Gigot's Pages

L. Gordon Crovitz, a former publisher of the Journal, now writes a weekly column for the publication entitled, "Information Age." (As a publisher he was responsible for all stages in the production of the Journal, including copyediting, graphic design, printing, marketing, and distribution.) In his latest article he makes the argument that the world of finance is a laboratory and that the creation and use of derivatives are experiments that have not yet been perfected. Derivatives are financial products that derive their value from an underlying security. A simple example is that of a call option on a particular stock. A call option allows someone who has made an upfront payment the right to buy ("call") 100 shares of that particular underlying stock at any time prior to the expiration date of that option. Another example would be a credit default swap, which got American International Group into its current financial troubles and precipitated a government bailout of the insurer. A credit default swap is an agreement between two parties and acts much like an insurance policy. The seller of the swap receives periodic payments from the buyer. The buyer is protected if the security that underlies the swap - a bond, for instance - defaults. In the case of default, the seller would have to make the buyer whole. Crovitz encourages the "financial engineers to find fixes for what's broken." He says that these products have benefits. He argues, for example, that derivatives help global businesses hedge currency risk. In a report to the shareholders of Berkshire Hathaway Warren Buffett offered another view, calling derivatives "financial weapons of mass destruction." Is the problem with the derivatives or the regulation of the derivatives? Can these products be properly regulated?

Some of you may have been following New York's "pay to play" scandal. Politically connected individuals acting as "placement agents" purportedly accepted undisclosed kickbacks from financial companies in return for the companies being given a piece of New York State's billion-dollar pension fund to manage. In New York State the comptroller is the political person who is completely in charge of doling out pension dollars to be managed. The Journal states, "The solution is to take these assets and the pension investments decisions away from political actors." With whom then should such decisions reside? Doesn't the decision ultimately have to come from a political player or players?

John C. Bogle founded a unique company in Vanguard. It is unique in that this investment management company, which manages mutual funds, is owned by the funds themselves. This keeps costs low. He is now an investor advocate and has written many books, including, most recently, Enough: True Measures of Money, Business, and Life (Wiley, 2008, 288 pages). In an April 21^st Journal editorial he argues for the establishment of a "fiduciary society." According to Bogle, one cause of the global financial crisis is the "deterioration in traditional ethical standards." Capitalism has evolved from an "ownership society" wherein the owners managed the business to an "agency society" wherein management that has little or no stake in the company manages it. For example, prior to the 1950's New York Stock Exchange member firms could only be partnerships or sole-proprietorships - an ownership structure. Prior to the 1970's they were prohibited from going public in an initial public offering. Now there are private corporate NYSE members (e.g., Mogavero Lee & Co. Inc.) and publicly-owned members (e.g. LaBranche & Co. Inc.). This agency society, according to Bogle, is a "failure." So he would like to see a legally mandated "fiduciary society" where the interests of shareholders are placed first. He does concede that "making that happen will be no easy task." Will Congress enact the requirement of "fiduciary society"? What would be the standards for complying with the legislation? How would the courts weigh in?

Michael Milken, "the junk bond king," is most notably remembered for preaching the benefits of high yield securities - securities that are rated below investment grade by a credit rating agency. As such, these securities are speculative. He and the now defunct firm he worked for - Drexel Burnham Lambert - financed many successful companies using these high yield securities. He might not, however, be remembered as much for his theory that capital structure - how a company is financed (i.e., with debt, equity, etc.) - is integral in determining the value and risk of a company's securities. (He expressed these ideas in a thesis he wrote forty years ago while attending the Wharton School at the University of Pennsylvania.) Franco Modigliani and Merton Miller, Nobel Prize winners in economics in 1985 and 1990, respectively, would not agree with Milken. The so-called Modigliani-Miller Theorem postulates that the make-up of a company's capital structure is irrelevant to how the company is valued. Milken does provide an example to back up his thesis. He states that Alcoa and Johnson Controls, each of which had an equity offering in March 2009, saw their stock prices rise. Usually, he continues, "issuing new equity securities can of course depress a stock's value" in that there is a greater supply of stock and the issuance occurs because "management thinks the stock price is high relative to its true value." Furthermore, Milken argues that many companies that had bought back their company's stock before the credit crisis hit found themselves with the "wrong capital structure" afterward. They didn't have "less debt with long maturities," which could have carried them through the crisis. (Neither Miller nor Modigliani, who died in 2000 and 2003, respectively, are here to defend themselves.) Could two prominent economists have been wrong?

In an April 23^rd editorial, Charles W. Calomiris, a finance professor at Columbia, provides a list of seven reforms that he believes will prevent a future financial crisis. He asserts that "we can all agree on" these reforms. They are as follows: (1) Require a company that is currently "too big to fail," i.e., one for which there is an implied understanding between the company and the government that they will be bailed out, to have more capital and to create "detailed and regularly updated [preapproved] plans" that would address financial problems they would encounter in a future credit crisis. (2) "Establish a 'macro' prudential regulator" that will vary the capital requirements of financial companies, depending on whether the economy is in a boom or bust cycle. (3) The Federal National Mortgage Association, affectionately known as "Fannie Mae," which was set-up in the late 1930's to purchase or guarantee mortgages, has failed, so improve the government "subsidies to low income, first time homebuyers." (4) Increase the transparency of over-the-counter derivative transactions by imposing a charge on those transactions that don't go through a clearinghouse. (5) Require regulators to use better "techniques for measuring risk," such as the interest rate "yields of uninsured bank debt," which can provide "useful information about the overall riskiness of a bank. (6) Credit ratings should consist of objective estimates, such as the probability of default of an issuer of securities. (7) Finally, Calomiris recommends the elimination of "ownership concentration limits imposed" through the Bank Holding Company Act of 1956 - legislation that has been amended numerous times - on investors in bank holding companies. Will these reforms help prevent a future financial crisis?

The current global financial crisis is "not really a crisis of capitalism." Rather, we must recognize that capitalism must live within certain rules. So argue George A. Akerlof and Robert J. Shiller. Akerlof, a professor at the University of California at Berkeley, was awarded the Nobel Prize in Economics in 2001. Shiller, a finance and economics professor at Yale has written many books, most notably Irrational Exuberance (Princeton University Press, 2005, 344 pages). They go on to state that it is important to regulate the economic activity and bubbles that are driven by "animal spirits," that is, "the human psychology and culture at the heart of economic activity." (The term was first used by the late British economist John Maynard Keynes in his 1935 work The General Theory of Employment, Interest and Money.) Akerlof and Shiller, continue, writing, "Devising new regulatory structures that will allow financial innovation to proceed and yet prevent new such systemic problems is the major challenge to our creative capitalism today." What version of capitalism is best? How much regulation is needed to counterbalance the future bubbles that will emanate from the public's "animal spirits"?

Robert B. Reich, the former labor secretary under President Clinton, wrote a weekend editorial that argued that each bank that took U.S. taxpayer funds through the Troubled Assets Relief Program (TARP) should be required to have a taxpayer representative on its Board of Directors. Regardless of how much these companies owe taxpayers, their duty should be to shareholders, who want a higher stock price, he argues. Reich states, "The immediate challenge is to sort out public from private responsibilities and to create clearer lines of accountability." A public director on the Board, who would represent the taxpaying public, would be the right start. Such a director (or directors, depending on the ownership stake) would be appointed by the President of the United States. Their votes, which would be influenced by the President and his economic advisors, would be made public. The public owns about 36% of Citigroup and 80% of AIG. Why hasn't the executive branch requested board seats?

[This article is entitled "Gigot's Pages" because Paul A. Gigot is The Wall Street Journal's Editor of the Editorial Page. This position, which he has held since 2001, makes him (and an Editorial Board) responsible for overseeing the Journal's editorial and opinion content. This series will focus on selected finance-related content of these op-ed pages.]

Sources:

L. Gordon Crovitz, "In Finance, Too, Learning, Entails Risk," The Wall Street Journal, page A13, April 20, 2009.

"The Public Pension Shakedown," The Wall Street Journal, page A14, April 20, 2009.

John C. Bogle, "A Crisis of Ethic Proportions," The Wall Street Journal, page A19, April 21, 2009.

Michael Milken, "Why Capital Structure Matters," The Wall Street Journal, page A21, April 21, 2009.

Charles W. Calomiris, "Financial Reforms We Can All Agree on," The Wall Street Journal, page A17, April 23, 2009.

George A Akerlof and Robert J. Shiller, "Good Government and Animal Spirits," The Wall Street Journal, page A15, April 24, 2009.

Robert B. Reich, "We Need Public Directors on TARP Bank Boards," The Wall Street Journal, page A11, April 25-26, 2009.