ECON 252: Financial Markets (2008)
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Financial Markets (2008)
ECON 252 (2008) - Lecture 8 - Human Foibles, Fraud, Manipulation, and Regulation
Chapter 1. Introduction [00:00:00]
Professor Robert Shiller: Next Wednesday we’re having David Swensen lecture to us. He heads up the Yale endowment — or the investment of the Yale endowment — and I have a New York Times article on the syllabus, just sort of a biography of him you could read. On reserve, I have his recent books, so I hope that you will get a lot from him. I misspoke, he’s not a Yale college graduate, he’s a Yale Economics PhD; his undergraduate was from University of Wisconsin but he’s been at Yale a very long time. He came to Yale from Wall Street in 1985 and at that time the Yale endowment was worth about one billion dollars. It is now, under his leadership, $22.5 billion and that explains a lot of the quality of your life because that means we have about $2 million dollars per student. The interest on $2 million dollars is — what is that? I can’t even do division — $100,000 a year. So that’s why Yale is much more generous with financial aid than other universities and why we have beautiful — of course, this room was built, I believe, in the 30s. Don’t thank David Swensen for this room but for a lot of other things.
So Yale had a 28% return on its portfolio last year, which was number one of all college endowments. Moreover, it’s had a 17.8% average return for the last ten years, which is number one among university endowments. We beat Harvard, we beat Princeton, but actually Princeton was — the head of the Princeton endowment is a protégé of David Swensen and I’m sure these people get together and talk. All of the major universities — Harvard has been doing very well too and so have Duke, MIT, Amherst, a lot of — it seems that universities manage to invest very well, at least they have in recent decades. I think that has — my theory — that has something to do with the intellectual atmosphere at universities. That is, investing well requires careful study and the intellectual tradition we have at universities helps promote that. I don’t know if David Swensen can continue to do this. I think we’re — he’s had a spectacular return, but he’s getting into a challenging year. This is a year of financial crises, so I’m warning you ahead that — don’t expect a 28% return on the Yale portfolio for the coming year. You can ask him about that. If he can do it again in this situation, it will be amazing. That would be next Wednesday.
Chapter 2. Human Errors in Financial Decision-Making [00:03:24]
Meanwhile, I want to talk today about regulation. Wow, I think we’re alright — something needs more regulation here — all these wires. I want to motivate regulation in terms of the last lecture. Our previous lecture was about behavioral finance and it was about human failings. I think that we to motivate a lot of our regulation of financial markets by the kinds of errors that people make. I wanted to list a few errors that are well-known and that are exploited by unscrupulous people in finance. I think they motivate a lot of what — I’m going to write a number of principles of behavioral finance down and just mention them briefly and then return to regulation. These are things from the field of psychology.
Wishful thinking. This refers to the fact that people — this sounds like something you probably already know but it has been documented by psychologists. People tend to make the error of believing what they want to believe. For example, people tend to believe that their team will win; this has been documented by psychologists. They have a bias. If you ask them, what’s the probability that Yale will win the Yale-Harvard game, don’t expect Yale students or Harvard students to give an unbiased probability. You tend to, in your mind, think that you’re going to win. This also applies to elections — we just had a primary yesterday. People tend to assume that the candidate that they believe in will win. So, it’s well-known and this is something that can be exploited by people selling investments.
Second thing: attention anomalies. These are — human attention tends to be sporadic. That is that you — the errors that people naturally make are often errors of inattention. You look at certain things and you overly — you pay too much attention to some things and too little to others. This is something that psychologists have been talking about for over a hundred years. Human attention is part of human intelligence. We have to know what to pay attention to People who are not good in focusing their attention on the right things — I’m not just talking about attention deficit disorder, I’m talking about some more high-level question of how you know what you should be paying attention to. Under attention, there’s a social basis for attention and that is that people tend to pay attention to what other people are paying attention to. It’s easy to sweep things under the rug and get people to forget something. The kinds of things that are naturally talked about get excessive attention and the details tend to get forgotten.
Three is anchoring. This refers to a tendency for people in making quantitative judgments to subconsciously have their judgments anchored by some arbitrary stimulus. I mentioned overconfidence last period; we then tend to have overconfidence in our anchored judgments. The classic experiment that demonstrated anchoring was Kahneman and Tversky — I’m writing K&T — in a wheel of fortune experiment, which they did in 1974. What they did was they got subjects to participate in a psychological experiment and the experiment consisted of asking the subjects questions that had quantitative answers, which were always numbers from zero to one hundred. Then they said, I’m going to ask you a question but before you answer the question I’m going to spin a wheel of fortune. You know what a wheel of — it’s like one of those things on quiz shows. You spin this big wheel and it rotates for a while and then it stops at one number, but obviously a random number, because this wheel of fortune had all the numbers from zero to one hundred.
One of the questions they asked was, what percent of African nations belong to the United Nations? That apparently is a difficult question that most people didn’t know in 1974. The way they did it — they said, we’ll ask you the question and think about it, but while you’re thinking about it — don’t answer yet — we’re going to spin this wheel of fortune. So it comes up with a random number then they asked for the answer. Well, it turns out that people tended to give an answer close to the number that came up on the wheel of fortune. Now, they perfectly well knew that the wheel of fortune was random. So, the experimenters, after they got the number, they’d say, hey your number is almost the same as the number that just came up. People would — and they would say, did you just give me the number that came up? And people would deny it. They would say, oh no I wasn’t influenced by that number.
The point of anchoring is that you are subconsciously influenced by numbers and it affects your judgment; you think you know. For example, in looking at a stock, if you ask people to predict a stock market price they think of some number that they saw before and they are overly influenced by that number. For example, in the late 1990s, if you were to ask a question — I’m hypothesizing — how likely is it that the Dow will be over 10,000 by the year 2008? People might give that a low probability because it had never been over 10,000, so they just had no psychological anchoring on that number. Once it passes 2000, then it seems completely natural; that’s anchoring.
Related to this is the representativeness heuristic. It seems to me that if you type this you’ll get a spell check error. And that’s Kahneman and Tversky again and it’s related to anchoring in some sense. What it means is that — it refers to a human tendency to judge events on the basis of similarity to other events that are prominent in our mind without regard to the actual probability of the event. I’ll give you — in one of Kahneman and Tversky’s examples, people were asked to judge the occupation of a young woman. They had a description of the young woman and the woman was described as sensitive, artistic, etc. The occupation choices that they were allowed were: bank teller, sculptress, or something else. Many people chose sculptress because they thought, well if she’s a sensitive, artistic woman maybe she’s a sculptress. But that is a terrible mistake because we should know that sculptresses are very rare; very few people have the job of a sculptress or sculptor, so it’s a mistake. What it means is that people will — what it means is — [I have to stuff this wire in my pocket] — that we sometimes exaggerate in our imagination some rare event and it colors out thinking. For example, the stock market crash of 1929 is repeatedly re-expected even though it only happened once; it’s just prominent in our thinking. People are looking at stock prices to see patterns that they remember that are prominent in their thinking and then those patterns are given an exaggerated probability.
When we looked at the random walk series — I think the representativeness heuristic played a role in there as well. When you look at a random walk you have the intuitive impression that you can extrapolate it — that it doesn’t look like — you can’t believe it’s really random, but the reason you can is because you overweigh the probability of certain things that caught your attention. There are some more.
Five is gambling behavior. Anthropologists have found that gambling is present in all human cultures. Not that everyone gambles but there will be — you go to any human society and ask about it and there will be some game of chance that they play at the — that influences their thinking. The problem with — there’s a problem with gambling behavior because in a certain fraction of the population we have pathological gambling. One study estimated that 1.1% of men and .5% of women, for some reason more common among men than women, but in both sexes are pathological gamblers. That means it’s like alcoholism; they cannot control themselves and it ruins their lives. They get divorces because the spouse complains that my husband or wife gambled away all of our money and that’s bad, but they can’t stop themselves. There’s an organization called Gambler’s Anonymous, which is like Alcoholic’s Anonymous. It helps people who are really in trouble. This is a problem. I think the financial industry attracts people like that, so you’re overrepresented — If people are not quite pathological — people who are stimulated somehow by chance; that is a problem.
Magical thinking. This refers — this actually goes back to B.F. Skinner, a psychologist who flourished in the first half of this century. I actually had him as a next-door neighbor. It was a strange thing. I was visiting Harvard and MIT in Cambridge and I rented a house and this guy was next door. He and I both used to walk into work together — not together, I never really met him, but I always felt an affinity to him. He must have died twenty years ago by now. But anyway, he did a famous experiment with pigeons which, in the 1940s — 1948 — in which he induced strange behavior patterns in pigeons by the following simple experiment. The experiment was, he would put — the pigeon was in a cage and he’d let the pigeon get pretty hungry — hungry pigeons are not happy pigeons. Then he had a machine that granted each pigeon one piece of corn every fifteen seconds; that’s very, frustratingly slow for a hungry pigeon to get one piece every fifteen seconds. Then he observed, through time, after subjecting pigeons to this torture for some time — it might be not approved by — it’s not really torture, it’s like dieting or something, you’ve all lived through that, right? Semi-torture for a pigeon. He noticed that the pigeons started behaving in strange ways and he kept them separate so they couldn’t learn from each other.
One pigeon was jumping up and down a lot, another one was bobbing its head, and another one was doing kind of a little dance. What he concluded was, these pigeons were trying to figure out what makes those pieces of corn come and they started to think — well, they had to get the interval between corns right to make this work. But he started — the pigeons started to think, effectively, what was it I did just before that last piece of corn came? I was bobbing my head, so maybe I better bob my head again and sure enough another piece of corn comes. So, he started assuming that what they were doing is making the corn come. But each one does a different thing. If they’re all in isolation they would all be doing different things. I think our financial markets are like that. That people — they develop some investment strategy and through pure chance it does well. But they — because of over confidence and magical thinking, it starts to go to their ego. They think, I’m really a smart investor, I figured it out,; it can reinforce the behavior until they get to maybe some terrible end. It doesn’t necessarily work out as well. B.F. Skinner never let his pigeons starve; they all made it out alright.
There’s something else called quasi-magical thinking, which was a term coined many years later by Eldar Shafir and Amos Tversky. Shafir is a young psychologist at Princeton who teamed up with the old psychologist Tversky and wrote this paper. What it refers to is — people get the impression that they can control randomness. Maybe the pigeons were thinking that, maybe not, we don’t know; Shafir and Tversky report experiments with people, not pigeons. Quasi-magical thinking is an illusion that they documented that occurs regularly in people, which they might deny if asked about, but there’s an illusion that I can control randomness through my willpower. I won’t talk about their experiments, but I just want to mention one by a Harvard psychologist Ellen Langer. I mentioned this before — I think I mentioned it before — if you say, I’m going to ask you to bet on a coin toss. There are two different ways of doing it. One is to say, how much will you bet and then I toss the coin. The other way is, I toss the coin first and I can conceal the outcome and then I ask, how much would you like to bet?
Langer found that people want to bet more if the coin hasn’t been tossed yet. Why would that be — why would you care? It’s still the same experiment. It appears that people, at some level, think that they can exert willpower over it and control it. This gives rise again to overconfidence among investors.
It’s also — another example, which is relevant, I don’t know if any of you voted yesterday. Why do people vote? Because an economic theory would say that nobody ever votes. If we’re all — conventional economic theory says, we’re all relentlessly selfish and calculating. Isn’t that what you’ve learned in economics? Well, maybe you didn’t necessarily but that is economical theory. If you’re relentlessly selfish and calculating you would say, the chances that I decide the election are zero, so I’m just not going to bother. The question is — you must have thought that, right? You know that you’re not going to decide the election, so what does it matter? If you can introspect and ask, why is it that I vote? I think that at least for many of us, there is a sort of logical conundrum we go through and that is, if good people don’t vote then we’ll be in a bad world; so I have to vote to prove that good people vote, then maybe it will happen. If I’m a good person, then other people will be good persons. This is magical thinking and it affects people because it gives them a sense of confidence and power over events that are thought to be random or uncontrollable. It can also be something that can be exploited by some not so nice people.
Chapter 3. Why Regulation of Finance Is Necessary [00:22:34]
I want to talk about regulation. The problem with finance is that it’s a beautiful — financial institutions are beautiful structures but they only are as good as the people who use them. The problem is that the history of finance is the history of a lot of people being exploited and treated badly, so there are temptations from the market. People who know human psychology know that they can exploit human weaknesses. There’s a temptation to oversell investments. That is, promise that they will do well — you see this all the time. I was just seeing yesterday’s paper — someone was selling gold coins. Don’t buy gold coins that you might see — and you know that, right? There were words in there — they said something — of course, we cannot guarantee that they won’t go up in value but historically they have always done it or something like that. They’re trying to oversell. You know that buying gold coins from some newspaper ad is not a smart investment, but they know that there will be people out there.
A recent example of overselling: the National Association of Realtors has been running ads saying that home prices have always doubled every ten years. They didn’t word it that — they put it in the present tense: home prices double every ten years. That’s an organization of people who sell real estate and they have ad campaigns trying to convince you that home prices are going to double. That’s overselling because we’re in a real estate crisis and home prices are falling and that’s the kind of thing that makes some people upset. There’s a tendency to hide information. You avoid telling people the things that would discourage them. People have attention anomalies, so they don’t go out and see all the information and if you don’t put it up front, then they’ll never find it.
There’s a tendency for loyalty to friends — that’s your own friends — and there’s this word, other people. I think different languages have different words for this–-there are friends and then there are all those random people that we don’t care about. So, investors will have a tendency to try to hide — or people who sell investments will try to channel the good investments to their friends and dump the bad stuff on other people. That’s what has been happening a little bit — more than a little bit — in the subprime crises. We’ve managed to package subprime loans that we thought — some people thought — were terrible and sell them off to unwitting foreigners who didn’t know. They thought that they were getting good stuff.
There’s also a tendency for churning for commission. This is a fault that real estate brokers can make. If they’re paid by commission on each trade they just keep calling you up and coming up with new ideas for new trades. That’s unethical behavior because it — if you keep trading too much, then you cannot possibly make money. The trading commissions will eat up all of your profits and professionals know that, so it’s bad behavior.
We have historically developed regulations that deal with these problems. The only reason I believe that we have financial markets that work is because we have regulations. I’m going to talk primarily about U.S. regulations and give a little history of them. The U.S. is actually an important country for regulation because it has been a model for much of the regulations around the world. I’m going to give a kind of a history of financial regulations in the United States that makes it rather a simple story. The simple story is that regulation mostly came in with the Progressive Era at the beginning of the century and reached its culmination at the time of the Great Depression and set up a lot of institutions that are still with us today. Then there was deregulation, which started around the 1970s, and the events we’ve seen — that we’re seeing today — are outcomes of both the regulation and the deregulation.
Chapter 4. The Rise of the Securities and Exchange Commission [00:27:51]
I want to start out with the origins of securities regulation. A critical point was a book written by Louis Brandeis, that’s the guy that Brandeis University is named after. He was an author, a lawyer, then Supreme Court Justice, but he wrote a book in 1914 called Other People’s Money and it was very influential. I have it on reserve, but that’s not required for the mid-term; it’s just if you’re interested in seeing it. He believed that the most important step for the government in promoting better financial markets is disclosure — to force businesses or financial businesses to disclose the truth equally to everybody. His famous quote is, “Sunshine is the best disinfectant.” Sunshine, meaning the truth, and everyone in the financial industry has to just tell people what they’re doing. He said it has to be really disclosed and he likened it to labeling. They were already, in 1914, starting to require that food packages show nutritional — or ingredients and nutritional information. It was on the package and he thought, that’s the kind of model for the financial industry.
The disclosure has to be made convenient so that — it’s not like you can get the information by going downtown to City Hall and asking for it. The principle is that you have to require that the information be given to the investor. That was a very important — Around the time of this book, state regulators were developing, at the state government level in the United States, what they called Blue Sky Laws. These were laws regulating how securities are sold. There are different theories about why they call them Blue Sky Laws. I think it was because people were overselling investments and saying, there’s no limit to this investment but the blue sky above. The problem with the Blue Sky Laws was that they were each done separately and it was hard for states to manage what were, basically, national businesses. So the Blue Sky Laws were basically coming in the teens.
In the 1920s, things changed because the telephone first became widely spread. Until the teens, telephones were very expensive because they didn’t have good amplification technology. But by the ’20s, everybody got a telephone in their house and the average person made hundreds of phone calls a year, so it was a big change in our society, This led to the boiler rooms — these were businesses that called around on the telephone and sold stocks — often bogus stocks — in the 1920s. The reason they call them boiler rooms is, if you are selling stocks by telephone there’s no reason to rent a nice office, so you get the cheapest — so you put a whole bank of telephones in the cheapest place. That would be the basement of some building where they have the boiler. So, you’d have a whole bunch of people selling securities down there and they could vacate quickly if the authorities challenged you.
In the 1920s, a lot of bogus stuff was sold — a lot of people were cheated — so after the stock market crash of 1929, it led to a movement for regulation. The most important thing was the 1934 foundation of the Securities and Exchange Commission — or SEC — which I think, ultimately dates back to–it was really the embodiment of Louis Brandeis’ principles. This Securities and Exchange Commission was an organization that — I guess you could say its principal structure — its principal thing was to make sure that disclosure was proper and that people found it easy to get the information about securities. The SEC was very controversial at first because it was seen as interfering with business and the U.S. has been built on principles of individual freedom; this seemed like unnecessary government intrusion. There was a hostile attitude between business and the original SEC. Franklin Delano Roosevelt was viewed as very left-wing by business and very contrary to American values.
But in fact, the SEC promoted the very free-market concepts that were widely believed in this country. Basically, what it did was it made it feel that people wouldn’t get cheated; the SEC was a strong regulator and it really did restore confidence in the financial markets in this country. Other countries — In Europe, after the 1929 crash, they had a different reaction to the scandals and problems of the ’20s and it wasn’t as favorable to markets as in the U.S. The Securities and Exchange Commission, from the beginning, had it as its mission to make financial markets work properly; that is a wonderful story.
One of the first Chairmen of the SEC was a man named William O. Douglas, who was actually a Yale law professor. I guess he influences me because — I have on the reading list — again it’s an optional reading, but he has a book called Democracy and Finance 1940 and what he advocated again was that financial markets have to be made to work for the people. I guess this influenced me–actually, in my 2003 book, New Financial Order, I talked about the democratization of finance as a fundamental principle. We have to make finance work for real people, so for me that meant understanding human frailties and understanding human psychology to make things work. He was also a major figure in the Legal Realism school that recognized human failings and human behavior and the establishment of laws. We have to realize that people don’t read all the fine print and don’t understand — if you have a precisely written contract in legal language, maybe they don’t get it.
One of the things that came out and was firmly embodied into law with the advent of the SEC. There were precursors to this, but the SEC forces the difference between public and private securities and this is a very important distinction. Public securities are securities that the SEC will accept as suitable for the general public and private securities are securities that have not been vetted by the SEC for the general public. The SEC — you have to decide — you hear about public companies and private companies. If you’re a public company it means that you’ve gone through the procedures at the SEC to be approved as a public company. If you are a public company, the important thing is you have to do all of the disclosure that Louis Brandeis would have liked; you have to file regular forms with the SEC, disclosing information. Public companies — these public companies — if you want to get on the SEC website, go to sec.gov and then there is a tab that you can click, which is Edgar. If you click on Edgar you can enter the name of any public company in the United States and then all of its filings are online and you can find out an incredible amount of information about companies. It’s all there, as long as they’re public companies.
A public — a lot of companies don’t want to be public because you can’t keep secrets very well; you’ve got to regularly put those things up online and they’re out there for everybody to see. Companies can choose whether to be public or private. Why do they choose to be public? Well they — it’s a balancing — they have to balance — sometimes they don’t like the choice they made but the advantage to being public is that people trust you more. Moreover, your market is bigger, so public companies have an advantage; so companies don’t like to be public, generally. It’s contrary to their instincts. We keep all sorts of secrets in our company; we don’t want to be filing all of our information all the time and to have it go right up on the website on standard forms so that everyone can easily process it. They may swallow their doubts because they have a sense that it will improve the market for their shares. So we have a lot of public companies.
Chapter 5. Regulation of Private Investments and Hedge Funds [00:39:18]
Now, if you are a private company, you are limited to where you can sell your investments. Let’s take an example of an important kind of private company, called a hedge fund. If you are — this is a private investment company — let’s think before we talk about hedge — think of — suppose you’re a public investment company approved by the SEC. The problem with being a public investment company is you have to file quarterly reports about all the things you’ve invested in. So you say, how can I make money beating the market if every quarter I have to tell everybody what I’m doing? A lot of investment companies don’t want to be public, they want to be private so they don’t have to. Hedge funds do not post their investments on Edgar, so they’re private. If you’re a private company, you’re subject to regulation that limits a lot of things you can do. Notably, you’re not allowed to advertise. If you’re a hedge fund, you’re not for the public — you’re not approved for investing by the public. So, what business do you have to buy ads in newspapers announcing yourself. As a result, hedge funds have a very low profile. It’s not their choice — they might like to advertise — but they can’t without running afoul of the SEC. They’ll say, you’re behaving like a public company and you’re not public.
So, hedge funds do not advertise, that’s why people don’t know about them and they have a mysterious — they sound mysterious. Moreover, very significantly, they are limited in what kind of investors they can take. Now, there are different kinds of hedge funds — there’s a lot of legal complexity here — but a 3c1 hedge fund is limited to ninety-nine investors. That’s not very many people and they must be accredited investors. You ask, what is an accredited investor? Well, if you want to find out you can get onto sec.gov and it will give you the current definition. I wonder how many of you are accredited investors? I would guess not many of you. Here’s how you become an accredited investor: (a) you have $1 million dollars in investable — that’s not including your house, it’s in investable assets. I won’t ask for a show of hands. (b) You’re making at least $200,000 a year, or (c) if you’re married, you have to be a couple making at least $300,000. So, it’s supposed to be for rich people.
Incidentally, they haven’t raised the definition of accredited investors for many years. Last year, the SEC put out a proposal that — it’s getting too easy to be an accredited investor — so they put out a proposal that we raise the wealth level to $2.5 million. I thought they were going to and that was to protect people who might be naïve, innocent people who only have a million dollars or only have two million dollars and don’t know what they’re doing from hedge funds. But, it got shot down apparently because it never happened. I think it’s very hard to raise the definition of accredited investors because the minute you do that you’re closing large numbers of people out from their ability to invest in hedge funds and they don’t like that; they feel insulted, so there was a lot of angry reaction.
There’s also another kind of hedge fund, 3c7, which can take five hundred investors. If they register as a 3c7, they can take more investors. But then, they’re limited to qualified purchasers. This is just an example of their regulations. A qualified purchaser has to have at least $5 million dollars or, if it’s an institution, at least $25 million — that is a natural person. A natural person refers to a human being, so it’s $5 million for natural persons and $25 million for institutions. So, if you’re a small college with only $20 million in a portfolio you don’t come across as a qualified purchaser. They’re trying to protect innocent, small colleges who only have $20 million dollars. The idea is that people who don’t have much money can’t afford expensive lawyers and they can’t figure it out and they really shouldn’t be investing in hedge funds.
These public-private distinctions are onerous — are offensive — to some people because it seems like the government is acting like a parent. Most of the people are — if you’re not accredited as an investor it’s like the government doesn’t respect you; it’s like they’re treating you like children. Why would it be that somebody else is allowed to invest in a hedge fund and I’m not? It rankles, but on the other hand, these regulations survive because the reality is that people are victimized all the time and we can’t just allow companies to act in secrecy. This is something that I believe in — not everyone believes in this — but the general principle has been now — ever since the 1930s — that the general public is not allowed to invest in things that are not properly documented.
Another important distinction in securities regulation is the distinction between insider and outsider. An insider is someone who is privy to the secret information of a company and the secret information could be used to trade. If you know the secrets of a company, if you know some good news about the company before the public does, you could buy the shares of the company and experience the profit when the price goes up. You would be exploiting insider information and you would be victimizing the outsiders. The idea, from the beginning at the SEC, was that insiders should not be allowed to trade on information that is not properly disclosed to the public.
There was an important change: Regulation F.D. came in 2000. F.D. stands for full disclosure — this is a SEC regulation. Regulation F.D. was, I think, passed in recognition of the internet. Under Louis Brandeis — Brandeis wanted companies to always present the information, but for him it always meant presenting a document, so they had something called a prospectus, for example. You could not sell a security without giving a prospectus to the potential buyers and the prospectus would be something approved by the SEC. I don’t know if the word is approved but it’s — you have to run it by the SEC and then you always have to give that up. But he was living in the paper age. We now live in the internet age and so Regulation F.D. — I don’t know if it actually mentions the internet but it’s — the Regulation F.D. basically says that whenever a company announces information it has to be available almost instantly to everybody in the market. So, the way it has worked out in practice is that companies, when they have a major announcement to make, they have some kind of web event. Anybody in the world — they would be notified and they could get on and hear it as it’s happening. So we have meetings — big meetings — on the web for disclosure of important information. This has made it very clear that there has to be — if you announce anything you have to announce it all at once on a certain date and you can’t have favored people that you give the announcement to.
Chapter 6. Nongovernmental Surveillance of Insider Trading and Accounting Regulation [00:49:14]
Market surveillance is a process that stock exchanges and other organizations do to make sure that inside information is not being mishandled. The self-regulatory organizations, SROs, are industry organizations that regulate the industry. That’s the American way of doing things. Rather than have the government regulate, we have an industry organization that does it so that the government doesn’t have to. The SROs have complex regulatory equipment, computers that can discover insider trading and the SROs will catch you or they may catch you if you try.
I want to give you an example of SRO behavior and this is just one news story. It was in 1995, a secretary at IBM Corporation was asked to xerox some documents by her boss and the documents described a proposed takeover of Lotus Corporation. Remember Lotus? That was the corporation that produced the first spreadsheet program. It’s now been replaced mostly by Microsoft Excel. But at the time it was big, so this was big news. IBM is going to take over Lotus or try to take over Lotus. We now know what happened because of the surveillance investigation. She told her husband that she had just Xeroxed this thing — she had read what she was Xeroxing — and she told her husband who was a beeper salesman about the news. He did nothing except tell two friends the story — he didn’t buy shares, he just told two friends, my wife says that IBM is going to take over Lotus. The friends immediately bought Lotus shares and then — that was June 2 — by June 5, twenty-five people had bought — had spent a half a million dollars to buy on this tip. They included a pizza chef, an electrical engineer, a bank executive, a dairy wholesaler, a school teacher and four stockbrokers; stockbrokers get the word faster. Guess what happened? Those people are all in trouble because it’s illegal to trade on insider information and they tracked them all down.
I’ll give you another example and this is the example of Emulex Corporation. Maybe this isn’t exactly insider trading, this is more fraud but in — what year was this? Around sometime in the late ’90s, Mark Jacob — he’s the criminal here, he’s probably out of jail now. Mark Jacob was upset with — he had been an employee of Emulex and had access to inside information of the company. I guess he was involved in the dissemination of information for the company, so he kind of knew how they did press releases. So he sent out a fake — he bought — he shorted the company and he — the stock in the company — and he bought — he put out a fake press release saying that there was bad news for the company. He knew how to make it look one of Emulex’s press releases. He also did it from the El Camino Community College Library because he thought, I’ll be careful, I won’t issue this fake press release on my own computer because they might be able to track me back to my own computer. So, he went to this community college and got one of their library computers and he issued the press release there.
He got picked up by all the major news services, the stock plummeted, he sold immediately and he made a lot of money. The problem is, it didn’t work. They tracked back who sold — who shorted and who had sold just before — just at that time. They also went back to the El Camino Community College Library and they interviewed the librarians and tried to ask them, do you remember somebody coming here that didn’t look like a student? They identified him and he was caught.
That’s what surveillance does. They make the markets work because if you didn’t have this there would be all kinds of crooks and bad actors. The thing about these organizations is that they cost money and they cause nuisances. A lot of people in the financial community are annoyed by them because these regulations are costly to comply with and they take a lot of resources. I think the enlightened view is that these things are absolutely essential to trust in the market.
Another form of regulation is accounting regulation. For example, we have in the United States the Financial Accounting Standards Board — it’s right here in Connecticut — or FASB. This is not a government organization. It was organized by the SEC in 1973, but the SEC didn’t want to do this job; they wanted it to be done privately. What FASB does for the United States is it creates what are called Generally Accepted Accounting Practices. They’re rules for how a company should keep its books so that there’s some regularity and standards in how accounting is done. When the Financial Accounting Standards Board listens to what corporations are saying and helps them — it adjusts these standards from time to time but it does have definitions that have to be maintained.
A company has a profit and loss statement and there’s something that is called net income, which is the measure of how much the company is making — the profits after expenses of the company, called the bottom line. The GAAP standards define this. There’s also operating income. Now, companies can use other definitions of — other accounting standards besides these and some of these other definitions, which are not always GAAP — other standards — and are widely used in the industry are other kinds of — they have what’s called core earnings, pro forma earnings, EBITDA, which is earnings before interest, taxes, depreciation, and amortization. Adjusted earnings. There are all kinds of different definitions and companies like to do it their own way because they want to present themselves in the best way to the public. But they’re not allowed to just do it their own way; they have to do it according to standards, so the GAAP accounting is standardized.
What a company can do is present things in two different ways. They can present GAAP and then that goes to Edgar and they can also present it any other way they like. But the law — the SEC requires that they at least present the standard earnings definitions for all these things. Now another — let me just mention off balance sheet accounting. The one thing that the SEC requires that companies file is their balance sheet, which you can look up for any company on Edgar. The balance sheet of a company has two columns; it has assets and it has liabilities. So, on one side is everything the company owns and the other side is everything the company owes. The net worth of the company is their assets minus their liabilities and that represents the value that the company has if they paid off all their liabilities.
Chapter 7. Protections for the Individual Investor: the SIPC and the FDIC [00:59:45]
What the SEC has to worry about is something called off balance sheet accounting, which occurs when companies try to hide some of the things that they — the liabilities that they have by not recording them on the balance sheet. If you can get away with that then you can do — you can conceal maybe some risky investments you’ve made or some leverage that you’ve had. You might have brought in investments or something by borrowing money, so the investment — the combined investment and liability — could be very volatile. You don’t want people to know that, so you don’t put it on the balance sheet. The SEC and other regulators have to watch for this.
The classic example of a company that did this — it’s a classic now — is Enron Corporation. They had a number of partnerships that they put on as off balance sheet. They were making risky investments but they weren’t reporting them properly on the SEC forms, so people didn’t know how risky Enron was. More recently — this came out last year — the SIVs, so called structured investment vehicles, were used by banks to cover up investments they had, often in risky subprime loans. Well, they created special entities called SIVs and the SIVs would be borrowing money on the commercial paper market to buy subprime loans. They were in a very risky position because subprime loans were already recognized as being risky. They’d borrow to buy them, so if the value of the subprime loans went down just a little bit the SIV would be in trouble. In the SIV contract, there was some language that implied that if the SIV ever went bankrupt, the bank would come back and rescue them. The SIV really was a liability but it wasn’t visible to investors investing in the bank. This is another example of off balance sheet accounting that was frustrating the rules of the SEC.
I wanted to talk about another instance of regulation that is important in the United States but it’s very poorly known. We have something called SIPC, that’s the Securities Investor Protection Corporation, which was created in 1970. This is the securities’ analog of the FDIC in banking. I don’t know if I mentioned — I assume you know about the Federal Deposit Insurance Corporation? I thought that was better-known. Well, let me just mention it by analogy.
In 1934, after the failure — it was actually created by Congress in 1933 and went into business in ‘34. The FDIC, Federal Deposit Insurance Corporation — I’ll put it down as 1934 — guaranteed for small depositors the savings deposits they had at a bank. That was to protect depositors in the case of bank failure and it was a very important innovation because, at that time, there were huge runs on banks. People were pulling money out of banks because they feared that if the bank failed, then they would lose their money; it created a huge crisis in 1933. It’s for small investors because currently the limit on the SEC is $100,000; that’s not a lot of money. Maybe you think of it as a lot of money, but it’s not. If someone’s saving for their retirement you better have a lot more than that; $100,000 is only a few years of income even for low-income people. At least we want to protect the small investors’ savings in banks. Actually, if you have more than $100,000 in a bank account you should probably pull it out and spread it around over several banks because each bank is separately insured, so there’s effectively no limit if you’re just a little bit smart and move your accounts around.
We had deposit insurance starting in The Great Depression and that’s been very important; it’s now in every country. We had a run on a bank in the UK, it was called Northern Rock, last year. It turns out that there was a failure of the UK deposit — I would say it’s a failure because UK deposit insurance insured Northern Rock only for the first £3,000. Then for the next — I forget how many thousand pounds — you were 90% insured so that was not good enough because people were worried about losing 10% of their deposits. So there was a big bank run and Northern Rock would have failed if the Bank of England hadn’t come by to rescue them.
I think that deposit insurance is very important but we didn’t have anything for corresponding accounts at brokerage services until 1970 This was motivated by a spectacular failure of a brokerage, Goodbody & Co., in 1970.
I hope you know what I mean; a brokerage service is a place where stockbrokers work and a stockbroker is somebody that manages your buying and selling of shares. So if you want to buy stock you can call the stockbroker. Merrill Lynch is a big retail broker — they’re right down here on the Green. You can go there and say, I want to buy stocks, and the broker will say fine, we’ll set up an account for you. You’ve deposited money in our account–now, he’s not a bank, he’s a broker — we’ll set up a cash account and a securities account. Put some money in and then you think about it and then you call me up and say, do you want to buy some stocks. Then I’ll take money out of your cash account and I’ll put it into these securities. That’s a broker. Goodbody & Company was a broker, but it failed in 1970 — it went bankrupt — and then it looked like the people who had money and shares in them would lose.
There are two things: you can have a cash account with them — you put money into the cash account and you haven’t bought shares with it yet; it’s just sitting — it’s like in a bank. You could lose that because Goodbody & Company is going bankrupt; it doesn’t have it anymore. Well, what about your shares? Well, Goodbody & Company is supposed to have your shares but they generally hold them in what’s called “street name.” That means Goodbody & Company owns the shares and you just have a contractual relationship with Goodbody that, in principle, some of those shares are yours. But the company that you’re investing in ultimately doesn’t have your money. It’s Goodbody that they’re dealing with, although they have ways of — for a proxy — and they have ways of finding out who’s who. The problem is, if your brokerage firm fails you could lose a lot; you could lose your cash account and your security account. So, SIPC was set up in 1970 and SIPC insures cash accounts up to $100,000 and securities accounts up to $500,000. That’s another example of government involvement. SIPC was set up by an act of Congress.
So the–unfortunately, I don’t know — have you ever heard of SIPC? Most people don’t even know it exists. SIPC did a survey of the U.S. population and this is one of the — In 2001, this is one of the questions SIPC asked. The respondents were asked to identify the organization that insures you against losing money in the stock market or as the result of investment fraud. Only 16% of investors knew that there is no such company. Let me make this clear, SIPC does not — if you invest in some stock and it does badly you can’t go to SIPC and say, hey my stocks went down please give me my money back. They won’t do it. Moreover, if you say, this stockbroker he was lying to me, he told me that this was a good investment and he even lied and said something to get me roped in, they won’t pay you back. The only thing that SIPC does is replace securities. In other words, if you had an account at a brokerage and you thought you had a hundred shares of IBM and now the broker is going bankrupt — the broker won’t answer your email anymore and he’s just gone — you go to SIPC and say, I had these hundred shares. SIPC than returns a hundred shares to you; they don’t pay you cash. They give you the hundred shares and that’s all they do.
Chapter 8. Conclusion [01:10:38]
You might say that our regulation hasn’t gone far enough and I think maybe it hasn’t gone far enough. We protect certain kinds of things and people have to pay attention. It’s a difficult problem that not everyone is smart — they vary in their ability — so we try to make a world in which it’s pretty safe for the small investor who’s not paying attention. It’s never perfect and we can’t figure out yet a way to make it perfect and we still have small investors who are defrauded, who are treated badly. The subprime crisis is an example: some people were treated badly in this recent financial crisis. So, we just have to keep improving our regulation and trying to make a deal with all of the problems as they come up. The problems are complex because we’re trying to make a system in which people are able to make their own decisions as much as possible and to make them in a way that — in an environment that they trust. But it’s just too complicated and too — it’s impossible to make it work perfectly. So, that will conclude this lecture. So I’ll — I won’t be here Monday but my T.A.’s will handle the exam and I’ll see you on Wednesday.
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