What good’s disclosure if no one gets it

Marketplace Staff May 13, 2008
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What good’s disclosure if no one gets it

Marketplace Staff May 13, 2008
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Bob Moon: It’s one of the first rules of investing, and it sounds like common sense: Don’t buy what you can’t understand. Trouble is, Wall Street is engaging in all kinds of confusing financial practices behind the scenes these days — as Bear Stearns investors learned the hard way.

Has financial innovation gone too far when even many PhD’s can’t seem to explain how things work? We’ve been putting that question to a few experts, Harvard University finance professor Josh Lerner among them. He thinks things crossed the line when Wall Street bankers came up with all-but-incomprehensible investment offerings.

Josh Lerner: Extremely complex hybrid securities piled on top of each other, where certainly their risk and return properties weren’t well understood, and where it seems that they weren’t solving any kind of fundamental economic problem by being set up. It was almost like it was innovation for the sake of innovation itself.

Or, he suggests, simply for the profit of the investment banks promoting those obscure investment offerings. As long as everyone was making money, there were few complaints. Lawmakers and regulators have kept their hands off for decades to encourage financial innovation. But, Lerner thinks regulators have to be inventive now, too.

Lerner: Just as there’s a need for innovation in terms of the kinds of financial securities that are being offered, there is a need for innovation in terms of what kind of roles and what kind of information regulators have — greater transparency in the system.

Michael Lewitt: Sounds good, but I think in many ways it’s a cop-out. There are certain practices that are just unwise.

That’s Michael Lewitt, president of Hegemony Capital Management. He argues transparency is worthless as long as executives are intent on using sleight of hand.

Lewitt: There was a lot of disclosure about what Enron was doing. There was only one problem: It was almost not understandable. Some of these things that they’re doing are so complicated, you can be as transparent as you want and disclose it all you want, and most people are not going to understand it.

Lewitt says the only thing Wall Street bankers have made clear lately is that they can’t be trusted to make things clear. And that leaves it up to regulators to draw very sharp lines about what’s permitted and what’s not. Democratic Congressman Barney Frank chairs the House Financial Services Committee. He’s convinced new regulation is necessary to bring clarity to the financial markets.

Barney Frank: As we talk about these plans, I did have one person say to me, “Well, you know Congressman, some smart people don’t agree with what you’re proposing.” My answer is, yes, no dumb people caused this problem. You had to be very smart to think up things that were exotic and as potentially damaging.

And then again, just maybe smart like a fox. As investment whiz Warren Buffett once observed about the confusing annual reports issued by some companies: “If I can’t understand it, I know they don’t want me to understand it.”

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