Legislating Trust

If, as Senator Phil Gramm (R-Tex.) has said, the Enron scandal is no longer a “feeding frenzy” that impels legislative action, perhaps the spate of scandals that have emerged since Enron’s collapse – Global Crossing, Tyco, Adelphia Communications, CMS Energy, Williams, WorldCom, Reliant – will cause enough turmoil in the financial markets to cause Congress to act. After all, everyday the market continues to underperform is another day the baby boomers must put off retirement. And as the oldest of the “me” generation approach 60, the political impetus for political solutions to the equity decline will be palpable.

During the days of 15 percent annual growth in corporate earnings and 25 percent portfolio advances, even boomers squarely in the middle class felt that an early and comely retirement was in the cards. Money shifted from corporations whose sales of real products could barely manage 5 percent growth to “new economy” stocks that were marketed enthusiastically by their investment bankers whether they were “dogs” or not. Federal Reserve Chairman Alan Greenspan warned soberly of “irrational exuberance,” but that was December 5, 1996, about 5 years before the stock bubble finally burst.

Over the past 30 months, the Dow has fallen by 20 percent, the S&P is down about 33 percent, while the NASDAQ has lost 70 percent over a similar period. Hopes for a sustained rally have been dashed by the September 11th atrocities and the crisis of confidence that has gripped investors since Enron. Were the collapse an isolated incident, the fallout would have been bad enough, but it is now clear that many of Enron’s most vilified practices were commonplace in the energy and telecommunications businesses.

While there is no question that such actions defrauded investors and led to billions in losses for JPMorgan and Citigroup, among others, the extent to which reporters have blamed the average investor’s misfortune on off-balance sheet entities, bogus “round-trip” trades, and debt leveraging is laughable. If anything, the meltdown in energy and telecom should reveal just how delusional efforts to “level the playing field” between Wall Street institutions and the average investor really are.

The average man on the street has no idea how to value credit derivatives, cable subscribers, and trading volumes correctly, no matter how factual and comprehensive the information. After all, the credit rating agencies Standard and Poor’s and Moody’s were not only responsible for issuing ratings for Enron, but also for the hidden off-balance sheet ventures that started the company’s downward spiral in the first place. And even with this information, these highly skilled, independent credit analysts did not even drop Enron’s bonds below investment grade until the company was already doomed.

Investors will always be dependent on the advice and judgment of financial professionals, the integrity of corporate executives, and the scruples of accountants; to pretend otherwise is naïve or malicious. Yet such dependence must be based on trust, and the events of the past seven months should make even the most gullible among us circumspect.

But investor trepidation should be viewed less as a symptom of the malaise in corporate ethics than its cure. No one should expect investors to jump back into the market until financial institutions and their corporate patrons reform sufficiently. And nothing has brought about these changes faster than investors, who have punished companies that have failed to reform their audit boards or continue to obfuscate earnings. Even the Big Board itself, the New York Stock Exchange, is demanding dramatic reforms from its listed companies that would transform corporate governance and reaffirm the supervisory role of independent directors.

But, in the end, none of this will matter much if corporations continue to find it difficult to raise capital and near-retirees continue to see their portfolios stagnate. Politicians will be eager to “do something” to cater to both constituencies. That “something” will likely be legislation to create a veneer of reform to cultivate faith in financial institutions. But, as U.S. Comptroller General David Walker said in testimony to Congress, “In the end, no matter what system exists, bad actors will do bad things with bad results.”

Trust is something that cannot be legislated. But in an election year that will be the last under the incumbent campaign finance rules, and possibly the first that will see equities experience a third consecutive year of decline, Congress will try to do the impossible. Hopefully its action will not undo the real reforms already well underway.

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