Infectious Greed (37 page)

Yet investors seemed oblivious to the breakdown of controls, and the markets continued to rise, so much so that Alan Greenspan of the Federal Reserve felt compelled to intervene. Some investors believed that the markets had entered a new phase—bolstered by technology—in which the returns from investing in stocks had doubled. (The technology-and-Internet bubble and its bursting are addressed in Chapter 9; for now, suffice it to say that investors either didn't read or didn't believe
The Economist
magazine, which was posting warnings about the speculative bubble practically every week.) From Greenspan's perspective, stock-price increases posed the same kinds of inflationary dangers as increases in the prices of consumer goods. He was determined to change investors' minds before the markets spun completely out of control.

However, Greenspan had learned from the interest-rate hikes of 1994 that, with so many undisclosed financial arrangements floating in the system, the Fed could no longer accurately anticipate the effect of changes in monetary policy. Instead of raising interest rates, he decided to use his bully pulpit. Perhaps he could jawbone investors into greater rationality by talking the markets down to more reasonable levels.

In December 1996, Greenspan gave a speech in which he famously asked, “How do we know when irrational exuberance has unduly escalated asset values?” This term—
irrational exuberance
—instantly became part of the vocabulary of average investors, who bristled at the accusation that they were behaving irrationally. If the stock market continued to go up by 20 percent every year, was it really so irrational to put more money in? And even if the market was just a speculative bubble, didn't it make sense to continue to invest, so long as you could get out before the bubble burst?

The classical economic models couldn't explain market behavior during the mid-1990s, so economists proposed two major revisions. First was the theory of
downward-sloping
demand for stocks. The idea was that the price of a stock depended on its demand, just as the price of gas at a particular station depended on how many people wanted to buy gas there. (In other words, a graph of quantity on the horizontal axis versus price on the vertical axis would slope downward from left to right.)

Although this idea sounds like common sense, it was a radical departure from classical theory, which assumed that all investors behaved similarly, so that demand was flat at a single price. For example, in the classical model, if Sunbeam stock were worth $50 per share, no one would want to buy for $60 and everyone would want to buy an infinite amount for $40. The equilibrium price for all investors would be $50.

In the newer models, some people would buy at higher prices—perhaps because they were unwilling to expend the resources necessary to learn the stock was really worth $50, or because they had different expectations about the company's future prospects and believed it was worth more. Other people would not buy even at $40, again because of laziness or differing beliefs. In the classical theory, demand was flat at $50; in the new theory, demand sloped down from $60 to $50 to $40, with more people demanding stock as the price declined. Law professor Lynn Stout has labeled this theory “heterogeneous expectations,” to note the differences among investors in the model.

This theory is heresy to a classical financial economist, but it easily explained the 1990s bubble. The demand for stocks increased because more individuals began investing in markets. As these individuals began buying more stocks, demand and prices moved up. Moreover, these new investors were more optimistic (or, perhaps, naïve) than previous investors, and so they were willing to pay more for particular stocks.

The reason this theory was heresy was that stocks were thought to have some value at a particular time, given the available information about the company at that time, and if the stock price diverged upward from that value, an arbitrageur could make money by selling the stock and waiting for the price to return to “normal.” Economists argued that heterogeneous-expectations theory made no sense in a market with arbitrageurs. If Sunbeam's price increased to $60 (or even $50.01), one of John Meriwether's traders would sell millions of shares until the price went back to $50.

The second revision to the classical theory was a response to this argument. What if there were limits to arbitrage? For example, if companies engaged in accounting fraud, so that many investors were persuaded that a stock was worth $60—even though it really was worth only $50—then arbitrageurs might bet against the stock and lose money, year after year, until the fraud was revealed. In a perfect market, the information about the fraud would come out right away, but the past few years had demonstrated that markets were not perfect. That made long-term bets against stocks very risky, which was why Salomon Brothers—and other major banks—rarely made them. Instead, arbitrageurs focused on shorter-term bets, such as mergers, where any price gap was virtually guaranteed to close within a month or so.

Another limitation on arbitrage was the difficulty of taking a position that would increase in value when the stock went down. The basic problem was that, although it was easy to bet in favor of a particular stock, it was difficult and expensive to bet against it by shorting stock. Moreover, put options often were unavailable, too expensive, or expired too soon.

In this way, the stock market was just like pari-mutuel betting at a horse race. It was simple to bet on a horse: you walked up to a window and bought a ticket. But how could you bet against a horse? You could try to find someone in the stands who wanted to bet on the horse, and bet with them. But that was time-consuming, and—unlike the cashier standing at the pari-mutuel window—you couldn't be assured that a random person you found would pay if she lost. Or you could do something more complicated: find someone who already had bet on the horse, borrow their ticket, and sell that ticket to someone else, promising to pay that person if the horse won, in which case she would give you the ticket, which you then would return to the first person, along with a fee. This second plan had problems, too. Not only did it have several complex steps, but a random person betting on the horse might not be persuaded that
you
would pay if she won.

In the stock market, someone wanting to bet against a stock generally had to use this second, convoluted plan. The first plan—finding another person who wanted to buy the stock and transacting with that person—was theoretically possible in the unregulated over-the-counter market, but it was too expensive to be worthwhile, except for very large institutions doing very large trades. That left the more complicated version: borrowing stock from a broker, selling it to another investor, promising
to pay that investor if the stock went up in value, and promising to return the stock to the broker at a future time. This complicated transaction was known as
shorting
a stock.

There were numerous limitations on shorting, in addition to its complexity and costs. Legal rules established in the 1930s restricted short sales. For example, you could only short a stock when the last trade in the stock had been at a higher price than the previous trade. This
uptick rule
was intended to prevent short sellers from manipulating the price of a stock downward. In addition, to short a stock you actually had to find shares to borrow. Because each company had a finite number of shares, it sometimes was difficult to find shares to borrow for a shorting transaction. This was true even for stocks with millions of shares traded. Some companies required employees to own stock, but prohibited them from lending it out, to limit the pool of shares available for shorting.

Given the structural obstacles to betting against stocks, it seemed entirely predictable that markets would have an upward bias, at least on occasion. This was true in horse racing, where each horse typically was “overvalued”—meaning that the odds payable on particular horses would have been higher if there had been a two-way market of people betting both for and against. It was less frequently true in stocks, but there was ironclad evidence that it was true at least some of the time. For example, for several weeks 3Com stock was worth less than the stock of its more fashionable subsidiary Palm (maker of Palm Pilot handheld organizers)—even though 3Com owned 95 percent of Palm. How was it possible for a piece of the pie to be more valuable than the pie itself? Simple: there weren't enough Palm shares for arbitrageurs to sell short. And put options, which would enable investors to bet against Palm, were too expensive and had limited terms. Investors who really loved Palm drove its demand—and stock price—to “irrationally” high levels.

Because of these limitations, short selling was a dying business, especially in the rising stock markets of the mid-1990s. In total, dedicated short-selling firms had only $2 billion total under management—less than one medium-sized hedge fund.
⁴³
Interestingly, Raymond L. Dirks, an insurance analyst who, in the 1970s, had warned his clients about a massive fraud at Equity Funding, was leading the attack on short sellers. He established a “Shortbusters” club at RAS Securities, where he found stocks that many people had shorted, and issued buy recommendations, hoping to squeeze the shorts into selling at a loss, much as Paul Mozer of Salomon had tried to squeeze the market for Treasury bonds.
⁴⁴
(If anyone
knew the consequences of betting against stocks, it was Ray Dirks. Regulators had rewarded him for uncovering the Equity Funding scandal by prosecuting him for tipping insider information to his clients, who then bet against Equity Funding's stock; Dirks was convicted, but later exonerated by the U.S. Supreme Court.)
⁴⁵

With these limitations, stocks could remain overpriced for long periods of time. If these new theories about the limits of arbitrage were correct, then stock markets weren't nearly as fair and efficient as regulators thought (most of them had been taught by the market-efficiency theorists of the classical school). It no longer seemed plausible to argue that market prices must be fair because, if they were not, someone would have shorted the stocks until the prices declined. Because of accounting misstatements and omissions, arbitrageurs never learned that stocks such as Cendant, Waste Management, Sunbeam, and Rite Aid were overpriced. And even if someone knew about these stocks, she might not be able to make money, because some investors would persist in believing in the higher valuation, and because shorting the stocks was both expensive and difficult.

Arthur Levitt realized much of this in 1998—five years into his term as chairman of the SEC. As more accounting schemes were disclosed, he reached what Carol Loomis of
Fortune
magazine described as “the gag point.”
⁴⁶
In 1997, 116 companies had needed to correct or restate their financial statements, and more companies were issuing such restatements in 1998. These disclosures woke up Levitt, and he began taking the actions that finally would form the basis for his mostly undeserved reputation as the investors' advocate.

In September 1998, Levitt gave the most important speech of his career—entitled “The Numbers Game”—in which he described various abuses and announced that the SEC would be clamping down on accounting fraud. With phrases such as “Managing may be giving way to manipulation; integrity may be losing out to illusion,” Levitt was trying to sound like John F. Kennedy—or perhaps Arthur Levitt Sr. He concluded, “It's a basic cultural change we're asking for. Nothing short of that.”

After Levitt's speech, the SEC sent letters to 150 companies that had taken restructuring charges in 1998. SEC enforcement lawyers brought cases against Cendant, Waste Management, Sunbeam, and Rite Aid, all relatively simple instances of fraud. (None involved derivatives, for example.) The choice to prosecute simpler cases was understandable. Even though the SEC enforcement division had more than a thousand lawyers,
it did not have the resources to prosecute every financial fraud. A complex accounting-fraud case against a major corporation required years of work, and dozens of lawyers and other staff. It was difficult for SEC officials to persuade federal prosecutors to bring criminal cases, and a major case was hardly worth the work if it merely resulted in a cease-and-desist order. Plaintiff's securities lawyers behaved similarly: they were busy enough with simple fraud cases against medium-sized corporations, and so they avoided the complex cases against major corporations.

As a result, the criminal convictions for accounting fraud and related shenanigans through 2000 did not exactly resemble a Who's Who of corporate America: Cendant, McKesson HBOC, Livent, Underwriters Financial Group, Donnkenny, California Micro Devices, Health Management, Home Theater Products International, FNN, Crazy Eddie, Towers Financial, Miniscribe, and ZZZZ Best. The only true “household name” on the list was Bankers Trust, back for a second round of fraud accusations after the derivatives fiascos of 1994. Bruce J. Kingdon, who ran securities processing at Bankers Trust, pled guilty to falsifying bank records in September 2000, but did not receive jail time (although he was ordered to see a therapist once a week for three years and to perform 450 hours of community service, which his attorney—reflecting the culture of Bankers Trust—said was for “cerebral palsy or muscular dystrophy or something like that”).
⁴⁷
At that time, Walter Forbes and Martin Grass had not yet been indicted; Dean Buntrock and Al Dunlap had apparently skated by.

By focusing on simple fraud cases, the SEC sent a message to major corporations engaging in complex fraud that they were likely to avoid punishment. Companies such as Enron and WorldCom were obviously managing their earnings, but were not the target of any investigations. All SEC officials had to do was compare the earnings a company reported to shareholders to the income it reported to the Internal Revenue Service. A huge gap was likely a sign of accounting fraud, tax fraud, or both. Between 1996 and 2000, this gap widened at numerous companies. Enron told shareholders it made $1.8 billion, but told the IRS it lost a billion. WorldCom told shareholders it made $16 billion, but told the IRS under a billion.
⁴⁸