Infectious Greed (48 page)

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 investors 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

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.
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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.

 

 

I
n reality, bankers and securities analysts had been corrupted by precisely the same forces that had corrupted accountants: pressure from corporate executives, limitations on liability, and conflicts of interest related to their own firms. Although investors hadn't noticed, there were signs during the mid-1990s that Wall Street had begun to behave very badly. First were the various derivatives fiascos, with Bankers Trust leading the pack. Then there were a series of scandals in the NASDAQ market, where most technology stocks were traded. In 1994, economists William Christie and Paul Schultz reported that NASDAQ traders were conspiring to charge investors high commissions (the securities dealers later settled disputes related to the conspiracy for more than a billion dollars.)
³⁴
In March 1995, several traders from Morgan Stanley allegedly manipulated the markets for several technology stocks—including Dell Computer, Novell, Sybase, and Tele-Communications Inc.—in order to profit from a complex scheme related to NASDAQ options (Morgan Stanley later was fined $1 million and the traders involved in the scheme were fined and suspended, although all of the fines were reduced substantially on appeal).
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Bankers also advised on technology-related mergers, which increased from $12 billion in 1992 to $150 billion in 1997,
³⁶
and wrote “fairness opinions”—that these mergers were fair for shareholders, even though the deals made no more sense than the disastrous conglomerate mergers of the 1960s.

In the late 1990s, two schemes in particular—one involving IPOs, one involving securities analysts—enabled investment banks to make billions of dollars at the direct expense of their clients and investors. Through these two schemes, Wall Street hid important facts from investors, facts that might have sobered those drunk on animal spirits. Frank Quattrone was the key figure in the IPO scheme; Henry Blodget was the key figure in the analysts scheme.

An Initial Public Offering is the most lucrative transaction any Wall Street firm can arrange for a corporate client. It is a special time in a company's life: the moment it finally “arrives” in the public financial markets; the time when the corporate executives and venture capitalists who have invested money, time, and sweat finally raise money from large
numbers of individual investors and establish a public market in which they later will be able to sell their shares. IPOs warranted high fees because they were risky and required more work than a typical deal. Securities regulators drew a bright line between private and public companies, and required that any company doing an IPO file an especially lengthy set of financial statements describing the company's risks.