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Causes Of The Recent Crisis
The causes of that crisis are manifold. Metaphorically speaking, the collapse in our financial system has 1,000 fathers: The cavalier attitude toward risk of our bankers and investment bankers, holding a toxic mix of low-quality securities on enormously leveraged balance sheets; the laissez-faire attitude of our federal regulators, reflected in their faith that “free competitive markets” would protect our society against excesses; the Congress, which rolled back legislative reforms going back to the depression years; “securitization,” in which the traditional link between borrower and lender—under which lenders demanded evidence of the borrowers’ ability to meet their financial obligations—was severed; and reckless financial innovation, in which literally tens of trillions of dollars of derivative financial instruments (such as credit default swaps) were created, usually carrying stupefying levels of risk and unfathomable levels of complexity.
The radical increase in the power and position of the leaders of corporate America and the leaders of investment America has been a major contributor to these failures. Today’s dominant institutional ownership position of 70 percent of the shares of our (largely giant) public corporations compares with only about 8 percent of all corporate shares a half-century ago. This remarkable increase in ownership has placed these managers—largely of mutual funds (holding 25 percent of all shares), pension funds (20 percent), hedge funds and endowment funds—in a position to exercise great power and influence over corporate America.
But they have failed to exercise their power. In fact, the agents of investment America have failed to honor the responsibilities that they owe to their principals—the last-line individuals who have much of their capital wealth committed to stock ownership, including mutual fund share owners and pension beneficiaries. The record is clear that, despite their controlling position, most institutions have failed to play an active role in board structure and governance, director elections, executive compensation, stock options, proxy proposals, dividend policy and so on.
Given their forbearance as corporate citizens, these managers arguably played a major role in allowing the managers of our public corporations to exploit the advantages of their own agency, not only in executive compensation, perquisites, and mergers and acquisitions, but even in accepting the “financial engineering” that has come to permeate corporate financial statements, endorsed—at least tacitly—by their public accountants.
But the failures of our institutional investors go beyond governance issues to the very practice of their trade. These agents have also failed to provide the “due diligence” that our citizen/investors have every reason to expect of the investment professionals to whom they have entrusted their money.
How could so many highly skilled, highly paid securities analysts and researchers have failed to question the toxic-filled leveraged balance sheets of Citicorp and other leading banks and investment banks and, lest we forget, AIG?1 [How could they miss] the ethics-skirting sales tactics of Countrywide Financial? Even earlier, what were these professionals thinking when they ignored the shenanigans of “special purpose entities” at Enron and “cooking the books” at WorldCom?
Again, going back to the stock market high reached in 2007, how many analysts questioned the typical corporate assumption that their pension plans would earn future returns of 8.5 percent per year, now obviously a deeply flawed assumption that is sowing the seeds of another crisis in the financing of our private and public retirement systems.
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