CHICAGO — The 500-point drop in the Dow Jones industrial average in midday trading on Oct. 6 “does not speak well of investor confidence in the economic stabilization” package, said former SEC Chair Harvey Pitt.
Mr. Pitt was a panelist discussing market regulation at the Council of Institutional Investors in Chicago. Another panelist was Richard Breeden, also a former Securities and Exchange Commission chairman.
With the lifting of the Glass-Steagall Act restrictions on banking, all financial firms have been engaged in all aspects of financial services, Mr. Pitt said. But because of turf wars in Congress, the regulatory system wasn’t modernized to oversee the new market structure. “We have a 21st century financial services system and a 19th century regulatory system,” Mr. Pitt said, adding the subprime crisis exposed the flaws in the regulatory system.
“Regulation didn’t keep up with changes in the marketplace,” he said.
Mr. Breeden said: “Regulators all over the world have misjudged (the amount of) leverage in our (financial market) system.”
He said efforts to converge global accounting standards should be suspended until the U.S. improves standards of transparency.
“We used to use derivatives to spread risk, but now we use derivatives to create risk,” Mr. Breeden said. Investors need to put their focus back to fundamentals and real economic value.
Mr. Pitt said lack of transparency — internally at financial services companies and externally to the market — contributed to the lack of understanding of the high level of leverage.
Internally, executives at companies that were leveraged 100-to-1 had no idea they were leveraged so high.
“Markets thrive on information,” Mr. Pitt said. Improving transparency is a role government should be performing and wasn’t.
Both Messrs. Breeden and Pitt blamed poor design of incentives in executive compensation programs for contributing to overleverage.
“The way we do it in this country is essentially un-American,” Mr. Pitt said of the design of many executive compensation programs that get away from the idea of a fair day’s wage for a fair day’s work.
If companies are performing well, “I’m in favor of generous compensation,” Mr. Pitt said.
Mr. Breeden said executives should not be allowed to keep bonuses and other incentive compensation later found to be based on inaccurate performance metrics.
“I think clawbacks are a good idea,” he said.
“The compensation system is part of the cause of excessive risk taking,” Mr. Breeden said. Encouraging risk-taking is necessary to build a company and keep it competitively dynamic, Mr. Breeden said. But the board has to ensure it has good risk controls to focus risk to constructive use.
Boards have to link executive pay to performance and have clawback policies in place, Mr. Breeden said.
Mr. Pitt said he believes executive compensation should be divided into two parts: an annual amount for living expenses with the rest going to an interest-bearing account until the end of the term of the performance objectives. If the goals are met, the executive receives the compensation; if not, the money goes to shareholders.
A key reason for the financial market crisis, Mr. Breeden said, is that the system had too much leverage and too little capital and too much reliance on mathematical risk models that when stressed did not work.
Both Messrs. Breeden and Pitt support giving shareholders access to corporate proxy materials to nominate directors.
“Absolutely, we shouldn’t need a meltdown to force proxy access,” Mr. Breeden said. “Proxy access is the right way to run the American system.”
Both also support fair-value accounting, which the $700 billion bailout package enacted Oct. 3 allows the SEC to suspend.
“The concept of fair-value accounting is unassailable,” Mr. Pitt said. “The problem is implementation,” applying measures to assets without a market.
On short selling, Mr. Pitt said there needs to be more transparency in pricing securities out on loan. Institutional investors should have better mechanisms to evaluate prices instead of relying basically on prime brokers.
“I think short selling, done properly, is helpful to the market,” Mr. Pitt said. He opposes naked short selling, which is shorting without borrowing securities.
Mr. Breeden said short selling isn’t to blame for the financial market crisis. But he is in favor of restoring the uptick rule, allowing short selling only when the price of a security has risen.
“When the market is down, short sellers shouldn’t be able to put their foot on its neck,” Mr. Breeden said.
