Speech by SEC Chairman:
The Importance of Transparency
In America's Debt Market
Chairman Arthur Levitt
U.S. Securities and Exchange Commission
At the Media Studies Center, New York, N.Y.
September 9, 1998
Thank you very much. Bob, thank-you for that generous introduction. I also want to thank the Freedom Forum and the staff of the Media Studies Center for all of their hard work in making this event possible.
As I walked in to the auditorium, I couldn't help but think back to my first job out of college as a young reporter for the Berkshire Eagle in Massachusetts. Although I spent most of my professional life on Wall Street, I never lost my interest in the media. After I left Wall Street, I found myself, once again, as a member of the press. But this time I wasn't a reporter. Nobody would hire me. Instead, I became the owner of Roll Call a newspaper which covers Congress.
Through those experiences, I observed first-hand the indispensable role the press plays in a democratic society. Now, as Chairman of the SEC, I see how quality financial news reporting brings emerging issues to our attention, augments our actions and arms investors with the knowledge to make informed decisions.
By reporting on issues ranging from price fixing in equities to microcap stock fraud to the disclosure of mutual fund fees, the press has made all of us more responsive and more accountable from the broker-dealer in New York to the fund manager in Boston to the government regulator in Washington.
The press and the SEC share a broad mission: to make available to the public vital, reliable and timely information to help ensure that officials and institutions public or private fulfill their fiduciary obligations and accept responsibility for their decisions and results. And so, I can think of no better place than the Media Studies Center to discuss the importance of transparency and disclosure particularly as it relates to America's long-term financial health.
In recent weeks, that has come into question. We've watched in awe as the perennial see-saw between bulls and bears has fallen and risen dramatically. And yet, despite the uncertainty we've witnessed, confidence remains strong.
Confidence doesn't make markets rise and it doesn't make markets fall. It makes markets possible. Without it, there would be neither buying nor selling. There would be silence.
Someone once noted that "Confidence awakens confidence." It is the underlying reason why America's capital markets are as strong as they are today. Transparency, disclosure and accountability aren't just catchwords. They are the essential ingredients to confidence. And without it, markets can neither sustain long-term growth nor adapt to a rapidly changing environment.
In the current financial situations in Asia and Russia, the word transparency has been employed rather frequently. Transparency is critically important in a number of ways. For instance, it's an issue in how publicly a government considers policies, or how a company's revenue is derived and what its true expenditures are, or how a bank's loan portfolio is constituted.
For securities markets, transparency is the extent to which timely data on prices are visible and understandable to all participants. At various times, some market participants have resisted efforts to increase the availability of information to investors. But experience has proven, again and again, that transparency to borrow from President Kennedy is a tide that lifts all boats.
Earlier this year, the SEC began reviewing the market for debt securities in the United States with a particular emphasis on the state of price transparency. This morning, I want to report to you the staff's preliminary findings. I also want to discuss what steps I believe should be taken to help ensure that all sectors of the bond market are functioning as fairly and efficiently as possible.
Today, anyone who buys a car, or a house, or even a piece of fruit can obtain prices on identical or comparable items to guide their decision. But in certain parts of the bond market you need a research department and a trading department to discover such information. How many individual investors do you know who can afford those resources?
The sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer or a homebuyer or, dare I say, a fruit buyer. And that's unacceptable. Guesswork can never be a substitute for readily available price data.
So today, I am calling for increased price transparency in the corporate debt market. We are doing so for one simple reason: investors have a right to know the prices at which bonds are being bought and sold. Transparency will help investors make better decisions, and it will increase confidence in the fairness of the markets. Simply put, it's in everybody's interests.
History of U.S. Bond Market
There seems to be a common misconception that the bond market is somehow less important than the equity market. But history shows, if anything, that the opposite may be true. The bond market has played an important role in this country's development from the very first days of the republic. The New York Stock Exchange, in fact, originated in 1792 as a bond exchange. For the first time, securities issued by the new United States government could be readily bought and sold. Those first government bonds funded the debt of the American Revolution. Treasury Secretary Alexander Hamilton not only helped create a new money supply, but he also linked the interests of wealthy bondholders to the fate of the new country.
As American corporations formed and evolved, a market for the issuance of corporate bonds followed suit. Between 1850 and the early 1900's, railroad company bonds dominated the corporate debt market. Those bonds fostered the growth of more railroad companies than there are Starbucks in Manhattan. At the same time, an expanding number of public utilities and industrial corporations were also issuing bonds. Between 1900 and our entry into World War I, corporate debt tripled from $6 billion to over $19 billion exceeding the federal debt.
Bonds in those days were sold to a great extent door-to-door literally. It was not unusual for Wall Street bond firms to hire a salesman and send him out with a bicycle, a designated territory and a list of bonds to sell. The salesman would cycle to storekeepers, farmers and country banks in the hopes of selling at least one bond a week.
As equities came to dominate the New York Stock Exchange, the vast majority of bond issues whether Treasury bonds or corporate bonds moved to trading on the over-the-counter market. For most of the 20th century, bonds were considered, in the words of one writer, "the staid province of high-quality borrowers...and highly conservative investors and creditors."
And, as recently as the early 1970's, most bond holders were still clipping interest coupons mailing them in to be redeemed. Simply put, bonds were bought and held. This, in part, reflected the slow movement of long-term interest rates. "Debt money," as Edmund Burke summarized in the 18th century, "is static." For a good part of this century in this country, Burke's statement rang true.
Recent Characteristics of the Bond Market
However, with the onset of inflation in the mid-1970's, deficit spending in the 1980's and the proliferation of technology in the 1990's, the debt market fundamentally changed in practice and in scope.
Long gone are the days of bond sellers on bicycles. Global electronic markets, computer-based analytical services and rapid fluctuations in bond prices are the order of the day. It's now a fast-moving medium that plays a major role in America's economy.
The bond market touches all aspects of our lives from the cost of building schools and hospitals to corporate investment in areas such as plants and equipment. It impacts the assets of public and private pension funds. It channels capital to mortgage and car loans. It even influences revolving credit.
This market also affects the prices in the equity market that everyone follows so closely. If you cannot value a company's debt accurately, it is difficult to determine the baseline value of its equity.
The bond market's economic significance is matched only by its sheer size. While New York Stock Exchange equity trading amounts to $28 billion per day, trading volume in all bond markets totals roughly $350 billion per day. U.S. corporate bonds outstanding have more than quadrupled since 1980. Municipal bonds have experienced similar growth. The total value of the bond market today is over $10 trillion up approximately 400 percent since 1980. Some tend to think of the financial market solely as an equity market. These numbers should correct that impression.
Review of the Bond Market
Our initial review of debt securities found that, as a whole, the market for government securities is characterized by high-quality pricing information for investors. We are also confident that, because of steps taken over the last few years, transparency is much greater in the municipal securities market. But, we believe that in the area of corporate bonds, price transparency is simply not up to par.
Historically, the debt markets have lagged well behind the equity markets in making price information available to investors and the public. There are good reasons for this: the debt market covers a much wider variety of instruments and is largely institutional. Nonetheless, the Commission, on several occasions, has acted to encourage debt market transparency.
In 1991 with encouragement from the Commission and Congress, GovPX a 24-hour, world-wide electronic reporting system was formed to distribute real time quotes and transaction prices for U.S. Treasury and other government securities. As a result, these markets now enjoy a higher level of quality price information.
In 1995, again with the SEC's active encouragement, the Municipal Securities Rulemaking Board began collecting the details of dealer-to-dealer transactions in the municipal bond market and distributing daily summary reports. And, just last month, with SEC approval, the MSRB expanded its daily reporting to include customer trades as well as inter-dealer trades.
Now, for the first time, investors, particularly smaller investors, have access to the prices and volume data of municipal bond trading between dealers and their customers. And, our effort is not stopping there. I expect that these actions will culminate in immediate transaction price reporting making the municipal bond market as transparent as it can possibly be.
It's now time for the corporate bond market to step up to the plate. The need has never been more evident. These days, bond dealers do not need bicycles or even telephones. Everything they need is at their fingertips.
Technology is revolutionizing how business is being conducted. But the corporate debt market remains one of the last major markets in the United States to not have some type of electronic price disclosure system. I think it is fair to say that the recent volatility in the markets underscores the need for greater price transparency in this market.
While everyone is familiar with the activity in the stock markets on August 31, most are probably unaware that there was virtually no buyer interest in the corporate bond market that same day. This lack of liquidity was readily apparent to the professional trader, but it was not known to the general public until reported by the press the following day.
What was not broadly reported even after the facts was the difficulty in the pricing of high-yield corporate securities. This, in turn, has a significant impact on a well-defined segment of mutual funds those which heavily invest in the high-yield market.
Now, I am not suggesting that we transpose the national market system built for equities to the debt markets. For many reasons, that would not work. But it's time for this segment of the debt market to catch up with the times and the technology.
To address the lack of price transparency in the corporate debt market, I have called on the National Association of Securities Dealers to do three things:
adopt rules requiring dealers to report all transactions in U.S. corporate bonds and preferred stocks to the NASD and to develop systems to receive and redistribute transaction prices on an immediate basis;
create a database of transactions in corporate bonds and preferred stocks. This will enable regulators to take a proactive role in supervising the corporate debt market, rather than only reacting to complaints brought by investors; and
in conjunction with the development of a database, create a surveillance program to better detect fraud in order to foster investor confidence in the fairness of these markets.
I am pleased to report to you that the NASD is moving forward on all of these recommendations. This is an important step. These actions will likely result in a higher level of price transparency for the corporate debt market than what currently exists in municipal securities. And, with the strong improvements the municipal markets have undertaken recently, this is no small accomplishment. I hope that, in the near future, corporate securities will no longer be lagging, but rather leading in the pursuit of greater price disclosure.
As I stated at the outset, we believe that, overall, the bond market is functioning effectively. We did, however, find certain sales practices which I find troubling.
First, I am concerned that certain mortgage-backed securities are being sold to individual investors without those investors fully understanding the risks involved. It's likely that many individual investors are not even aware of the variables that influence the return and duration of their investments.
I'm principally referring to the sale of collateralized mortgage obligations, or CMOs. Issued by either a federal agency or private corporation, a CMO is a bond backed by a large pool of home mortgages.
These are complex financial instruments. Even professionals require sophisticated analytical tools to evaluate them properly. I doubt that many individual investors realize exactly what they have purchased. I am also very troubled by reports that brokers may be marketing only the higher-risk classes or tranches to individual investors, while lower-risk classes are sold exclusively to institutions.
Second, we found anecdotal evidence of the possible misuse of inside information in the high-yield market. We were told that investment bankers and institutional investors who buy high-yield corporate bonds sometimes participate in syndicated loans for those same corporations issuing high-yield debt.
These participants in syndicated loans are entitled to send representatives to regular meetings with the borrower's management and bankers. Fine. But if confidential information from internal discussions in these meetings is being used or improperly leaked affecting the prices of these companies' bonds that would be unacceptable.
As I have said time and time before, insider trading whatever its form is plain and simply, wrong.
These matters are now under investigation and you can be sure that if we discover abuses, we will be quick to take action.
There is little doubt that the debt market is vital; that it has experienced strong growth; and, in many respects, is the backbone of corporate development in this country. But, these facts by no means guarantee its future prominence.
The imperatives of globalization and rapid advancements in technology have put a premium on information. Governments analyze and respond to it; the press reports and editorializes it; companies sell it; markets act on it; and investors rely on it.
Today, market information moves at the speed of light. The availability of accurate information to ensure the long-term stability of our markets has never been more important. The corporate debt market is not immune from these realities. And it would be folly to think otherwise.
I simply refuse to accept that this market cannot be as transparent as other markets. That logic runs counter to the values of trust, accountability, innovation and confidence that have been the hallmarks of America's capital markets.
Cicero once wrote that "Nothing so cements and holds together all the parts of a society as faith or credit." But faith and credit are not just simply arrived at through terms on a piece of paper. They are painstakingly forged over years in the day in and day out practices of a society.
The American experience proves that public disclosure is not a theoretical concept but a living principle. Everyday practices whether in government, the media, academia or finance when examined through the public lens, attain a measure of veracity and probity that would not exist if consummated under the veil of darkness.
Transparency is both a means and an end. It plays a fundamental role in making our capital markets the most efficient, liquid and resilient in the world. And, at the same time, transparency is a goal. We know from our own past experience and from the current situation in Asia and Russia that there is a direct relationship between information and investor confidence: Increase one and you increase the other; decrease one and you decrease the other. This is not rocket science. The choice is clear.
If we continue to be vigilant in the dissemination of market information to all investors, our nation's markets will remain the envy of the world. You can be sure the SEC will do its part. I expect all our markets to do theirs.