The following speech was presented by Jack Willoughby at the CMRE meeting, The Economic Consequences of Empire, held November 20, 2002.

 Mr. Willoughby is Senior Editor for Barron's "Dow Jones" financial weekly. He writes the "Offerings in the Offing" column.

His speech was part of the session entitled, "The Ghosts of Glass-Steagall, Fraud and Careless Risks"

They say that history never repeats itself but as the old sage once said it  sure rhymes a lot. This is especially so when we look at the current financial markets today and compare them with the Roaring Twenties and the reforms that followed in the Great Depression.

Good evening my name is Jack Willoughby, I'm a senior editor of Barron's, and I'm here tonight to share with you some of my thoughts about the thinking that led to Glass Steagall, The formation of the Securities and Exchange Commission and the Public Utilities Holding Act and the Investment Company Act.

I should start the evening’s presentation by thanking CMRE for the opportunity to address you and to say that my opinions come from my 25 years as a financial journalist.  They in no way represent that of my publication Barron's.

That said, I'm going to focus primarily on John Thomas Flynn, who specialized in writing on financial issues, and who exerted a remarkable influence over the reforms of this time.  He wrote an influential column for the New Republic entitled "Other' People's Money" named after the book penned by Louis Brandies. He advised Senators and later became an impassioned advocate for reform. Ferdinand Pecora of Wall Street investigation fame hired Flynn as one of the examiners on the famous Wall Street practices committee whose work led to the creation of the Securities and Exchange Commission. My talk will sketch out some of the themes and remedies that Flynn outlined in his writings and books. The articles helped set the agenda for change.

I contend that Glass Steagall, which ultimately separated banking from brokerage, and introduced deposit insurance, cannot be separated from the reforms that followed The Securities Act, The Public Utilities Act, and the Investment Company Act. Many of the reforms came in reaction to articles and columns printed in Flynn articles years before and later backed up by Congressional investigation.

I believe that many of the issues raised by Flynn pertain directly to problems we face today. They offer us a course of action as we decide what to do in the face of some of the worst stock market losses since the Great Depression.

Compared to the sweeping changes introduced in the Thirties, today’s  so-called reforms appear as mere Band-Aids. Indeed many businessmen see them as meaningless efforts forwarded to contain the political damage, and allow for the venting of public rage. 

The Investment Company Act, based on an eight-year investigation by SEC investigator David Schenker shows that serious reform requires much deeper  consideration that will ultimately address a raft of issues not the collective carpings of  factions.  Truth is people we haven’t even started the job yet.

A brief note on Flynn: John Thomas Flynn was born in Maryland and educated to be lawyer but settled upon journalism as a career coming to New York in the Twenties to become managing editor of the New York Globe. He specialized in writing about finance, real estate and stock market scams. You can find a  brief biography of him may read a chapter contained in Richard Radoshes book entitled "Prophets of the Right."

Flynn wrote about financial excesses of all sorts throughout the Thirties in a way almost no journalist did. He painstakingly took apart major collapses at a time the public was reeling—grasping for answers. He analyized Ivar Kreuger's match empire,  Samuel Insull's complex utility networks, and autopsied the failure of the Bank of the United States. In his articles he showed how the mechanisms of finance often worsened the ultimate collapse. His reporting outlined a common linkage that, he believed ultimately made these calamities possible--the holding company, a company that does nothing but hold the securities of other companies. He believed that it should have been outlawed entirely to ensure this mischief could not recur. Many of his more aggressive suggestions were dropped. But most all of the laws passed bear his fingerprints. Flynn believed that the roles of broker, floor trader, and specialist should have been separated by legislation.

He opposed all forms of financial devices designed to concentrate power in an inside group, devices such as lettered stock or concentrated voting shares he argued should be permanently banned. For years  the New York Stock Exchange actually banned non-voting stock, only recently relenting. 

Flynn believed sound stewardship would be prompted by transparency. He believed that stock ownership, all management side-deals, and director transactions should be made public. He argued in “Graft In Business” that stock ownership, the latest source of wealth, should receive the same treatment as real estate. These transactions can be looked up by anyone in a county courthouse. These and other devices permitted financial manipulations that put the companies outside regulatory oversight. And the ultimate collapses left much for the regulators to ponder and  even more economic hardship. Subsequent legislation by the SEC such as the Public Utilities Holding Company Act, partially addressed Flynn’s concerns in the utility area. The Investment Company Act in 1940 addressed Flynn’s charges laid down in “Investment Trusts Gone Wrong” a scathing indictment of the industry.

In one of Flynn’s early books entitled "Graft In Business" Flynn outlined how the mechanics of finance could be used for mischief.  He showed how New York developer Bernard Marcus of the Bank of the United States was able to legally siphon off most of the profits of the bank for insiders, and ultimately organize more than 50 separate affiliates, simply by using concentrated voting shares. Marcus deployed a technique popular today, that of  spinning off the affiliate to the stockholders of the Bank of United States, creating common stock ownership thus avoiding control restrictions.

Then, as now, the banking industry wanted to diversify into other lines of businesses, and viewed the old regulations designed to protect depositors money as being outmoded: Wrote Flynn: "I am not speaking of bank robbers, and embezzlers. I am speaking of perfectly fine gentlemen, men looked upon as pillars of society. But there are many such who have held that our banking laws were a little bit old-fashioned, who thought our banks should be more like the banks of other countries, Germany, for instance, where the banks get into all sorts of business and control it. And so they gradually invented a form of banking affiliates which enables them to do the very things which half a century of banking law development was needed to prevent."

Ladies and Gentlemen, that statement could well have been written today even though it was written in the Thirties.  In fact our position is worse now than back then because of two things--the intense participation of the public in this gamesmanship through mutual funds and savings plans, and the imposition of government guaranteed deposit insurance providing a government guarantee backing the game.

While the corset of regulations has been loosened allowing financial intermediaries to flop into all sorts of activities, Congress has made it easier to bail out failed institutions with quick loans from the Fed window. Recent legislative reforms make it possible for bankers and brokerage firms to receive loans from the Federal Reserve. Fed Window loans that can now be made on any kind of securities deemed fit by the Federal Government. I admit it’s a stretch but what about how about telecom stock?  Banks have been able to diversify into brokerage without giving up their deposit insurance and so represent a government-guarantee nightmare.  A level playing field is one thing. But a feathered bed quite another.

Lobbyists seem to forget one simple fact. Membership in the United States credit system is privilege not a right. Never has this privilege been sold as cheaply as it is being sold today.  I wonder how many of you know that up until 1935 the United States actually held the stockholders of failed banks liable for the full amount of their investment in bank stock.

By the Thirties as now, it was evident to all that these institutions had branched into speculative ventures. Failure in single ventures transmitted instability like a fever across the whole enterprise thanks to the holding company structure. What made holding companies so deadly  was that the structure allowed the bankers to hide their problems from regulators behind a dense screen of  corporate transactions that only became evident upon the failure of the institution.

Flynn aimed his criticisms at the methods in an attempt to reintroduce a sense of public stewardship to the process and to limit speculative ventures. Ultimately Flynn was to be disappointed in his reform efforts. Flynn blamed none other than Franklin Delano Roosevelt, author of the America's New Deal, for pulling much needed separation of powers out of the Securities Exchange Act of 1934.  The President also cut back stiff margin requirements that Flynn favored. And one more important issue was skipped in all this legislation.  Congress itself in proceedings addressed and rejected the notion of separating agency from principal business and so left open the door to the current confusions over conflicts. How can Elliot Spitzer expect Merrill Lynch, or Salomon Smith Barney to do what Congress was unwilling to do when it enacted the reforms in the Thirties?

The result is our current system rife with conflicts far deeper than anything Elliot Spitzer can ever address in his email campaign.  Now we have banks owning not only brokerage firms and New York Stock Exchange specialists. We have brokerage firms bowing to the demands of mutual funds. I only mention Fleet Financial, which owns Quick & Reilly and a specialist firm, as one example. I might also mention Goldman Sachs a major equity underwriter, a dominant force in commercial paper, and money manager which happens to own one of the largest specialist firms on the New York Stock Exchange.

What were reformers like Flynn trying to do when they set about lobbying for specific changes? They were trying to return a semblance of sanity and stewardship to depository institutions by restricting the various activities all to ensure that the rampant speculation of the Twenties never happened again.  Their efforts were all inclusive. "There can be no intelligent handling of the problem unless the exchange itself, the money lenders who supply the funds and the issuers of corporate stocks as well as their agents the underwriting houses are included in the plan of control," wrote Flynn in his book "The Economics of Securities Speculation," published in 1933.

Flynn's writings give a reader a bird's eye view of how the reforms progressed. The first efforts were met with frustrating delay. Then as now business had a sense that the good times were soon going to come back. Flynn despaired back in 1933: "I have very little faith in the country learning a spiritual lesson out of this crisis. Somehow we will struggle out of it. We will have a momentary gushing up of cheap evangelism and then everyone will settle down to get the old National City shares up to $575 again. This course is too deeply embedded in our nature. Our civilization got off on the wrong foot forty of fifty years ago. It is not going to be turned in another direction by just a little depression."

When you read Flynn's writings you get the sense of deja vu. Can't the current Band-Aids of reform be regarded as mere evangelism to head off serious study of the root causes of some of the regulatory easing that ultimately allowed some of these failures to occur? We have by my count, four efforts at reform, IPOs, accountants, analysts, and hedge funds but no agreement yet on what happened during the 1999 Bubble.

What we need, I believe, is a comprehensive study much like the Special Study in the Early Sixties that will outline for all the various roles played by the various factions. The public should be able to know who profited the most from the IPO craze? Was it the mutual funds that bought big chunks then passed the gains on to new funds thereby attracting new investors? We need a big comprehensive account of what happened to 20 highest flying IPOs in 1999 and 2000, who bought and who sold. Only the SEC with its subpeona power can make such a document public. The object of such an exercise would be to put a comprehensive account before the public to ensure an informed debate.

Already there are plenty of examples out there that suggest we re-examine the need for a re-separation of the various functions. Survey the current financial wreckage and you'll find examples resonant of the Twenties excesses. There's the utility Montana Power that slipped the traces of regulation only to invest in internet companies with disastrous results for ratepayers. There's Internet Capital Group, a public holding company ipo floated with nothing besides the shares of high-flying internet companies for assets that rose above $200 before crashing down to around $2.  With apologies to Sandy Weill, there's Citicorp itself, under stewardship of John Reed; Citi’s near insolvency in the early Nineties showed up the problems and risks of the holding company structure.

Pain avoidance was a major point Flynn made in his call for a ban on the holding company. The device allowed banks and brokers to go to great lengths to avoid taking their tough financial medicine. And risk is like water it flows to the weakest part of any financial structure.

So according to Flynn's writings we can expect more failures to hound us even as we hope for a market revitalization. My candidate for future trouble happens to be the telecommunications sector. Since 1997 the banking systems has made roughly $780 billion in loans--two thirds of it in syndicated loans, one-third in debt. And judging by what's happened to the stock of these telecommunications companies and how the debt now trades in the market,  many of these loans are not going to be paid back. The banking community has only started writing down their exposure.

Contrast this with the fact that the banking system has roughly $400 billion in capital in it, and you can see at least the potential for serious trouble. Granted no one really knows how much of the telecom debt is held by brokerage firms and non banks. But the potential for problem still exists. The holding company structure makes it almost impossible for regulators to see into the machinations and prevent a disaster. 

Finally one has to remember that reform kept occurring over a ten-year period. SEC investigator David Schenker an associate of Flynn's worked for eight years to produce the Investment Company Act. Where are we going to find regulators dedicated enough even to produce a thorough definitive study just outlining what happened so that earnest attempts can be made at reform?

The SEC has been bled dry by Congressional  budget hacks, so it's pretty hard to feel sorry for politicians who will ultimately feel the sting of a public no longer willing to speculate with their pension plans because they believe the game is fixed. The SEC and the reforms that followed in the Thirties was designed ultimately to win back credibility lost to the speculative excesses of the Twenties. We seem to be headed down the same road once more. But where will we find the dedicated men like David Schenker and Flynn willing to brave wrath of corporate kingpins and politicos for a bureaucrat’s pay?  These men were idealists.  The only man who fits that bill, to my mind, would be Stanley Sporkin. And nobody’s considering Stan for the job.
Thank you.