By Robert Kuttner
New York State Attorney General Eliot Spitzer's long-awaited settlement with most of Wall Street is official. What's remarkable is not the severity of the remedy but its mildness. Even more remarkable is the indignation on the part of free marketeers who should be thankful that, once again, regulators have saved capitalism from its self-cannibalizing instincts.
To recap: Through old-fashioned police work, Spitzer was able to document, over a two-year investigation, that "research analysts" were acting as stock touts for the firms' investment banking business instead of providing objective, independent analysis to investors. The investigation, which began in late 2000, further uncovered investment banker kickbacks to favored CEOs via preferential access to hot initial public offerings ("spinning").
Corrupt practices were not limited to a few rotten apples but included the cream of Wall Street, from Merrill Lynch (MER) & Co. to Citigroup (C). Anyone familiar with the Great Depression can draw the obvious inference: Although capitalism is potentially an astonishingly efficient system, the insiders who put entrepreneurs together with investors have irresistible opportunities to feather their own nests. After 1929, we fashioned regulatory constraints to keep these conflicts of interest from wrecking capitalism.
In the past two decades, free-market ideologues and self-interested Wall Street insiders have dismantled much of this regulation. Spitzer has begun to resurrect it, but only after much damage was done. And what is the response? The Wall Street Journal editorial page, a crusader for deregulation, has disparaged Spitzer as a headline-grabbing political climber who doesn't understand markets -- and declared conflicts of interest a natural part of capitalism. After Spitzer's settlement was announced, on Apr. 28, the Journal said that such "structural conflicts have existed for decades" and "were also well known to regulators." But that doesn't mean conflicts of interest are benign: It only means that regulators were compromised. Former Securities & Exchange Commission Chairman Arthur Levitt's 2002 memoir, Take on the Street, documents how his reform efforts were stymied by Wall Street's allies in Congress.
It was left to Spitzer to look out for the small investor. The joint press conference announcing the broad $1.4 billion settlement between regulators and 10 of the biggest Wall Street firms made it look as if state, federal, and industry regulators had acted jointly. It gave the SEC's new chairman, William Donaldson, top billing. In reality, the SEC, the New York Stock Exchange, and the NASD moved only after Spitzer's own investigation made stricter enforcement inevitable. How tough is the settlement? Not all that tough. The firms pay some $487 million in civil penalties and nearly $400 million to a restitution fund for investors. They will kick in over $400 million more to fund investor research by independent firms. Nobody has to admit wrongdoing, no CEO loses his job, and nobody will go to jail. Spitzer himself rejected a criminal prosecution. He only wants to repair Wall Street's conflicts of interest.
Will the settlement do that? By requiring analyst compensation to be based solely on analyst performance, and by erecting a management wall between research and investment banking, the deal does make it much harder for research analysts to illegally promote stocks that their investment banker colleagues are underwriting. However, the other major element, the promise to stop spinning IPOs, is voluntary for now. An official regulatory ban awaits SEC rules.
The nub of the problem is that Wall Street and its regulators remain far too clubby. Self-regulation is delegated to the NASD, the stock exchanges, and the accounting profession, which lack the appetite to go after the conflicts that enrich their brethren. The opportunities for insiders to profit from conflicts of interest are pervasive.
Just as the checks and balances of the U.S. Constitution were built on an understanding of human frailty, so is effective regulation of capitalism. Temptation is ubiquitous, but the supposed inevitability of self-dealing on Wall Street is nonsense. The regulatory era between the 1930s and the '70s, in which savings and loans and banks were far more tightly controlled and the Glass-Steagall Act separated commercial banking from investment banking, was largely free of big scandals, systematic fleecing of investors, and huge loan losses. That's because the structure of the regulatory regime precluded most kinds of conflicts of interest.
Let's remember, too, that free market ideologues pray to the god of efficiency. But whenever an investment banking firm cynically pumps up a loser stock, capital is wasted. By that criterion, people such as Jack Grubman and Henry Blodgett were worse than common thieves. They decimated Wall Street's highest moral justification: the service of efficient capitalism. As we keep learning the hard way, efficient markets require tough regulators. Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale.