philosophies appear to be winners too. We're in the Lake Wobegon of stock markets, where all our returns will be above average. The sourpusses haven't been able to ruin the party. They are, like James Grant of Grant's Interest Rate Observer, detached from the festivities. They appear on television to solemnly note the silliness of full-bellied markets. PBS Frontline last season donned bearish spectacles in a program produced by Fortune editor Joseph Nocera. The cameras entered a suburban home and documented the spirited grin of an investor who had heard that a company would "double by August." She invested the family money. She could remember the letters of the stock ticker, but she couldn't remember the name of the company or which talking head on CNBC actually said it would double. That's scary. And it's scary not because she might make money or lose it. It's scary because there is no reasonable connection between her money and the company's prospects. She has more in common with lottery ticket buyers than with traditional speculators. If she is characteristic of a large class of investors, then that company, call it Stocks Unlimited, would seem to have the same benefits of a high-flying S&L in the eighties. There is cash coming in irrespective of boardroom decisions. The people who are giving that cash to Stocks Unlimited feel good about it for a number of reasons.

Perhaps they feel protected in some way because they believe market dips are temporary, that earnings have become less relevant, that the general level of the market has a floor under it. Consider if all companies together could attract blissfully ignorant investors. Then what is to stop the executive managers from running the company to benefit themselves and shift the risk of loss into the future? Sounds like an S&L to me. There are, obviously, important differences. Investors are different from depositors. They buy stock which is not guaranteed. Deposits are protected by federal deposit insurance. Stock investors can and do lose large sums of money. But there is an important similarity which deserves consideration. Consider the two major financial events of the eighties: the S&L crisis and the wave of leveraged buyouts (LBOs), many of them hostile restructuring. The fundamental explanation offered for the disaster in the thrift industry was that deposit insurance created a moral hazard. Insurance companies face the problem that a person's behavior can change if that person is protected against loss. In S&Ls, the risk-taking behavior of financial executives went far beyond what the insured depositors would have preferred. The result was that depositors got their money back while taxpayers as a whole paid for the reckless (and occasionally fraudulent) behavior. The takeover market started full steam in 1985, about the time oil entrepreneur T. Boone Pickens made a grab for Unocal using leverage finance. Michael Milken's junk bonds provided a means of unlocking for shareholders the petrodollar cash that Unocal's executives were squandering. The fundamental explanation offered for the hostile leveraged takeover is that the separation of ownership and control created an agency problem. An agent represents a client, and the client (or principal) authorizes that agent to act on his behalf. Shareholders, because they are dispersed, often have difficulty organizing and authorizing action. The separation of ownership and control is a mild economic rigidity which has been fortified by law and politics. The dispersion of ownership diffused power over the corporation and prevented serious competition for management. Pickens was just such a competitor who discovered there was a real deficiency in the way oil corporations were governed; shareholders were not receiving their full due. Similarly, other large conglomerates enjoyed wide, liquid trading in their securities, but over time, their competitive advantage diminished from lack of managerial foresight. The takeovers

acted to strengthen the owners and weaken the professional managers. By the end, shareholders were able to realize submerged values. Some estimate nearly a trillion dollars in economic value was created in the leveraged restructuring movement. If only S&L regulators had been as wise as Pickens and the other LBO entrepreneurs of consolidation, then the public would have been saved from the protracted and costly bailout. Though highly controversial at the time, the argument today is settled: hostile takeovers, leveraged and otherwise, were good. Why? Because they aligned the interests of owners and managers. In most cases, this meant pay for performance. In practice, managers were made owners and given a high stake in the outcome of the firm. Come back to the S&Ls. Moral hazard is a type of agency problem. In both cases, the managers are not monitored sufficiently. An unfortunate consequence of poor monitoring is that S&Ls could enter business lines in which they don't have competency. They could invest in the most ludicrous real estate deals, as they occasionally did. But this too describes the behavior of some of the unwieldy conglomerates. Companies like Litton and several oil companies got into businesses they knew nothing about --oil company executives were particularly poor at running unrelated business units. Executives feathered their own nests with perquisites unrelated to their job performance. They objected to Milken-financed takeovers because they wanted to keep their jobs at the expense of shareholder accountability. And just like the S&Ls, business establishment lobbyists worked to preserve their turf, prolonging the problems of poor management. The American Petroleum Institute and the Business Roundtable, like their S&L lobbying kin, attempted to limit restructuring by any means available. A third agency problem faces us today. The Federal Reserve's and the deposit insurer's roles in propping up market values through credit expansion have been widely understood. Less understood is how the complex web of securities laws contribute to the current euphoria. The securities laws are built around the notion that concentrated power is bad and diffused power is good. It's good because the power is evenly distributed and perceived to be fair by the investing public. And that is what they say publicly: the market should be fair. The arcane administrative and regulatory directives of the Securities and Exchange Commission are inspired by the same populism behind anti-trust and deposit insurance.

The building block of fairness, in the SEC's view, is the preservation of liquidity. Investments must be easily reversible, for that will attract people who will risk their money. Here, the SEC is involved in a nefarious deception. The SEC does not protect investors, as its mission claims, but the liquidity of investments. However, liquidity is one of the products offered by the securities markets. How can it be government policy to promote a product? The direct benefits from high levels of trading go to the securities industry; the public benefits indirectly, if at all. The money from naive investors is channeled away from competing investment alternatives. Many securities laws are not laws at all, but thinly-disguised economic policies that benefit the securities-market professionals. That explains, for instance, why insider trading and warehousing (stock parking) are illegal. There is no reason to ban them outright, as Justice Thomas noted in an important dissent last year. There is no inherent evil to these practices and in fact they have important economic functions. The basic objection to insider trading, offered by SEC commissioners before the Supreme Court, is that it undermines economic regulatory policy. It can reduce the wide market liquidity that a stock enjoys and that the stock market as a whole enjoys. So what? Concentrated ownership, as in the days of Morgan, and more recently, the LBO, gives up the liquidity in exchange for control and influence. Contrary to SEC policy, concentrated ownership and less-than-perfectly liquid markets (like real estate or fine art) are neither evil nor undesirable. Market makers on the exchanges can create liquidity independent of the government; what they cannot create on private exchanges, they should not ask the state for. A private citizen who booked phony trades to create the illusion of liquidity would be arrested, rightly, for fraud. The securities industry has a legitimate purpose in trying to get that woman on Frontline to invest in stocks, rather than jewelry, real estate, education, or a trip to Hawaii. By stressing that the markets are kept "fair," securities law encourages over-confidence. Restrictions on insider trading and similar laws foster the dangerous illusion that the uninformed and ignorant can compete on a level playing field with people who sit at computer screens making a living at being informed in a timely manner. Perhaps it is a stretch to say that the SEC functions like deposit insurance, which guarantees the liabilities of financial institutions. How different is that woman on Frontline from an S&L depositor? Are stock and mutual fund holders akin to S&L depositors, oblivious to the real underlying values? And are central bank functions and the SEC goals not cut from the same cloth? They are. And together they violate the basic principle that confidence has to be earned. Any government that recklessly sustains hopes, whether in the form of low interest rates, high and

stable employment, low currency variability, secure retirement savings, safe bank deposits, or evenly-informed stock trading, is engaging in systematic and dangerous tomfoolery. Confidence is a product; it can be created and nurtured by the free market. Confidence should not be hijacked for special interests. Nor is it so fragile that it needs a special caress from the state. There is such a thing as irrational exuberance, but its source is not the "greed and fear" of Wall Street. Instead, it is a product of nanny-state meddling. The guarantees of federally insured depositors in the 1980s contributed to this entitlement mentality, now endemic. If our Treasury bailed out Mexico, Malaysia, and Indonesia, surely the public will ask: don't our 401(k) plans have higher ranking claims? The SEC, as adjunct to the central bank and as marketing director for the securities industry, is culpable for this mindset. What is our government today if not the bastion of bailouts? Market sentiment, more than ever, is distorted by the federal safety net. That, in turn, distorts market values by taking evaluation out of the realm of reason. Investing has been dumbed way down. There is some evidence that the people who are moving funds into the markets increasingly disassociate the money they put in trust with the assets that will provide future earnings. It may be that the regulation of capital formation has caused the public to divorce behavior and consequences. Contemplate for a moment, the stock market and economy of Japan over the last five years. It is a frightening prospect. The poor woman on Frontline doesn't realize that she is the victim of a confidence game that even the worst of the S&L crooks could not have dreamed up.
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Jeff Scott is an analyst for Wells Fargo, San Fransisco FURTHER READING: Mark J. Roe, Strong Managers, Weak Owners (Princeton: Princeton University Press, 1994); Jonathan R. Macey, "Administrative Agency Obsolescence and Interest Group Formation,"Cardozo Law Review 15 (1994): 909-49; James Grant, The Trouble with Prosperity (New York: Times Books, 1996). Back