Thoughts on the SEC, 1977 Edition.

Thomas Frank on Porn and the SEC (my bold):

Now, if you’re looking for reasons why the SEC failed in the past they aren’t hard to come by. Start with political leaders who clearly didn’t believe in the mission; proceed to the agency’s grotesquely underfunded workplace where lawyers had to do their own filing, mail-sorting and photocopying; and arrive, finally, at the revolving door, which sometimes transformed SEC jobs into stations on the Wall Street career path and worked fairly predictable effects on enforcement.

This was an agency whose mandate, essentially, was to crawl out on an ice floe and die…What all of this overlooks is the highly advanced concept known as “change.” The purpose of federal agencies can be redefined and their personnel changed. Once upon a time, the SEC performed well; then it performed poorly.

And now that it threatens to perform well again, we are told it can only fail, that no federal operation can ever overcome the unalterable depravity of its employees.

I bring it up because I’ve been reading a lot about financial reform from the late 1970s. And it’s still a point right before the financial industry went big, and right before the efficient markets hypothesis took over, where people could still argue for the need for financial regulation over conflicts of interests, transparency and honesty without having an overwhelming burden of proof work against them.

I’m reading the 1977 version of The Transformation of Wall Street, Joel Seligman’s definitive history of the SEC. It’s been updated to take it through 2001, but I like this old version because it’s being written during a transformation time, when the agency was under assault by academic theorist and a brand new type of lobbying. You can see the old midcentury guard coming out in defense of the prosperity they helped build.

Check out this blurb: “Myths breed myths. The myth that the ICC and SEC are there to protect consumers against the villains created the counter-myth that they are there to serve the industry’s interests. Joel Seligman’s airing of the facts of the SEC history clears the mind of lots of rubbish.” – Paul A. Samuelson.

From the book, check out this completely un-ironic defense of how Wall Street has changed for the better after the New Deal:

During the last half-century, this nation’s system of corporate finance has been fundamentally transformed. Long gone are the days when new securities sales were doominated by private investment banks, such as J.P. Morgan and Company, when references to “bear raids” or stock market “pools” daily appeared in the nation’s press, when the New York Stock Exchange fairly could be described as a “private club,” when Senate hearings riveted the nation’s attention with revelations of fraudulent Peruvian bond sales, “preferred” stockholder lists, bribed journalists who “touted” securities, or stock price manipulation. Gone too are teh public utility holding companies, the least justifiable corporate structure to evolve during the 1920s’ “bull” market, “blank” corporate proxies, and the time when securities fraud usually was irremediable because of the deficiencies of state corporate law. In the past decade, fixed minimum commission rates, a way of life on the New York Stock Exchange since 1792, have been abolished. Efforts today are under way to supplant, partially or fully, the hardwood floors of this nation’s securities exchanges with an electronically linked national securities market system.

The principal actor in this transformation of corporate finance has been the Securities and Echange Commission. During and immediately after the New Deal period, the SEC earned the reputation as one of the most ably adminstered federal regulatory agencies….

Ten years later you get Oliver Stone’s “Wall Street.” And now we don’t even have a coherent language to criticize the private club of Wall Street as anything other than a symbol of national pride and an omniscient calculator of everything our country should value.

The book deals with the crisis the agency had from not taking on the fixed commissions of Wall Street. Even though they were shining a spotlight in a dark corner of the economy, the accusations of cronyism and cartelizing a business line for Wall Street was there, and the SEC didn’t react quickly enough.

But what’s fascinating is in the last 10 pages of the 550+ page book is a new challenge – an academic theory that postulated that the SEC was incapable of doing anything. That the omniscience of an efficient market made the job of forcing companies to disclose information to all its stakeholders and potential investors superfluous.

Jump forward to the end of the book,

Nevertheless, beginning in the 1960s, economic research on the investment process raised fundamental questions about the usefulness of the SEC’s corporate disclosure program. Several studies appeared to corroborate the “efficient market” hypothesis…For securities law, the crucial implication of the efficient market hypothesis was that securities prices theoretically would be the same regardless of whether most investors ever received or read mandator corporate prospectuses and reports. All that was necessary was that a “sufficient” number of investors act on available public data.

Similar fundamental questions were raised by what was called the “portfolio” theory. This theory suggested that since investment risk could be substantially reduced by diversification of an investment portfolio, the value of data concerning any individual security’s risks or potential rewards was substantially reduced.

Two libertarian economists, the University of Chicago’s George Stigler and the University of Rochester’s George Benston, attempted to corroborate a more sweeping hypothesis: that there was no value whatsoever to the mandatory disclosures required by the 1933 and 1934 Securities Acts….

Data errors in Stigler’s research and some highly debatable inferences he drew from his study “substantially invalidated” Stigler’s conclusion, in the words of Wharton School profressor Morris Mendelson and the opinion of others….In particular, Benston’s suggestion that there was little securities fraud before 1934 was ludicrous…

But the cumulative significance of economic theories such as the “efficient market hypothesis” and “portfolio theory” and the Stigler and Benston critiques did prompt the SEC…to publish a rationale for a mandatory corporate disclosure system that took into account the recent economics literature.

The report offered four grounds for doubting that market forces alone would result in the publication of sufficient, reliable and timely data. First, “very often there are significant motives for at least temporary concealment of adverse information on the part of corporate executives…second, the actual experiences of many financial analysts led them to believe that in the absence of requirements imposed by federal law they would be seriously handicapped in securing corporate data…

Third, even if analyst interest could prompt disclosure of adequate firm data, the vast majority of publicly traded securities were not followed by analysts. Finally, securities analysts sought information for themselves and their customers: “they do not regard themselves as surrogates for the universe of investors and hence do not feel under obligation to disseminate widely information which they secure.”

Though the important ideas of informational asymmetries, free-riding and short term manipulation are an obvious defense of the importance of the SEC’s mission, you can practically hear the priority being downgraded and budgets not kept in line as everyone focuses on the dubious relevance of the beautiful mathematics of martingale theory to the ugly rip-the-face-off-the-client world of Wall Street.

It’s kind of an amazing game of three-card monte. Libertarians simply claim that the SEC can’t do anything. The mission of the SEC is downgraded accordingly. The SEC fails, and libertarians take that as proof that the SEC can’t do anything. Rinse, and repeat.