The Secret History of Securities Regulation: Frear-Fulbright Edition
It was August, 1964. President Lyndon Johnson was about to sign into law the most important Wall Street reforms since the Great Depression.
The law, then known as the Frear-Fulbright Act, was the culmination of years of study by a special investigatory commission launched by John F. Kennedy.
"The law signed today should further strengthen the securities markets and public confidence in them. Industry and government have worked together in the writing of these laws. Industry and government will work together in making these measures succeed," Johnson said.
That’s not what happened.
Just a few years later, Wall Street found itself in a crisis that crippled hundreds of brokerages, badly damaged investor confidence, contributed to a decade long bear market, and resulted in the passage of yet another round of regulation intended to restore investor confidence.
It’s been well over a year since I first described how a law introduced in 1970 drove Wall Street to abandon its partnerships in favor of becoming publicly held companies.
Now it’s time to begin pushing that story a bit further—all the way back to 1964.
My argument today is that market reforms signed into law in 1964 led, just a few years later, to the most serious Wall Street crisis since the Great Depression.
Last year I argued for a counter-narrative to the standard version that the transformation of Wall Street firms into publicly held corporations was driven entirely by a combination of market pressure and avarice. It simply made no sense to me to say that Wall Street had suddenly become a greedier place in the last few decades.
What I discovered was that the necessity of going public arose from the need to raise additional capital, beyond what partnerships could provide, for Wall Street firms. The need for capital, in turn, was driven by a law passed in order to—as its sponsor put it—“restore investor confidence and help securities markets to flourish” in the wake of a Wall Street crisis.
That law was the Securities Investor Protection Act, or SIPA. It created something like FDIC protection for the customers of securities firms. In the minds of lawmakers, this raised the concern that brokers—no longer fearing a “run on the bank” by customers—would behave recklessly. So, following the banking model, SIPA authorized the SEC to impose capital adequacy requirements to ensure against that “moral hazard.”
The capital rules the SEC set up required firms to maintain specified levels of net liquid assets as a ratio of obligations to customers and creditors. Initially, many firms merged with each other in response to the rules and found that they were able to meet the capital requirements as partnerships.
But the market boom of the 1980s resulted in enormous growth of many Wall Street firms. The strongest capitalized firms or those with the least SIPA-exposed businesses, such as Goldman Sachs, held out the longest.
SIPA was the response to what was known as “the Paperwork Crisis,” which itself was the result of a huge increase in stock market volume in the late 1960s. From 1966 to 1967, the annual volume increased 33 percent. Brokerage firms were unable to keep up with the increase in volume.
The brokerages failed to make customer trades, errors became rampant, fraud and outright theft of securities flourished. They took losses because their inability to execute trades left them in short positions on stocks.
In reaction to this, the NYSE and other exchanges, agreed with the SEC to curtail trading hours. During one period, the NYSE would shut down every Wednesday to allow member firms to get their books in order.
The NASD urged its members to cut back on their business. The SEC gave similar orders to firms it considered the most troubled.
Not surprisingly—with firms cutting back on their business, trading hours constrained, capital losses from poorly executed trades—trading volume dropped off badly. By 1969, Wall Street was in a deep slump. Over 160 member firms of the NYSE went out of business.
Why was Wall Street caught so unprepared by the increase in volume?
I now believe that the cause of this was an earlier set of regulations designed to make the markets safer. Those rules, known as the Frear-Fulbright Act, were passed in 1964 as amendments to the Securities Exchange Act of 1934. Among other things, the rules encouraged companies to list themselves on the New York Stock Exchange by imposing burdensome disclosure and reporting requirements on non-listed companies.
It was a severe blow for the over-the-counter markets and solidified the the oligopolistic position of the New York brokers. Not surprisingly, the oligopolies became inefficient and poorly suited to the market because they were deprived of the kind of feedback market processes would have provided.
The law may have also had its intended effect of increasingly investor confidence—which might well have spurred the explosion in trading volume. Despite over a year of research into this topic, I have found no other persuasive explanation for the explosion of trading volume that lead to the Paperwork Crisis.
In short, the history of securities regulation stretching at least as far back as 1964 is one of unintended and unanticipated consequences triggering crises. That crises then leads to another set of regulations, which in turn have unintended consequences that no one anticipated.
At the very least, I think this demonstrates that we do a very poor job of predicting the consequences of our regulatory reforms.
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