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Tuesday, May 26, 2009

Married to the Market: How We Got There in Five Easy Steps

The stock market has a much bigger presence in the life of the average American now than it did a couple of decades ago.  As a result, the pain inflicted by the current economic crisis has been more widely felt than ever before. 

How did we come to be married to the market?  Others could no doubt add to this list, but here, in roughly chronological order, are five changes that have helped to tie the knot.[1]

No more planning for the unforeseen

In the nineteenth and early twentieth centuries, many public companies regarded it as prudent to set aside a portion of their earnings as reserves against a rainy day.  The idea was that the reserves would enable them to continue paying dividends – and thereby safeguard the market value of their shares – in years when their current earnings were inadequate. 

In 1975, this practice was ruled unacceptable by the Financial Accounting Standards Board.  Its FAS Statement No. 5 required reserves to be accrued for losses that were “probable” and could be estimated; it explicitly prohibited “reserves for general contingencies” (§14).    The board was fully aware of the arguments in favor of a general reserve fund.  In its words, “The Board recognizes that some investors may have a preference for investments in enterprises having a stable pattern of earnings, because that indicates lesser certainty or risk than fluctuating earnings.  That preference, in turn, is perceived by many as having a favorable effect on the market prices of those enterprises’ securities” (§65).  But the alternative to setting aside reserves – purchasing insurance or reinsurance – was preferable, the Board concluded, and it overruled prudence:  “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur” (§65). 

FAS Statement No. 5 thus tied public firms more closely to the ups and downs of the market (and surely stimulated the insurance/derivatives market as well), with pro-cyclical consequences, as others have noted.[2]  When the market speaks (that’s an allusion to my childhood memories of “The Shadow”), it now speaks louder for public firms.

The shrinkage of regulation

A confluence of factors that has shrunk the scope and coverage of regulation has also – inevitably – given market forces a stronger presence in American life than at any time since the 1930s.  One is the drive to deregulate American industries that began with the de jure deregulation of airlines in the 1970s, followed by the banking and trucking industries, and continued through repeal of (what was left of) the Glass-Stegall Act in 1999 and beyond.  De facto deregulation has also occurred through the de-funding and understaffing of regulatory agencies.

Alongside domestic deregulation, the globalization of financial markets since the 1980s, as many commentators have noted, has also produced an international “race to the bottom,” that is, towards ever laxer regulation.  The international competition that drives this race looks very much like the competition among the American states that first gave rise to a “competition in laxity” in the late nineteenth century.[3]  In arguing (successfully) against the regulation of derivatives in 2000, Federal Reserve Chairman Alan Greenspan summed up the competitive pressures wrought by globalization in these inimitable words:  “I see a real risk that, if we fail to rationalize our centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of foreign investors without imposing so many regulatory restraints.”[4] 

With large holes torn in the American regulatory net, trading not only of exotic securities but also of commodities such as oil has shifted increasingly to “dark markets,” whose byways are unlighted by regulation.  In this sense, we live with the market in ways that we did not before the 1980s.

Incorporation of investment banks

Until the 1980s, the large private investment banks, whose business itself is highly dependent on the state of securities markets, were organized as partnerships.  This gave them a measure of insulation from short-term market pressures.  Beginning in the 1980s, however, one after the other, they converted themselves into public companies.  The last to go over to the short-term-pressured fast lane was Goldman Sachs, which went public in 1999 with Henry Paulson as its chairman and CEO.  As a result, large investment banks – like the new investment houses of the 1920s – are now doubly vulnerable to the power of the stock market.  For the banks’ clients, this means that not only their stock investments but now the brokerage firms that handle them are subject to short-term market pressures.

“Forced capitalists”

And more Americans are now in the market, whether they like it or not.  Leo E. Strine, Jr., Vice Chancellor of the Delaware Court of Chancery, coined the nifty term “forced capitalists” to capture the consequences of the widespread shift from defined-benefit to defined-contribution pension plans in recent years.

Traditional defined-benefit pension plans, which have all but disappeared, once guaranteed employees fixed retirement benefits tied to their wages and length of service.  These have now been largely supplanted by defined-contribution pension plans, which carry no guarantee of retirement benefits.  Instead, and at best, employers make contributions to employees’ 401(k) plans, which the employees invest in the market.  “As a result of these changing dynamics,” observes Vice Chancellor Strine, “most ordinary Americans have little choice but to invest in the market.  They are in essence ‘forced capitalists,’ even though they continue to depend for their economic security on their ability to sell their labor and to have access to quality jobs” (p. 7).  Millions of Americans, in other words, find themselves in forced marriages with the market.

“Mark to market” rules

Last but not least, a recent FASB accounting rule change has, like the prohibition on  general-contingency reserves, tied firms more tightly than ever to the fluctuation of markets – with disastrous results, it turns out, when those markets freeze up.  The culprit here is FAS 157 – the Financial Accounting Standard Board’s Statement No. 157, Fair Value Measurements – issued in 2006.  This requires that assets and liabilities be carried on a company’s balance sheet at their present market price, rather than at a reasonable estimate of their long-term value.  Like the prohibition on general-contingency reserves, this rule was intended to increase “market transparency,” and market transparency translates into greater exposure to short-term market forces.  I won’t belabor this point, since it’s gotten a lot of attention in the last year.  Try a Google search of “mark to market” and wade through some of its 1,160,000 hits.

This is by no means an exhaustive review of the changes that have brought Americans into more intimate relations with markets.  One could add others such as the decline of unions (part of the deregulation, in effect, of labor markets) and the rise of computerized trading (even computerized trading based on computerized reading of the news).  But they would merely reinforce my main point:  Americans today find themselves on more intimate terms with the market than ever before.

[typos corrected 5/26/09, 7:05 p.m.]

[1] Thanks are due to my students in History 247, who got a preview of this blog in my last lecture this semester.

[2] Cheyenne Hopkins, “Dugan:  Turmoil Shows Need for Reserve Leeway,” American Banker, March 3, 2009, on Lexis-Nexis Academic.

[3] Colleen A. Dunlavy, “Bursting Through State Limits:  Lessons from American Railroad History,” in The State, Regulation, and the Economy:  An Historical Perspective, eds. Lars Magnusson and Jan Ottosson (Cheltenham, UK and Northampton, MA:  Edward Elgar, 2002), 44-60.

[4] Joseph Rebello and Dawn Kopecki, “Greenspan Urges Congress to Exempt OTC Derivatives From U.S. Regulation," Wall Street Journal, February 11, 2000, C11.

Tuesday, March 24, 2009

Cuomo and AIG - a history lesson

Doesn't anyone know the (peculiar) history of insurance regulation in the U.S.?  

Based on the tv coverage of President Obama's news conference this evening, it seems safe to assume that the tv pundits aren't aware of it.  In his press conference, President Obama was asked why Attorney General Andrew Cuomo of New York was able to make more headway (regarding bonuses) with AIG than the federal government.  What Pres. Obama could easily have said (had he not focused on the questioner's second question) was that the insurance business is one of the few industries (the only industry?) in the U.S. that is still regulated principally by the state governments (click here for a brief synposis).  This is despite the fact that the insurance industry -- one of the first businesses (after the slave trade) to expand across state lines -- lobbied Congress for federal regulation after the Civil War.  It is precisely because insurance companies have taken on much broader financial activities in the last couple of decades that the Obama administration is (finally) proposing to broaden federal regulation of financial institutions so that it encompasses entities such as AIG. 

For details on the post-Civil War efforts on behalf of federal regulation, see Philip L. Merkel, "Going National:  The Life Insurance Industry's Campaign for Federal Regulation after the Civil War," Business History Review 65:3 (Autumn 1991): 528-553 (on JSTOR).

[edited to correct typ0]