What has the on-going financial crisis to do with information law? Everything
Financial services today are regulated by laws written when Bonnie and Clyde were robbing banks with Tommy guns—that is, when money was a physical commodity. As finance has evolved into a virtual industry, particularly in the last twenty years, the regulatory system hasn’t kept up. As a result, we’ve seen an accelerating string of increasingly dangerous crises of confidence.
The last time the markets melted down, you remember, was after accounting scandals were uncovered at Enron, WorldCom and others. The companies had manipulated their balance sheets to hide transactions that inflated earnings and shifted losses to shell companies. To end such shenanigans once and for all, Congress passed the Sarbanes-Oxley Act, which since 2004 has cost public companies in the U.S. billions of dollars, much of it in the form of new and overhauled financial systems. According to the Financial Executives Institute, the average company spends $1-2 million every year for on-going compliance costs.
As has become painfully clear over the last year, however, SOX failed in its principal goal of making financial statements “transparent.” Somehow the entire financial services industry was able to hide the true risks of its subprime-related mortgage debts, which have so far racked up two trillion dollars in related losses.
The problem with SOX was that its authors didn’t understand what actually caused the 2001 crash. SOX tightened up reporting requirements for the kinds of transactions Enron used to hide its true earnings, but the real problem, then and now, is that assets and liabilities have moved increasingly from tangible (factories, inventory, cash) to intangible (data, intellectual property, derivatives). Many analysts are blaming the meltdown, for example, on the complexity of mortgage-backed Collateralized Debt Obligations (CDOs), an unregulated security that was invented in the 1980’s at the defunct brokerage Drexel Burnham Lambert, whose “junk” bonds were responsible for an earlier crisis.
The accounting profession has steadfastly refused to develop metrics for valuing information products, which for the most part don’t even show up on the balance sheet. In March, for example, Washington Mutual Chairman and CEO Kerry Killinger told investors that the bank had adequate capital to weather the housing storm. Six months later, WaMu, with over $300 billion in assets, became the biggest bank to fail in U.S. history. JP Morgan Chase, which acquired WaMu’s banking operations, plans to write off $31 billion worth of bad mortgages, a staggering amount that isn’t even hinted at on WaMu’s most recent balance sheet.
The $770 billion bailout bill that Congress passed includes no specific provisions to change the behavior of public companies, but you can be certain these are coming. Whether Congress and the regulators actually solve the problem or whether they simply apply more lipstick to the pig remains to be seen, but either way the impact on corporate budgets will be substantial. My guess is that they’ll make SOX look trivial by comparison.
Of course it would be nice if the money we’ll have to spend goes for something useful, but it’s hard to be optimistic. The dismal performance of the financial services industry and its regulators, after all, has had a lot of rehearsals. Let’s hope this time they actually read the reviews.