October 29, 2004 LAWFUEL – Law, legal, attorney newsLet me begin today by thanking the Detroit Economic Club for giving me the opportunity to speak here today. Thanks as well to the University of Toledo ‘s College of Law for co-hosting today’s events. Let me also salute the Detroit Economic Club, on the occasion of its 70th anniversary, for your long history of providing a forum for the discussion of important economic and business issues. Your informed membership, and commitment to discussion and debate, makes it a pleasure to come here today. And of course, I am honored to join the distinguished individuals who have appeared at your meetings through the years.
Today’s date, October 29, occupies an ominous place in the annals of America ‘s securities markets. As we all know, it was on this day 75 years ago that the Dow Jones Industrial Average plunged nearly 12 percent, earning it the moniker “Black Tuesday.” On the previous day, the Dow fell nearly 13 percent, and was subsequently named in the history books “Black Monday.” There have been a few unhappy market days in the 75 years since – but none so heralded as October 29, 1929.
Labels aside, these two days represent a seminal moment in American history: the stock-market crash of 1929. Today I’d like to talk about the crash and the impact it had on the U.S. economy, and then draw some comparisons between that era and the one we have all lived through, which began in the late 1990s and extended into the new millennium. I believe we can learn valuable lessons from these two eras. Before I go any further, let me offer the obligatory and standard disclaimer that the views I express here are my own and do not necessarily represent those of the Commission or its staff.
To fully understand the events of 1929 requires a brief review of the decade popularly known as the “Roaring Twenties.” As the U.S. economy and global economy recovered from the ravages of World War One, then-President Calvin Coolidge captured the optimism of the period with his talk of a “new era of prosperity.” It was a time when the proliferation of electricity and electric-powered manufacturing were sparking productivity gains throughout the economy. Tax reductions were helping to boost income and job creation. Unemployment averaged just 3.7 percent from 1922 to 1929, and the nation’s average annual growth rate was nearly 5 percent.
The rise in disposable income created demand for new luxuries, like telephones, radios, refrigerators, and, of course, as you Detroiters know so well, the automobile. The number of people owning cars quadrupled during the decade, from less than seven million to more than 27 million. The nonstop solo flight of Charles Lindbergh across the Atlantic Ocean in 1927 symbolized the seemingly-limitless opportunities of the era. Indeed, such was the frenzy about aviation that a company called Seaboard Air Lines started issuing stock, and saw it skyrocket, even though it was nothing more than a railway company.
On the investment side, stocks started to enter the mainstream, with the number of Americans holding equities increasing from 500,000 to 15 million, at a time when the U.S. population hovered around 120 million. And the number of investment trusts – similar to today’s mutual funds – increased six-fold. The Dow also increased by a factor of six, between 1921 and 1929, and new technologies helped to drive the boom. The share price of Radio Corporation of America – better known as RCA – increased from 85 in 1928 to 549 a year later. Annual volume on the New York Stock Exchange exploded from 171 million shares in 1921 to more than one billion in 1929. The average daily volume during this period increased from 632,000 to nearly 4.3 million, though this pales in comparison to the 2003 average of nearly 1.4 billion. A now-infamous article was published in Ladies Home Journal in 1929, under the headline “Everybody Ought to be Rich.” And, according to lore, Joe Kennedy sold all of his investments when his shoeshine boy began touting the latest hot stocks.
His pessimism was well timed. Between October 23 and November 13 of 1929, the Dow fell by 39 percent – which would be equivalent to a fall of approximately 4000 points today. But the response, of course, was alarm but not panic. President Hoover said at the time that “the fundamental business of our country . . . is on a sound and prosperous basis.” And optimists at The Wall Street Journal said of investors: “They have lost a few tail feathers but in time they will grow again, longer and more luxurious than the old ones.” Indeed, by the following April, the market had regained half of what it lost, and appeared to be on the road to recovery.
But the recovery would prove short-lived, for reasons I will touch on in a moment. The Dow resumed its downward slide in the summer of 1930, and the slide continued for two more years, bottoming out in July 1932. By then, stock prices had fallen 85-90 percent from their peaks in 1929.
While the percentage of households directly holding stock was small compared to today, the market decline, coupled with bank failures and an economic downturn sparked by ill-advised measures such as the Smoot-Hawley Act, had a punitive effect on everyday life. Between 1929 and 1932, the number of unemployed rose from one-and-a-half million to 15 million. For those who were lucky enough to hold jobs in the dominant manufacturing sector, average weekly earnings fell by one-third. The nation’s GNP fell by 30 percent, manufacturing production dropped 48 percent, and personal income declined by 45 percent. Making matters worse, the annual deflation rate was close to 10 percent, and nearly one-quarter of all commercial banks failed. Groucho Marx captured the bleakness of the period with his quip that, “All I lost was $240,000. I would have lost more, but that was all the money I had.”
These events, and many others that would follow, severely eroded investor confidence. Annual trading volume on the New York Stock Exchange fell more than 60 percent from 1929 to 1932. The underwriting of stocks by investment banks fell from $5.1 billion in 1929 to just $31 million in 1933. And the price of a seat on the exchange fell from $550,000 to $68,000. Capturing the bleakness of the period was the 1938 conviction, and subsequent imprisonment, of the President of the New York Stock Exchange – Richard Whitney. Repairing the damage from this era would take many, many years. Indeed, the Dow would not match its 1929 peak until 1954. For those of us who grew up in the 1930s and ’40s, I suspect that the financial devastation that defined this period remains deeply embedded in our memories, and remains a stark reminder of the human toll that can be exacted by an extended downturn in our market and our economy.
Today, we are just a few years removed one of the biggest market downturns since the period I’ve just described. The Dow declined for three consecutive years – 2000, 2001, and 2002 – and when the Nasdaq bottomed out in October 2002, it was 78 percent below its peak. Amidst these market tumbles, a wave of corporate corruption was uncovered, starting most famously with Enron, followed by a hall of shame that includes WorldCom, Adelphia, and countless others. Given the broad exposure to the stock market – with over 50 percent of all households directly or indirectly owning equities – this “perfect storm” of a collapsing stock market, corporate corruption, and an economic slowdown created the conditions for severe economic uncertainty and weakness.
Yet the apocalyptic forecasts of a 1930s-type economic calamity have not come true. While there has been undeniable hardship, the U.S. economy has proven remarkably nimble. Unemployment has not exceeded 6.3 percent, and stands today at just 5.4 percent. The home ownership rate is at record-high levels. And nearly two million new jobs have been created since April 2003. So this begs the question: Why have we been able to date to emerge relatively unscathed from the economic turmoil, while our forebears suffered for many, many years? I’d like to answer that question by looking at the changes in the U.S. economy since the 1920s and ’30s.
One factor working in our favor today is that we are much more integrated with the global economy today than 75 years ago. The exposure to international competition has boosted our competitiveness, and enabled us to draw on individuals and innovations from throughout the world. The globalized economy also promotes liquidity, while helping to reduce the cost of capital and ensure that it is allocated efficiently.
A second difference between today and 75 years ago is the greater access to information. With the Internet, rating services, and investigative journalism, information has been democratized and is no longer the province of market insiders. That said, we saw in recent years that the real challenge can be distinguishing good information from bad. It’s a constant struggle, remains a source of concern for the SEC, and should be of concern to all in the investing community.
A third difference is that the United States benefits from the existence of many more sophisticated instruments to advance diversification and risk dispersion compared to 75 years ago. Consider derivative contracts, which didn’t exist in the 1930s. Today the U.S. Comptroller of the Currency puts the national amount of derivatives in commercial bank portfolios at $81 trillion, up from $17 trillion at the end of 1995. Similarly, 92 percent of the world’s top 500 companies now use derivatives as a hedge against interest-rate risk. These instruments and others have helped to redirect risk toward those most willing and able to take it, and are helping with market stability and efficiency. A cautionary note – derivatives themselves may contain new sorts of risks as global investors expand into uncharted waters with increasingly complex instruments and strategies.
Chairman Greenspan has pointed to the boom and bust in the telecommunications sector as an example of how the financial system is better equipped today than in the past to cope with severe stresses. Because banks have had more capital with which to absorb the pain from telecom bankruptcies, they have been able to distribute the financial risks using a variety of tools unavailable to market participants in decades past, such as loan syndications, pooled asset securitizations, credit default swaps and collateralized debt obligations. These instruments also help to provide additional information to the market, which results in more accurate pricing and assessment of credit risk.
The 1930s and the more recent era also highlight the importance of having government occasionally step in to help stabilize markets. The absence of such intervention in the early 1930s resulted in half of all U.S. banks either closing or merging, which caused massive material losses and a severe erosion of confidence in the financial system. The Federal Deposit Insurance Corporation began offering insurance in 1934, and ever since it has been a cog in the foundation of our financial system, and promoted long-term confidence in it.
A more recent illustration of valuable government intervention came in the summer of 2002, approximately six months after the implosion of Enron and on the heels of WorldCom’s collapse. Faced with the prospect of a crisis in investor confidence, Congress and the White House moved with dispatch and vigor to approve the Sarbanes-Oxley Act. Within a single year from enactment, the SEC adopted all of the implementing rules and regulations designed to make the Sarbanes-Oxley Act effective.
The law and our enactment of the subsequent regulations represented a swift response designed to begin to restore confidence in the accounting profession. With the creation of the Public Company Accounting Oversight Board, strong new oversight has been installed over the auditors of public companies. The legislation and regulations have also helped to improve the “tone at the top” of America ‘s public companies by requiring CEOs and CFOs to personally certify their companies’ financial statements. Moreover, the role and independence of important gatekeepers, such as audit, governance, and compensation committees have been substantially strengthened.
The implementation of Sarbanes-Oxley through regulation highlights another major difference between the recent era and that of 75 years ago: the very existence of the Securities and Exchange Commission. Before the SEC’s creation, the stock market was widely distrusted and easily subject to manipulation. And while some distrust continues today, our markets are far more transparent and secure than they were in the earlier era. That is a tribute to the select corps of professionals who populate the Commission, and who are working today to promote even greater integrity and accountability among market participants.
The past two years represents the greatest period of activity in the history of the SEC. The Commission has ratcheted up our enforcement efforts, expanding the size of the enforcement staff and moving even quicker to crack down on corporate wrongdoing and impose fines against wrongdoers. Over the past two fiscal years, the Commission has filed more than 1300 enforcement actions, obtained orders for penalties and disgorgements totaling nearly $5 billion, and has sought to bar 331 executives from serving again as officers or directors. We have also utilized new powers granted to the SEC by Sarbanes-Oxley – powers that now allow us for the first time to return penalties directly to those who have been harmed. Moreover, we are now able to pursue more vigorously the enablers of corporate wrongdoing, such as bankers who help to disguise illegal schemes.
In response to the mutual fund scandal involving late trading and market timing, the Commission has proposed or adopted 13 new regulatory reforms in just the last 13 months. During the same period, the Commission has brought 51 enforcement cases related to the mutual fund scandals and levied $900 million in disgorgements and $730 million in penalties. A cornerstone of our mutual fund reform agenda is the new requirement that funds maintain compliance policies and procedures, as well as a chief compliance officer. I believe the presence of a designated chief compliance officer, who is answerable to a fund’s board, will strengthen the focus on compliance controls and procedures. Our reform agenda is capped by a requirement that funds relying on certain exemptive rules must have an independent chairman, and 75 percent of board members must be independent. This will improve the overall atmosphere in which those funds operate, and hopefully prevent the mutual fund industry from becoming engulfed in the kind of crisis of confidence that asphyxiated our markets 75 years ago.
There are a number of other future measures we’re considering to shore up investor confidence that I’d like to touch on very briefly:
We are seeking to modernize the structure of America ‘s stock markets through proposed Regulation NMS, and we have proposed reforming the antiquated reporting regulations associated with asset-backed securities and public equity offerings. We also are examining ways to strengthen the voices of shareholders in the face of poor performance and oversight by corporate boards.
Perhaps most important, and longest lasting, we have also created an infrastructure at the SEC around the idea of risk assessment. I believe our program of risk assessment will change everything about how the SEC goes about its business. We are seeking to create an enhanced oversight regime that will equip the Commission to better anticipate, find, and mitigate financial risk, potential fraud, and malfeasance. The effort is designed around so-called risk mapping, which is a running list of potential risks identified by our field staff, and the creation of a new Office of Risk Assessment, which brings together professionals experienced in seeking out potential areas of concern. We want our efforts and oversight to be more anticipatory and preventative in nature – to look over the hills and around the corners of the securities markets in ways that will help us deter and detect fraud, and ameliorate damage when it occurs. An early warning system is a necessity at a time when the transactions in our markets are becoming increasingly complex.
An example of our risk assessment efforts is our initiative to require the registration of hedge fund advisers. The Commission approved this proposal earlier this week, and it will allow the Commission to gain greater insight into the activities of hedge funds – soon to be a one trillion dollar corner of the securities industry.
Although we have made substantial progress, our job is far from done. We have helped to strengthen the role of boards of directors of America ‘s issuers and move away from the iconic “imperial CEO,” but again, it is obvious there is much more work ahead. Corporate malfeasance continues to be uncovered, and investor confidence has not been fully restored. We must work one day at a time, everyday, to repair the damage.
But bringing enforcement cases and adopting new rules can only accomplish so much. Drawing new “bright white lines” of legal and illegal behavior will not be enough. If past is prologue, we will see some in our markets go right up to the edge of those lines just so they can technically conform to the law. Other, more unscrupulous actors will try to find ways around the lines to avoid the intent of the law entirely.
The only sure path to restoring full investor confidence is for the management of our issuing companies and participants in our financial markets to relentlessly instill a corporate culture of ethics in their own organizations. I urge you to make every effort to affect such ethical change at every level – from the board room to the assembly line. It is critical for the corporation to be entrusted to the leadership of a Board and a chief executive the Board selects – to a leadership team that demands an approach that stays well short of pushing “up to the line.” This means instilling an ethic – a company-wide commitment to do the right thing, this time and every time – so much so that it becomes the core of what I call the essential “DNA” of the company. Only with the widespread inculcation of these values will our markets resume their rightful place as an engine of prosperity in the United States and throughout the world. I believe the pendulum is swinging in the right direction, but to paraphrase Thomas Jefferson, the price of prosperity is eternal vigilance – by regulators, by corporate leaders, and by investors of our constantly-changing markets.
Thanks again to the Detroit Economic Club for giving me the opportunity to speak on the anniversary of an infamous but historic day. I’d be happy to take your questions or hear your observations.