Infectious Greed

by Frank Partnoy

  Although most investors now know these facts all too well, what is not widely understood is how intimately this technology boom and bust was connected to earlier changes in financial markets. It is tempting to blame the bubble on investor greed or banker venality. But the story is not that simple. Human nature didn’t change; human behavior did, as a natural response to the changes in the structure of financial markets and legal rules during the previous decade.

  Three groups of people—investors, bankers, and corporate executives—formed the key connections. Investors succumbed to incentives for increasingly risky behavior and, given the complexity of financial reporting, decided it no longer mattered whether companies made money; they rushed to buy stocks without earnings, anyway. Bankers substituted for accountants as the primary facilitators, responding to investor demand, deregulation, and the limited prosecution of financial fraud by pumping stocks in return for fees. Frank Quattrone and his ilk were not evildoers; they were simply the most skilled in responding to new circumstances, like the strongest lions of the pride after a kill. Young corporate executives engaged in deceitful practices, just as their elder counterparts at Cendant and other companies had a few years earlier; but, in a new milieu—technology—where it was even more difficult to distinguish fraud from mere puffery. Their behavior, too, made perfect sense, given the upside associated with “free” stock-option grants and the low probability of punishment.

  In short, the “dot.com” era was not some bizarre anomaly in which investors briefly went insane. Nor was the bubble created solely by the nefarious “pump-and-dump” schemes of a few greedy bankers and corporate executives. Instead, the era followed, inexorably and seamlessly, from the earlier changes in markets and law. Investors, Wall Street, and corporate executives were all participants; but, given the incentives facing each group, their behavior—if not excusable—should not have been surprising, either.

  First, as markets became more complex, individuals became intoxicated by what economist John Maynard Keynes called the “animal spirits” of markets.15 The various international bailouts were only the most recent incentive for investors to take on more risk. During the two decades before 1990, individuals actually had taken money out of the market. But then, in 1991, the stock market went up 30 percent, and individual investors began buying stocks, fueled a few years later by the media—especially television network CNBC—which expanded coverage of financial markets. Individuals began trading based on anything from a whim to a trend to a tip from a relative, coworker, or Internet chat room. Day trading—making numerous stock trades throughout the day—became a popular pastime, even though nearly all day traders lost money. As investors focused less on detailed financial statements, they became open to investing more speculatively—in, say, shares of an Internet bookseller or a provider of wireless telephone products.

  Year after year, more people became investing experts, and devoted innumerable hours to comparing stock prices and financial ratios. Everyone knew about the Netscape IPO, even though most investors had not heard of either Netscape or IPOs a few years earlier. Even teenage tennis-star Anna Kournikova and N.F.L. football tight-end Shannon Sharpe were discussing P/E ratios in television advertisements for Charles Schwab. And who could forget on-line broker E*TRADE’s commercial about the emergency-room patient with “money coming out the wazoo”?

  Almost anyone who invested in stocks during the 1990s made money. It was the longest bull market since World War II, and the numerous financial debacles of the decade seemed far removed from most investors’ lives. So what if Orange County declared bankruptcy, or Procter & Gamble lost a hundred million, or Barings failed? Why agonize over a few bad apples at Cendant and Waste Management? And why worry at all about international crises? The various crises of the 1990s led to bailouts, which encouraged investors to take on excessive risk. Economists from Morgan Stanley wrote an essay entitled “It Started in Mexico,” in which they reported, “Our analysis of correlation between markets and investment styles points to the Mexican bailout as a factor that set the stage for increasing investor confidence worldwide and helped to ignite the growth market of the late 1990s, along with a strong U.S. economic expansion.”16

  A few disasters might occur here and there, but in the long run, you couldn’t afford not to be in stocks.17 The numbers spoke for themselves: as Jeremy Siegel argued in his 1994 book, Stocks for the Long Run, stocks had been chronically undervalued throughout history. The trend continued through 1999: an investment in the Standard & Poor’s 500—the index of the largest U.S. stocks—returned an average of more than 16 percent per year. If you had put just $75,000 into stocks in 1984, you would have over a million dollars by the end of 1999.

  Were investors behaving rationally during this period, or not? One view was that higher stock prices were justified because of a technology revolution of the scale of the industrial revolution, in which new Internet and telecommunications tools would—at some future date—lead to record corporate profits, just as the railroads had revolutionized business a hundred years earlier. The other view was that investors were simply manic, or “irrationally exuberant.” There was evidence supporting both views. It was undeniable that consumers were using new technologies, especially wireless telephones and the Internet. But hundreds of telecommunications companies were competing in markets that, like the railroad industry, would support only a handful of leading firms. And it was difficult to imagine, paradigm shift or not, that very many of the hundreds of on-line consumer websites would ever make any money.

  As investors were rushing to buy stocks in a rising market, several experts were demonstrating how the second view—of investor mania—was the correct one. Experiments by Daniel Kahneman, Richard Thaler, and Amos Tversky—which showed that people overestimated their own skills, overvalued items they owned, were shortsighted, greedy, and occasionally even altruistic—were an assault on the citadel of efficient-market theory that well-regarded economists such as Paul Samuelson and Eugene Fama had been putting forward since the 1960s. More than a generation of business and government leaders had been taught that markets were efficient and that stocks were “rationally” priced; based on these teachings, they had implemented a deregulatory approach to financial markets since the 1980s.18 But as the markets continued to soar, these new studies were evidence that the prior assumptions about markets had been wrong.

  At first, finance theorists dismissed the new studies as mere anecdotes—just evidence looking for a theory—because they did not have the mathematical rigor of previous rationality-based efficiency theories. Moreover, in a market with “arbitrage,” where sophisticated investors could buy and sell mispriced securities, stocks arguably would be “rationally” priced even if some investors were irrational. It might be true, as some new experiments showed, that 80 percent of car drivers thought they were of above-average skill, or that most gamblers took greater risks when playing with house money (money they already had won). But, the argument went, the same irrational behaviors didn’t matter in financial markets, because sophisticated, rational investors could make money trading with irrational investors until arbitrage opportunities were gone, and stocks were no longer mispriced.

  When a few economists—led by Andrei Shleifer—translated the experimental data about irrational human behavior into the language of advanced mathematics, the study of irrational investing got a name, behavioral finance, and some credibility.19 Behavioral finance offered a retort to the powerful arguments about arbitrage. As the traders at LTCM had found, arbitrage—buying low and selling high, until a stock was correctly valued—had limits,20 including the difficulty of shorting stocks and the impossible problem of predicting how long investor irrationality would last. Behavioral-finance theorists expressed these limits in mathematical terms, and concluded that, although arbitrage theoretically would drive prices in the long run, it was inevitably risky in the short run, when irrational investors could drive stock prices instead. In other words, sophisticated i
nvestors betting that irrational ones would regain their senses might have to wait for the long run—and, as John Maynard Keynes famously quipped, “This long run is a misleading guide to current affairs. In the long run, we are all dead.”21

  Behavioral finance quickly found a following, including many banking and securities experts who had been arguing for a decade that unregulated financial markets didn’t allocate risk in an efficient or fair manner. Instead, these people had argued, risks were like hot potatoes being passed to the people least able to hold on to them. According to author Martin Mayer, in unregulated banking markets, credit risk—the risk that a borrower would not repay—moved from banks, who knew how to assess risk, to other investors, who did not. William Heyman, former head of market regulation at the SEC, argued, “In manufacturing, the market price is set by the smartest guy with the best, cheapest production process. In securities markets, the price is set by the dumbest guy with the most money to lose.”22 Those ideas, in essence, were behavioral finance.

  The most powerful evidence supporting these new theories began accumulating on August 9, 1995, when Frank Quattrone did the billion-dollar Initial Public Offering of shares of Netscape Communications, the provider of Internet-access software. Netscape originally had planned to sell shares for about $13 each, but investors were so eager to get into the deal that Quattrone and Morgan Stanley raised the IPO price to $28, and increased the number of shares by half.23

  The day of the IPO was a wild ride. The shares were sold to investors in the IPO for $28, but there was so much demand that Netscape shares began trading at $71—five times their anticipated price just a few weeks earlier. During the morning of August 9, Quattrone and his bankers had planned to raise $1 billion for Netscape. At the peak of trading that day, those shares were worth $3 billion. At four P.M., when trading closed, the shares were down to $2 billion, but still up 107 percent for the day. These violent moves suited the “bucket-shop” trading of the 1920s more than a modern stock market.

  The Netscape IPO sparked investors’ attention and prompted numerous questions. By any objective account, Quattrone had massively underpriced the deal. Historically, the average first-day IPO return had been in the range of six percent. During the early 1990s, first-day returns had doubled.24 But Netscape’s first-day return of 107 percent set a new standard. Was it a mistake? Incredibly, Jim Clark, the founder of Netscape, wasn’t upset about underpricing the IPO by a billion dollars. Nor was Frank Quattrone, who apparently had given up tens of millions of dollars in IPO fees, which were set at a standard seven percent of the initial proceeds of the deal. (On a two-billion-dollar IPO, a seven percent fee would have been $140 million, but on a one-billion-dollar deal, the fee was a mere $70 million.)

  These men apparently were willing to leave huge amounts of money on the table, and they weren’t alone. Bankers continued to underprice IPOs, and by 1999 the average first-day IPO return was 70 percent.25 There were various theories about why corporate executives would allow bankers to sell IPOs at such low prices: the young executives were inexperienced and negotiated bad deals; they were getting so much money they didn’t care; they wanted to feed a market frenzy so that their stock prices would be even higher in six months, when they finally were permitted to sell their shares (in an IPO, the insiders typically were not allowed to sell their own shares for 180 days, a restriction known as a lock up). Whatever the reason, instead of selling stock in an IPO for, say, $25, firms were selling for $15—over and over again.

  Post-IPO prices remained high throughout the first year of trading. Historically, only about half of IPOs had gone up during their first year; but, in 1995, IPOs began performing much better than the historical average. Netscape, a typical example, was up from the IPO price of $28 to a price of $171 by the end of the 1995. As more Internet companies issued shares whose values doubled—and then doubled again—Alan Greenspan issued his warning about irrational exuberance, and some commentators admonished investors to avoid a market bubble. In an efficient market, the warnings shouldn’t have been necessary; sophisticated investors should have been able to short these stocks, and drive prices down to rational levels. Instead, as behavioral-finance theory predicted, the “sophisticated” investors who bet against Internet stocks were eaten alive.

  Consider Palm, the subsidiary of 3Com that made handheld Palm Pilots. When Palm issued five percent of its shares to the public, Palm’s shares had a higher value than 3Com’s, even though 3Com still owned 95 percent of Palm.26 Strangely, the part was worth more than the whole. Two factors made this anomaly possible, both explained by behavioral finance: first, individual investors flocked to high-profile companies such as Palm, and were willing to buy shares at exorbitant prices; second, sophisticated investors who might have been willing to bet against Palm, thereby bringing Palm’s price down to a more reasonable range, could not do so because of regulations restricting short selling, and because of the limited supply of Palm shares available to sell short. As a result, the anomaly persisted. As behavioral-finance theories predicted, the upward bias of overly optimistic investors determined stock prices more than the grounded views of sophisticated experts.

  After Netscape, media coverage—especially on CNBC—fed investors’ desire to buy “hot” technology IPOs, which began occurring nearly every day: Amazon, Yahoo!, eBay, and then lesser-known start-ups such as Gadzoox, GoTo.com, and VA Linux. According to John Cassidy of The New Yorker, “CNBC didn’t create the stock-market boom, but it did perpetuate and amplify it. To borrow a term from biology, the network acted as a ‘propagation mechanism’ for the investing epidemic.”27 The media began covering the NASDAQ—the National Association of Securities Dealers Automated Quotation system, where most technology stocks were traded—even more than the New York Stock Exchange. (By 2002, the average volume of NASDAQ had surpassed that of the NYSE.)

  One of the thorniest issues related to investor mania and the media was the role of the securities analysts who recommended stocks. Many economists argued that these analysts were the key players making stock markets efficient. Investors trusted securities analysts to make accurate and informed assessments of companies, just as they previously had trusted accountants. These analysts began appearing regularly on television, and many investors followed analyst recommendations, word for word. Why shouldn’t they?

  On December 16, 1998, in the midst of the holiday-shopping season, 33-year-old Henry Blodget, an unknown securities analyst at CIBC Oppenheimer, a second-tier firm, predicted that Amazon would nearly double, to $400 a share, within a year. The stock suddenly shot up from $243 to $289. Investors believed Blodget’s prediction, even though he had only been issuing analyst reports on Amazon for two months, and didn’t have any unique insight into Amazon’s business plan, or any inside information. Blodget was more like Peter Jennings than Peter Lynch, more television personality than investment guru. He was clean-cut and articulate and had a degree from Yale—and that seemed to be enough for most investors. If such a nice young man said Amazon stock would be worth $400, then it was a steal at $250.

  That day, Blodget received more than fifty media calls, and he immediately began appearing on CNBC on a regular basis. Less than a month later, Amazon hit $400, just as Blodget had predicted, and his credibility was confirmed. Investors were justified in relying on Blodget; he was the one who had made so many people rich on Amazon. Blodget capitalized on his new-found value, moving to Merrill Lynch in 1999, with a guaranteed combined annual salary and bonus of $3 million.28 Looking back on his Amazon prediction, Blodget said, “It was like touching a match to a bucket of gasoline. I was shocked.”29

  After Blodget’s prediction came true, the floodgates opened. From 1999 through March 2000, there was a deluge of new Internet IPOs as the overall NASDAQ market more than doubled in value. Blodget made hundreds of television appearances, recommending stocks that, for the most part, went up.30 Day trading increased to 15 percent of the volume on NASDAQ, even more in hot Internet stocks.31
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br />   In 1999, three-quarters of all IPOs increased in price during their first year. An investor who bought into every 1999 IPO would have tripled her money; even an investor who bought at the end of the first day of trading would have made 81 percent.32 All of these companies were supported by securities analysts shouting “buy,” including not only Blodget but a few “superstar” analysts—notably Mary Meeker of Morgan Stanley and Jack Grubman of Salomon Brothers (more on him in Chapter 11)—who were nearly as well compensated as Frank Quattrone. Investors listened and obeyed when Henry Blodget said to buy Pets.com, or Frank Quattrone’s analysts at CS First Boston said to buy mortgage.com, or when Jack Grubman said to buy Global Crossing or WorldCom. Investors did it and, more often than not, the analysts were right. Until 2000, anyone betting against these analysts’ recommendations would have lost money.

  Charles Mackay wrote in the preface to his 1852 book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one.”33 For almost five years, from August 1995 until March 2000, investors joined in a fanatic stampede, oblivious to the fact that they were approaching a cliff. But the cliff was always there—as Alan Greenspan, The Economist magazine, and many others had warned—and, by 2002, most investors had lost everything they had made during the earlier madness, and more. After news of repeated corporate bankruptcies and frauds, individual investors would only slowly recover their senses.