The Great Crash, Part II

In the Company of Owners: The Truth about Stock Options (And Why Every Employee Should Have Them) By Joseph Blasi, Douglas Kruse and Aaron Bernstein, Basic Books, $27.50, 344 pages

Pipe Dreams: Greed, Ego, and the Death of Enron
By Robert Bryce, Public Affairs, $27.50, 320 pages

What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in U.S. History By Peter C. Fusaro and Ross M. Miller, John Wiley & Sons, $14.95, 256 pages

Take on the Street: What Wall Street and Corporate America Don't Want You to Know By Arthur Levitt with Paula Dwyer, Pantheon Books, $24.95, 352 pages

Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen By Barbara Ley Toffler with Jennifer Reingold, Broadway Books, $24.95, 288 pages

The lessons of the stock-market crash and corporate scandals of 1999-2002 are only now beginning to sink in. The larger story is the second collapse of laissez-faire as a plausible ideology and an efficient way of organizing the economy. But unlike its first failure in the 1930s, laissez-faire has not yet collapsed as a politics. Evidently that will take a little longer. A spate of recent books provides ample fuel for the political reversal that still awaits the necessary political leadership.

The basic story has three strands. At its core is the overturning, in the 1980s and 1990s, of many of the safeguards that kept the capitalist system honest and efficient. At the heart of these regulatory protections were the policing of capital markets and financial institutions by the Securities and Exchange Commission and the several agencies that regulate banks. Both political parties, as the books under review demonstrate, colluded in the demise of effective regulation.

This regulatory reversal was part free-market ideology, part opportunism. In conservative theory, all these regulations only constrained financial "innovation" and prevented capital from flowing freely to its most efficient use. That was the ideology. In practice, the dismantling of regulations allowed a small number of insiders to get very rich, often at the expense of ordinary investors. In the absence of regulation, the flourishing of opportunism was efficient for the insiders who profited but highly inefficient for the larger economy, as a great many investments ultimately went bust, wasting trillions of dollars in capital. As events proved, the opportunism was beyond the competence of market forces to keep in check. So much for the theory.

If the demise of effective financial regulation is one strand of the story, the second is the overturning of regulation of other industries, notably banking, energy, telecommunications and airlines. As the Enron scandal epitomized, these two forms of deregulation fed on each other. Deregulated energy markets allowed corrupt energy traders to manipulate prices, plundering both consumers and Enron's own shareholders and pensioners. Meanwhile, the collapse of effective policing by the SEC invited the phony accounting that allowed Enron to build a pyramid scheme that did substantially wider damage before the company finally collapsed. At the same time, weakened banking regulation enabled colluding commercial and investment banks to help inflate the Enron bubble and to profit from it while it lasted.

The third part of the story is the stock-market collapse. It wasn't just the aftermath of random euphoria; high-flying Enron and its abrupt downfall serve as metaphor for the larger crash, which involved hundreds of other Enrons, with accountants and bankers as enablers. The great stock bubble of the 1990s had multiple causes, including dot-com mania. But surely the paramount cause was deregulation -- of the banks and brokers that profited from touting bum investments; of the industries such as electric power and telecommunications, which speculated with both shareholder and ratepayer money; and of the accountants that colluded in the phony books. Had effective regulation not been sabotaged, the bubble would have been neither so excessive nor so damaging the morning after.

This is one connection that has yet to be fully teased out.

If you have time to read only one book on this set of events, spend it with Arthur Levitt's Take on the Street. Levitt, who was named chairman of the SEC by President Clinton, served almost the entire eight years of Clinton's two terms. Clinton got more than he bargained for. Levitt was a tough and honest regulator, increasingly skeptical of self-regulation and appalled by what he found. The book is one part consumer's guide on how to avoid investment pitfalls, one part memoir. The latter reveals a series of efforts by Levitt to outlaw the abuses that eventually led to the market collapse, to Enron and to the other Enrons.

Levitt is no Monday morning quarterback. He saw the excesses as they were unfolding, while the stock market was still flying high, and he tried mightily to keep regulation one step ahead of abuses. He was stymied at nearly every turn by a Congress eager to please the accounting, banking, stock brokerage and technology industries. He spent much of his first year at the SEC defending the efforts of the quasi-governmental Financial Accounting Standards Board (FASB) to force corporations to count stock options as expenses. Failure to do so allowed them to artificially inflate stated profits, which in turn pumped up stocks, which in turn gave value to the stock options.

After the collapse, options were revealed as one of the signal abuses. Faced with overwhelming pressure from both parties and knowing that he didn't have the votes in Congress, Levitt backed down. "I regard this as the single biggest mistake during my years of service," he writes.

Levitt's book recounts one such episode after another, and reprints several joint letters he got from representatives and senators bluntly warning of dire consequences if he failed to relent. The SEC's appropriations were threatened. As late as September 2000, after the conflicts of interest in the accounting industry had become widely known, scores of legislators were still warning Levitt not to proceed with regulations requiring accounting firms to refrain from collecting lucrative consulting fees from the same corporations whose books they audited.

For a reader who is not an expert in securities regulation, the most remarkable revelation of Levitt's book is the degree to which Wall Street regulates (or fails to regulate) itself. On paper, the SEC has immense power to limit conflicts of interest, move against corrupt underwriters, brokers and traders, and establish ground rules for accounting. This is the famous "transparency" on which honest money markets and efficient investment depend, a transparency that we regularly commend to developing countries. But in practice, nearly all of the SEC's powers are delegated to industry bodies, or to quasi-independent but industry-dominated ones such as the FASB.

Did you know, for instance, that most enforcement actions against corrupt stockbrokers are taken not by the SEC but by the National Association of Securities Dealers (NASD)? Did you know that the American Institute of Certified Public Accountants, the lobby for the accounting industry, has long dominated the process of defining acceptable practice, with its standards essentially rubber-stamped by the SEC? As Levitt saw the abuses mount in the 1990s, this was the club he was up against, a club with powerful friends in both parties. As his book demonstrates, in case after case the SEC chairman does not issue regulations but delicately negotiates agreements with the industries he ostensibly regulates, as if they were sovereign powers.

Long before revelations poured into the press -- thanks largely to the investigative work of New York Attorney General Eliot Spitzer, who detailed how ostensibly independent "stock analysts" were really pumping up stock recommendations so that their investment-banker bosses could win underwriting business -- Levitt was giving speeches warning about such conflicts of interest. He was finally able to issue a very mild regulation mandating disclosure, but only in the year 2000, after the damage had been done and the bull market had begun to unravel.

Nobody has written the full Spitzer story yet, but it's clear that the New York attorney general has essentially functioned as the SEC in exile. The heavy investigative work on conflicts of interest between retail stock brokerage and stock underwriting has been done by Spitzer's office thanks to the 1921 Martin Act, an obscure New York law that empowers the attorney general to bring civil or criminal charges for fraudulent sale of securities in his state, which includes Wall Street. The New Yorker's John Cassidy, who wrote a useful book, on the Internet bubble, Dot.con, has provided a first installment of the Spitzer story in a riveting April 7 New Yorker profile. Free from congressional pressures, Spitzer issued extensive subpoenas and exposed the pervasive and systemic conflicts of interest among the stock analysts whose salaries, sometimes in excess of $10 million a year, were based on currying favor with companies and not dispassionately "analyzing" them for the benefit of retail customers.

Spitzer settled many of the cases for relatively modest fines and consent agreements to change longstanding practices. But his comparative aggressiveness, Cassidy recounts, roused the SEC and the NASD to launch their own investigations. Eventually, every major New York bank and brokerage agreed to a settlement worked out jointly with Spitzer, the SEC and the NASD. It included $1.4 billion in fines and prohibited some of the more egregious conflicts of interest, requiring greater independence for stock analysts and prohibiting investment banks from rewarding favored clients by giving them quick profits in hot IPOs.

But these reforms stop short of those that Spitzer originally sought, and the SEC, under tight Republican control, remains a paper tiger. Most of the post-Enron reforms will be neutered by weak enforcement, and the system is already reverting to its habits of toothless self-regulation. Charmingly, as these investigations began to unfold in 1999, Congress was in the final throes of repealing the Glass-Steagall Act, the single most important piece of New Deal legislation that kept bankers from underwriting stocks and underwriters from engaging in commercial banking. Conflicts of interest are in Wall Street's DNA.

Several books have appeared on the emblematic Enron meltdown. The most comprehensive and entertaining is Robert Bryce's Pipe Dreams, which chronicles how Kenneth Lay built Enron from a small pipeline operation into what was nominally America's eighth-largest company, using off-the-books partnerships that enriched insiders. Enron made these deals with the collusion of every major investment bank in New York, including Merrill Lynch, Citigroup, J.P. Morgan Chase and literally dozens of others. Enron also sought to recoup its massive borrowings not by creating efficient energy-trading markets in the new climate of deregulation but by amassing so much market power that it could manipulate them. (Though Bryce's book has genuine merits, he appears to have written it in haste; among other blemishes, he spells Arthur Levitt's name wrong.)

As Peter C. Fusaro and Ross M. Miller write in their What Went Wrong at Enron, the basic flaw in Enron's business plan as a legitimate trading company was that huge profits were not to be had honestly on energy trading margins: "[T]he bulk of the legitimate profits from creating a new [trading] market would come in the first year or two of its existence. As producers and consumers would figure out how the market worked, they would strike increasingly better deals, squeezing out Enron's profits in the process." So Enron had to make its exorbitant returns either by fraud or by using its position to gouge consumers. As we now know, it did both. Before it crashed, Fusaro and Miller note, Enron had unveiled an online affiliate that proposed to conduct trading transactions in no fewer than 1,800 different commodities.

Fusaro and Miller's book is useful for its explanation of the dynamics of energy trading. But like Bryce, they fail to explore fully a key aspect of the Enron story: the rigging of California's electricity markets and the wider lesson about the wisdom of deregulation. The Enron debacle could not have occurred without the failure to supervise accountants and investment bankers. But it also could not have occurred without the utopian attempt to deregulate electric power.

Besides Enron itself, the other casualty of the collapse was the company's accountant, the once-irreproachable Arthur Andersen. In Final Accounting, Barbara Toffler has written a book that is partly a tell-all memoir and partly a history of Andersen. Toffler had what seems, in retrospect, a hilarious job description: She was head of Andersen's Ethics and Responsible Business Practices Consulting Services. Much of the frothy memoir deals with the author's frustrations with the Andersen subculture and her mounting unease as the company's consulting and accounting businesses merged, undermining the integrity of the firm. There is a lovely chapter that describes in detail the intense competition among executives to generate fees (known delicately as the "fee fuck") and the clash of norms between auditors, who were trained to measure, and consultants, who aimed to fleece clients for whatever the market would bear. Toffler left Andersen in 1999. There's not much in this short book about the relationship between Andersen and Enron, which was fully covered in the business press thanks largely to public documents that emerged in the course of litigation. But the book offers one more glimpse of the pervasive culture of self-dealing that became American capitalism in the 1990s.

Conflicts of interest are at the very heart of all these stories. Auditors, after all, were supposed to be serving shareholders and the public. Instead, they did what was necessary to get consulting business from the companies they audited and to inflate their own salaries and bonuses. Stock analysts were supposedly there to help retail investors. But they were really cultivating the very corporations whose stocks they were touting. Investment bankers were ostensibly the instruments of an efficient capital market. They turned out to be more interested in self-enrichment. It is sometimes said that norms ultimately matter more than laws. In fact, as these books document all too well, the norms of professionalism and probity in accounting, commercial banking and investment banking were very much the creatures of regulation and law enforcement. Take away the laws and regulators and opportunism soon crowds out integrity. As every other insider is getting rich playing ordinary investors for suckers, the last professional holding out for honor is Lucky Pierre.

One other important book provides a counterpoint to this story. In The Company of Owners, Joseph Blasi, Douglas Kruse and Aaron Bernstein turn the recent history of stock options on its head. In the 1990s, stock options were used as bonuses for top executives. They were supposed to "align the incentives" of the boss and the ordinary shareholders. But because options only had value if and when the stock reached a certain price, they created a perverse incentive for bosses to inflate the value of the stock artificially and cash in fast, leaving the long-term fate of the company to others.

Blasi, a sociologist and tireless crusader for employee stakeholding, Kruse, an economist colleague of Blasi's at Rutgers University, and Bernstein, a senior writer at BusinessWeek, contend that options, differently configured, could and should be an instrument of wealth spreading, broadened employee stock ownership and more efficient capitalism. The problem, of course, is the current set of ground rules, which favor insiders and harm ordinary workers and shareholders. The authors conclude, accurately in my view, that "most corporations in America would enjoy more motivated workers and larger profits if they embraced partnership capitalism centered around employee stock options." More broadly diffused ownership has always been a possibility. As Blasi et al. point out, it has been tried in fits and starts at different times in the history of American capitalism, but the system always has a tendency to default to insider enrichment.

Blasi and company are well worth reading, but they don't quite convince me why options, rather than direct stock-ownership plans, are a superior approach, or why employees should bear a double risk (as workers and then as shareholders) if the company fails for reasons beyond their control. Wouldn't workers be better off with some company stock and a broad, diversified portfolio as well? In assessing why the stakeholder brand of capitalism has failed to take root, the authors also tread lightly on the politics. Rather than proposing a comprehensive policy of broader employee stock ownership, they hope to persuade sensible corporations to embrace options-for-all out of enlightened self-interest. This may place too much faith in corporate executives, who have much to gain personally by looking to the short term and adopting a personal enrichment strategy of winner-take-all.

We regulate capitalism and use democratic politics to produce the votes to enact the necessary legislation. Otherwise, insider enrichment, corporate corruption and calamity for the rest of the economy become the norm. None of these books entirely connects the dots between the stock-market meltdown, the regulatory reversals and the concentration of political power on Wall Street (Levitt's comes closest). But the connection is there for the reader to make. The story of how democracy will reassert the necessary governance of capitalism remains to be written. Indeed, it remains to be accomplished.

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