Tuesday, October 21, 2008

Financial Meltdown: Been There, Done That

Foreclosures and bank failures dominate the headlines. Politicians are in a tizzy over whom to blame. It’s not 2008, but 1932 and the devil du jour is not some Wall Street CEO, but Chicago financier Samuel Insull, whose securities became worthless during the Great Depression, leaving 600,000 investors in the lurch.

Insull, whose utilities empire failure – the largest in American history at the time (more recently eclipsed by the bankruptcy of Lehman Brothers Holdings, Inc.) -- launched a raft of New Deal reforms and is little remembered some 150 years after his birth. Yet his startling rise from Thomas Edison’s factotum to the billionaire mogul of one of the nation’s largest utility combines, holds many lessons for today.

Unlike the CEOs of today, who walk away from corporate shipwrecks with tens of millions of dollars in compensation, Insull died broke after lending his own money and going into debt to save his companies before they fell into receivership in 1932. Having felt he had done all he could to rescue them with his personal capital, he left the country until he was extradited from Turkey to the U.S. to stand trial in 1934. When he returned to the Windy City, he was more infamous than Al Capone and tried in the same courtroom and by the same judge as ``scarface.’’ Insull never went to prison as juries recognized that Insull effectively went down with his ship; the utilities mogul was later acquitted of fraud in three separate trials.

Like today’s hedge funds and even the seized mortgage entities Freddie Mac and Fannie Mae, Insull’s pyramid of holding companies that provided power and light to some 6,000 communities across the Eastern and Midwestern U.S., were little understood and barely regulated. The accounting for his empire was opaque and annual reports from the 1920s told investors little about how his empire was capitalized. Because they were pyramided and cross-financed with other holding company stock, his entities were the collateralized mortgage obligations of that time – and became just as toxic to investors.

Insull’s legacy is a chiaroscuro tablet. While he succeeded in helping to bring electricity into the homes of some 72 million people by 1927, his holding company failures became a touchpoint for the New Deal securities legislation. FDR’s reforms separated investment from commercial banks. Utility holding companies were dismembered and broken up. Stock offering prospectuses became much more detailed in their capital underpinnings and risks.

With the repeal of the Glass-Steagall Act in 1999 and the scrapping of the Public Utility Holding Company Act in 2006, two linchpins of the New Deal investor protection era were severed. The utility industry has re-consolidated somewhat and over the past decade Wall Street investment banks went hurtling into a lightly regulated environment that promoted everything from troubled auction-rate securities to subprime mortgage pools. Eliminating some of the heart of the New Deal protections has changed the entire landscape of high finance.

With the recent tumult on Wall Street, pure investment banks will cease to exist and regulators will have even more oversight over opaque financial vehicles. The rescue legislation recently passed by Congress comes full circle back to FDR’s era as buying mortgage assets, creating new layers of oversight and expanding federal deposit insurance seeks to protect savers and investors.

Unlike the 1930s, the combined forces of the U.S. Treasury, Congress, President, Federal Reserve, foreign central banks and the American taxpayer have been united as strange and often unwilling bedfellows to prevent a global financial system collapse (although we’re not completely out of the woods yet).

As the executives who captained the current debacle beat a hasty retreat, a natural question emerges: How can we best learn from both the Insull and current eras to strengthen the integrity of markets and investments?

One of the answers can be derived from the extensive disclosure and enhanced oversight that emerged from both crises. Once investors have a clear and comprehensive look at what they’re buying, they can better gauge risk and make prudent decisions. While you can never take greed out of the equation in investing, sunlight in the form of transparency is more than a disinfectant, it can illuminate any number of perils.

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