The Fool's Bill Mann (TMF Otter) talked with former Securities and Exchange Commission Chairman Arthur Levitt on Nov. 18. The two discussed stock options expensing, the bull run and bubble of the late '90s, the politics of U.S. monetary policy, and Levitt's new book, Take on the Street: What Wall Street and Corporate America Don't Want You to Know. This is an edited version of their talk.

Bill Mann: Ben Graham once said that hidden behind every bull market was an increase in securities fraud. The fraud that took place during this last bull market was unbelievable. At least part of what was going on with WorldCom, Tyco, and Cendant happened while you were still at the SEC. You spoke a lot about this in Take on the Street -- but what were some of the things missing and what were the conditions that existed that so many billions of dollars could have been destroyed by these long-lasting frauds?

Arthur Levitt: I think that we have had an almost two-decade-long erosion of ethical values on the part of American business. It is understandable if you place it in the context of a runaway bull market where investors suspended disbelief, where analysts saw everything they recommended go up, where brokers saw every recommendation work out.

Everybody believed it was because they were genius rather than the sweep of a bull market, which brought along what was really awful and dreadful and stupid with what was really good and quality.... Pretty soon, what was bad practice or questionable practice became out and out fraud. That is unfortunate because we will be paying a price for this for some time. What is really tragic about it -- what bothers me the most -- is that the people least able to afford it have been the ones most punished by this fraud. The ones who lost their retirement savings, lost the funds that they had to pay for tuitions.

Mann: That is very true. We hear from people every day who wonder, for example, what they should do with their WorldCom stock. Unfortunately the best advice that I could give them is "don't invest in it two years ago."

Levitt: It is well and fine to talk about the wrongdoers at WorldCom and at Enron and all the gatekeepers, everyone of them: the boards, the lawyers, the accountants, the standards setting agencies, the regulators. All of them were asleep at the switch. But the real issue is where were the investors? Why didn't they ask questions about a company they couldn't possibly understand? They have to pay out a portion of the blame as well.

Mann: Absolutely. I had a chance to speak with [Treasury Secretary] Paul O'Neill recently, and he separated the difference between investors and speculators. He said, "You know, although I am sad for anyone who loses their money to fraud, I don't have as much sympathy for people who speculate and who aren't reading the 10-Ks and 10-Qs and getting to know the companies they were investing in."

Levitt: That's right. These were the people that bought into a phony eel farm when I was at the Commission. Imagine that. On the Internet a seller of electric eels raised $12 million. Well, those people who didn't bother to question deserve to lose their money.

Mann: You are serious?  I thought that was a just a good allegory. (Laughs)

Levitt: No, no. Unfortunately it was true. The people who allowed many of the scams to go on just simply didn't equate risk and rewards.

Mann: There is definitely truth to that. Did you think that stock market evaluations were absurd in 1998-1999? I am interested to know if there is anything that you felt at the time as these revenue-less companies were suddenly shooting up into the stratosphere. There was a lot of capital that was poorly allocated, but I am just wondering if you felt like that you had the position to take the bully pulpit?

Levitt: I had enough experience in the securities industry to understand that the economics of the industry had changed, and the only way firms could afford analysts was by subsidizing their work with compensation from investment banking. That was producing research which was absolutely tainted. I knew it at the time; I spoke about it, and I could have done more than I did. I requested the NASD and the New York Stock Exchange to clamp down on it. Because I was so consumed with other issues such as accounting fraud and regulation fair disclosure, I didn't do what I could have done. I knew that stock exchanges had a conflict of interest, that they depended on their list of companies and the brokerage firms to bring them business, so that they would be less likely to rush to judgment and really clamp down on research and eventually they did when things really collapsed. But I could have used the power of the SEC to do our own rulemaking in this area, and I simply didn't do it and I should have.

Mann: In some ways, you must have felt like it was the barbarians at the gate, like you couldn't catch everything going on.

Levitt: Well, it was hard to tell at the time, but the battle on the accountants was a political battle involving the House and the Senate. I think the magnitude of it is captured in the appendix of my book when I reprinted the letter from an executive who said, "Arthur Andersen is vital to our success. Please don't do anything to disturb the relationship they have between their auditors and their accountants; they help us so much." That letter was signed by Kenneth Lay.

It was symptomatic of the fact that Congress was totally under the control of their corporate sponsors, the fundraisers, and the lobbyists. Every day as we speak, the lawyers and the accountants of the stock exchanges have lobbyists on the Hill fighting for things that are not in investor interest and investors have nobody up there. That is why I say over and over again that investors should, through organizations such as The Motley Fool and AARP, develop a lobbying source to counter enormous amounts of money spent by corporate America against the interests of investors.

Mann: I can give you a good example of that on an issue you are very familiar with. Recently we received a letter from a trade association called the AEA [American Electronics Association] celebrating the rollback of [Senator] John McCain's proposal for expensing stock options, and they were not just saying the stock options and the way they were accounted were good for business, but they were essentially wrapping themselves in the flag. You had said in the book that you felt like your greatest failure, back in 1994, was not pushing forward stock options expensing. What do you think about the effect from recent Conference Board recommendations that you participated in?

Levitt: I think that stock options are going to be expensed. They are a litmus test of companies that either stand with investors or companies that do not. I think the last holdout against the expensing of stock options will be Silicon Valley, and that is unfortunate because they have created so much that is good and worthwhile and innovative. They should be in the vanguard of this when they argue this will kill the use of stock options. I say that is nonsense.

It is just as ridiculous as some years ago when they wanted to do away with fixed commissions. I argued and I guess I believed that that would kill the brokerage industry, but it didn't. The industry is stronger than ever and expensing stock options won't kill stock options.

Mann: What did you think about former Federal Reserve Chairman Volcker's conclusion that stock options constitutes such a moral hazard that they ought to be banned?

Levitt: Well, I was surprised when Paul dissented from the vote of our commission, and then when I heard why he dissented, I said that is Paul, and I certainly understand his feelings. I don't agree with that. I do think that options have a legitimate place. Just as dynamite can be terrible and destructive if it is improperly used, it can be enormously important if it is properly used.

Mann: Over the last few years and really during your term as SEC chairman, the number of families invested in the stock market just exploded. More than half of all families have some form of stock ownership. It seems to me, and I'm young, so maybe I don't have the perspective, but people are using stock market levels as a proxy for measuring economic health. A lot of politicians are pointing to it as a way to show that administrations have done well or done poorly. What is your interpretation of the risks of such tactics?

Levitt: I think that equating market gains with wealth is a risky notion. Market gains are paper gains until they are exercised. Taking political advantage of that I think is really wrong. I think that what we need more than anything else in this country is a universe of educated investors. Most investors access our markets through 401(k)s, and most of them really don't understand the market and its risks and what options they have available to them. Most investors invest emotionally rather than intellectually. What I try to get across in the book and every way I can is investors must become skeptical. Question everything instead of taking the wisdom from brokers or analysts or investment bankers.... There is no such thing as a dumb question, and investors should understand that.

Mann: Do you think that the government should be more interested in a rising stock market, or a healthy one?

Levitt: I don't know what you mean by the government being "more interested." Should the government try to promote a rising market? No. The government should promote a strong, healthy, long-term market that people can trust and people won't be abused in.

Mann: What I mean is that I look at the bear market over the last two years as a sign that the market is healthy. Obviously, we could do without the scandals that have gone on. But dropping markets are a sign of the free market really saying there have been companies that have misallocated capital. I read in Bob Woodward's book Maestro about George Bush, Sr. being very upset when Alan Greenspan was going to raise interest rates.

Levitt: Yeah, that is political talk, and the Fed has to be as independent as possible. I think Greenspan had done a good job, but of course good markets make regulators look smarter than they are. That is just the nature of the markets.

Mann: One of the things I thought was really interesting, and I didn't know this before I read Take on the Street, was the fact that your partners when you were just getting started were Sandy Weill [chairman of Citigroup], Arthur Carter [owner of the New York Observer], and [famed Broadway producer] Roger Berlind. A real group of underachievers there.

Levitt: That's right.

Mann: Mr. Weill has had a tough time with things as of late.

Levitt: He sure has. I have known him to be very honest. I am sorry to see his travails, but he operates in the fast lane.

Mann: That is true. In 1972 he was very critical of your famous speech describing the conflicts of interest amongst brokers. What advice would you give Mr. Weill now?

Levitt: You know, I think he is doing the things that he should be doing. I think by separating research from investment banking -- that was the right thing to do. I think that by hiring someone to head up the research operation and be president of that division was the right thing to do. I think calling for the expensing of stock options was the right thing to do. I think it is important that he appear to be changing the culture of that company to one that is investor friendly.

Mann: Which do you think was worse, the S&L scandals following the last bull market or the Enron- and WorldCom-type scandals of this one?

Levitt: I'd say they are pretty much the same. They affected a different universe, but they are pretty much the same.

Mann: It seems that because people were directly invested in the WorldComs of the world as opposed to the LBOs that it felt a lot more visceral, but the monetary damage was very similar.

Levitt: Yes, absolutely. But I think in terms of systemic damage that the danger to our system -- the danger to our system is much greater when millions of investors lose confidence in our markets.

Mann: We have the opportunity now to fill your old position, the SEC chairman. We also have the opportunity to fill the Public Company Accounting Standards Board Chair. What is the message that you would give the people who were going to take those positions and also to the people who are currently looking for the person to fill them?

Levitt: I think the person must be strong; must be viewed as being independent; must be focused and must keep the interests of investors above all others; above business interests; above market interests; above all interests as every judgment is made on the basis of what does this do for America's investors? He or she will be on the right track.

Want to ask Chairman Levitt your own questions? You can join him during a live chat on on Wednesday, Nov. 20 at 1:00 p.m. And as always, keep your Eyes on the Wise right here at -- our discussion board community is always a catalyst for change.