Mutual fund scandal isn't over
Wednesday, November 19, 2003
seattlepi.nwsource.com
By PAUL KRUGMAN
SYNDICATED COLUMNIST
You're selling your house and your real estate agent claims
that he's representing your interests. But he sells the
property at less than fair value to a friend, who resells it at
a substantial profit, on which the agent receives a kickback.
You complain to the county attorney. But he gets big
campaign contributions from the agent, so he pays no
attention.
That, in essence, is the story of the growing mutual fund
scandal. On any given day, the losses to each individual
investor were small -- and that is why the scandal took so
long to become visible.
But if you steal a little bit of money every day from 95
million investors, the sums add up. Arthur Levitt, the
former Securities and Exchange Commission chairman,
calls the mutual fund story "the worst scandal we've seen in
50 years" -- and no, he's not excluding Enron and
WorldCom. Meanwhile, federal regulators, having allowed
the scandal to fester, are doing their best to let the villains
get off lightly.
Unlike the cheating real estate agent, mutual funds can't
set prices arbitrarily. Once a day, just after U.S. markets
close, they must set the prices of their shares based on the
market prices of the stocks they own. But this, it turns out,
still leaves plenty of room for cheating.
One method is the illegal practice of late trading: Managers
let favored clients buy shares after hours. The trick is that
on some days, late-breaking news clearly points to higher
share prices tomorrow. Someone who is allowed to buy on
that news, at prices set earlier in the day, is pretty much
assured of a profit. This profit comes at the expense of
ordinary investors, who have in effect had part of their
assets sold off at bargain prices.
Another practice takes advantage of "stale prices" on foreign
stocks. Suppose that a mutual fund owns Japanese stocks.
When it values its own shares at 4 p.m., it uses the closing
prices from Tokyo, 14 hours earlier. Yet a lot may have
happened since then. If the news is favorable for Japanese
stocks, a mutual fund that holds a lot of those stocks will
be underpriced, offering a quick profit opportunity for
someone who buys shares in the fund today and unloads
those shares tomorrow. This isn't illegal, but a mutual fund
that cared about protecting its investors would have rules
against such rapid-fire deals. Indeed, many funds do have
such rules -- but they have been enforced only for the little
people.
In some cases fund managers traded for their own personal
gain. In other cases hedge funds, which represent small
numbers of wealthy investors, were allowed to enrich
themselves. In return, it seems, they found ways to reward
the managers. You make us rich, we'll make you rich, and
the middle-class investors who trusted us with their money
will never know what happened.
And there's probably more. During last year's corporate
scandals, each major company that came under the
spotlight turned out to have engaged in some original
scams. By analogy, it's a good guess that the mutual fund
industry was cheating its clients in other ways that haven't
yet come to light. Stay tuned.
Oh, and about that corrupt county attorney: Last year it
seemed, for a while, that corporate scandals -- and the
obvious efforts by the administration and some members of
Congress to head off any close scrutiny of executive
evildoers -- would become a major political issue. But the
threat was deftly parried: A few perp walks created the
appearance of reform, a new SEC chairman replaced the
lamentable Harvey Pitt, and then we were in effect told to
stop worrying about corporate malfeasance and focus on
the imminent threat from Saddam's WMD.
Now history is repeating itself. The SEC ignored warnings
about mutual fund abuses and had to be forced into action
by Eliot Spitzer, the New York attorney general. Having
finally brought a fraud suit against Putnam Investments,
the SEC was in a position to set a standard for future
prosecutions; sure enough, it quickly settled on terms that
amount to a gentle slap on the wrist. William Galvin,
secretary of the commonwealth of Massachusetts -- who is
investigating Putnam, which is based in Boston -- summed
it up: "They're not interested in exposing wrongdoing;
they're interested in giving comfort to the industry."
I wonder what they'll use to distract us this time?
Paul Krugman is a columnist for The New York Times. Copyright 2003
New York Times News Service. E-mail: krugman@nytimes.com
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