When times are good innovation in the financial markets is applauded. But when times turn bad, as they inevitably do, the horse of innovation is thought to be dangerously outdistancing the mule of regulation.
Since 2003 times have generally been good. To be sure, there has not been a major setback in U.S. equities since the war in Iraq began, the U.S. economy has grown at an average quarterly rate of 3.5% since 2Q03, and corporate earnings have been on a tear. As for overseas, dazzling growth in China has quickly become the given, Japan's economic expansion - weak yen and all - is poised to become the longest since World War II, and most other major economies/markets are either considered to be strong or stable. One final example of just how 'good' times are can be seen in the following contrast: as recently as 2002 many battered pension funds were thinking about exiting the poorly performing U.S. stock markets while today many of these same funds are lining up to pile money into hedge funds.
Suffice to say, the argument can be made that recent innovations and/or market trends have brought with them a great deal of uncertainty, but so long as times remain good 'uncertainty' easily translates into 'opportunity'. For example, it is supposedly wonderful news that new asset backed and credit derivative instruments are growing rapidly, that hedge funds have been more widely accepted as an alternative investment, and that one-time market safeguards could soon be 'innovated'-away. In fact, recent market developments are, apparently, so wonderful that U.S. regulators have, to Wall Street's satisfaction, finally started to recognize that financial market success can only be had by embracing more risk. Enron and Amaranth be damned, America must innovate or die.
The Fight to Remain Financial Capital of The World?
Signed into law on July 30, 2002, the goal of the Sarbanes-Oxley Act (SOX) was to "deter and punish corporate and accounting fraud and corruption" (Bush), and "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws" (Stated Objective). Although SOX was widely credited for helping restore investor confidence in the markets, it is about to come under attack.
Backing the attack against SOX is the Washington-based Chamber of Commerce, which lobbies for three million companies (Bloomberg). The ammunition being used is as follows: SOX regulations should be less restrictive because along with the Act's stated objectives another "objective is to make sure that capital remains here in the United States and we don't drive it out because of over-regulation." To get an idea of how imminent the blitzkrieg against SOX is, the aforementioned quote came from President Bush less than two-weeks ago.
Along with the brewing SOX battle, not to mention the recent hedge fund 'registration' court win against the SEC, another disturbing event is that the SEC is about to loosen margin requirements that were first put in place after the Crash of 29. By reducing institutional margin requirements from as high as 50% to 15% the markets would not become more dangerous but - supposedly - more 'innovative': "The move removes a key barrier to the competitiveness of the US capital markets as similar margin rules already exist in Europe, attracting increasing numbers of hedge funds..." (FT)
Obviously there are risks to innovating-away what were previously considered to be groundbreaking market safeguards. But the party line from many in America is that if everyone else is doing it (or not 'doing it' in the case of SOX), why not us? London is attracting more hedge fund activity and IPOs than the U.S., the largest IPOs today are coming out of Hong Kong, and even India is lining up IPOs. In the mind of U.S. regulators this is a call to arms.
The Margin Debate...What Debate?
Margin requirements are, per code, "For the purpose of preventing the excessive use of credit for the purchase or carrying of securities". If reducing margin rates is now on the table, wouldn't it be wise to at least save this policy option for when it can be used to help absorb a shock in the markets? (i.e. Dow crashes by 1,000 points and credit is tight, so margin requirements are reduced). Encouraging the use of more credit amidst a market boom wastes a potentially stimulative regulatory move.
Noticeably absent from the margin debate is Fed Chairman Bernanke - who has opted to keep his mouth closed since the Bartiromo debacle. In September 1996 Greenspan said "I guarantee that if you want to get rid of the [stock market] bubble that [increasing margin requirements] will do it." With a reduction in margin requirements threatening to add fuel to what many are already calling a liquidity bubble will Bernanke soon speak up?
Even if Bernanke remains silent and margin requirements are reduced to satisfy hedge funds, the larger issue at play is SOX reform.
Who Will "Protect Investors"?
Recent events have made it painfully clear that Treasury Secretary Paulson, who is starting to campaign for SOX reform, and Wall Street sweetheart/SEC boss Cox are forming a front for the less regulation/more market speculation lobby. With the backing of President Bush, corporate America, and others (Thain, Thornton, and possibly the PCAOB) this tells us - baring something dramatic - that changes to SOX are coming. Unfortunately the only party that may represent the interests of the smaller investor is the recently formed 'Committee on Capital Markets Regulation'. This Committee is set to release its first report on Novembers 30 and, as co-chair R. Glenn Hubbard recently suggested, "Rolling back the Sarbanes-Oxley law wholesale is not the answer. But subjecting regulation to rigorous cost-benefit analysis is surely right."
With Hubbard's potentially investor friendly group unable to actually change policy, there is the risk that regulator-strings will ultimately be pulled by Wall Street masters. The hope is that regulators can break their mind-meld with the Street and corporate America and instead see the reality before them. Note the word 'hope'...
SOX Didn't Start The Fire
It is important to point out that the U.S. financial markets have historically been the most attractive place for a company to list not only because they were the largest and most trusted, but also because they were - by leaps and bounds - the most liquid markets in the world. This is no longer the case. Rather, investors have discovered new and exciting places to invest abroad and this has helped narrow the liquidity gap between U.S. and non-U.S. markets. Hand-and-hand with more competitive global 'liquidity' conditions is the fact that company's vying to go public are also seeing a less favorable set of mathematics. To be sure, 10-years ago a company got a premium for listing in the U.S. compared to anyplace else while today that premium, if it exists at all, is much smaller.
In light of these trends, regulators trying to woo companies to list in America with the Wal-Mart-like slogan 'We regulate less!' could be myopic. After all, is SOX really to blame for Chinese banks listing in Hong-Kong? Are Russian companies (many of which acquire assets through questionable routes and would not comply pre-SOX U.S. standards), really rushing to list in London instead of New York because of SOX? With the Sensex booming and new rules allowing foreign investment in IPOs about to pass, are Indian real estate companies ignoring America because of SOX? The proponents of SOX reform would have you believe 'yes!', but the superior performance of many international markets (compared to the U.S.) since 2003 says otherwise.
The Long-Term Advantages of Doing Nothing
What is forgotten in the mad rush to dilute SOX is, to reiterate, that times are generally good. When times turn bad, as they inevitable will, it could actually be to the U.S.'s advantage if current standards are left in place.
Two related benefits of not allowing Wall Street to rewrite Sarbanes-Oxley is that the U.S. markets will encounter fewer unforeseen corporate collapses in the future, and when collapses do occur they will be prosecuted more aggressively. Some of the major SOX changes being talked about are to make management less responsible for financial statements (to attract more companies to list in America) and to limit lawsuits against companies (also to attract more companies to list in America). Realizing that being tough on corporate crime can be an effective tool at preventing corporate crime, do ordinary investors approve of these proposed changes to SOX?
Another potential benefit of SOX is that when less regulated markets/companies around the globe blowup the trusted and transparent U.S. markets will (again) become a safe haven for capital. With the markets booming and liquidity steadily shifting from beaten down asset classes into equities, very few policy makers seem concerned that liquidity in American markets will ever dry-up. The word for this lack of concern is complacency.
Conclusions
With SOX about to come under attack there is that risk that policy makers are headed down the wrong path; that at a time when effort should be spent simplifying accounting standards and, eventually, reaping the benefits of falling SOX costs, energy is instead being wasted rethinking SOX to placate the business lobby and increase Street profits. Quite frankly, if SOX is now regarded as the result of policy overshoot made during bad times for the markets, what assurances can be made that a similar overshoot in the other direction will not occur today, or during the 'good' times?
If you can somehow forget that the U.S. already attracts a ridiculous amount of global savings, concern that American capital markets are growing less competitive washes. If not, an alternative conclusion is that the U.S. capital markets are losing some business to global competitors not only because of listing cost considerations, but also because the launch-premium of listing in America is disappearing. On this second point there is very little policy makers can do to return the U.S. markets to their glory years (or when acquiring a U.S. listing was akin to winning the lottery). However, one way to ensure that the glory years never return is to loosen standards and openly attempt to import the next Enron.
Lowering margin requirements and watering down SOX does offer potential benefits for the American markets over the short-term. But when framing the debate it is nonetheless important to remember that SOX is not what is forcing Americans to increasingly move more of their investing dollars overseas. Rather, the global liquidity boom and superior performance of foreign markets is. Policy makers should not be naive and think that companies looking to go public are not taking notice of this trend.
In other words, the big question is whether or not U.S. regulators have turned raving mad by trying to modify longer-term regulatory policies to suit the short-term movements of capital. No matter how good times are, ridding the markets of safeguards intended to protect investors is not 'innovative'.
