Why the Bubble Popped

Why the Bubble Popped

This clutch of books offers an excellent retrospective on the recent stock-market crash, which wiped out $8.5 trillion in market value.


This clutch of books offers an excellent retrospective on the recent stock-market crash, which wiped out $8.5 trillion in market value. The value of individual retirement accounts dropped by one-third, and in just twelve months, 2 million Americans lost their jobs.

But the lessons from the crash will probably soon be shrugged off. Memory will be softened by a market that is beginning to recover at an impressive pace. The NASDAQ index, a swamp where tech alligators lurk, is double its value of eighteen months ago. That’s a pity. Politicians never work up the nerve to really reform Wall Street until, as after the 1929 collapse, half the population in some cities is unemployed and ex-millionaires start jumping out of windows.

Many of the exploiters and attitudes and wobbly rules that launched the crash are still with us. A sign of the unchanging times could be found in the February 25 Wall Street Journal, which reported that Goldman Sachs is once again suspected of violating securities rules, this time by charging excessive bond-trading price markups. The accompanying report also sounds normal: Goldman’s chief executive took home $21 million last year, a 75 percent increase over 2002.

Still, we can try to read the future in these analyses of the past. Paul Krugman’s essays have the snappy smartness his followers have come to expect, but for me the best interpretations of the marketplace and the so-called New Economy come from Robert Pollin, a University of Massachusetts professor of economics, who for one thing helps strip the populist mask from Bill Clinton; Doug Henwood, whose tart humor keeps one awake even when he discusses Wagnerian topics, as in the chapter on globalization, where he calls Ralph Nader “a special case, a man who seems proud of his (locally produced) hair shirt”; Joseph Stiglitz, a Nobel Prize-winning economist who writes with admirable candor about the sellouts of some of his colleagues in the Clinton years; and Roger Lowenstein, a master (as I first learned from his book When Genius Failed) at making our financial pirates as interesting as those who sailed with Long John Silver. David Denby’s American Sucker is not so much a critique of the era as it is a tragicomic, introspective tale of how much it can cost an ignorant investor to learn the true character of Wall Street. Denby, a film critic for The New Yorker, lost nearly a million.

Most of these writers properly feel that the crash was caused by a combination of all or most of these influences: deregulation to the point of anarchy; a towering secrecy that conceals the financial world from ordinary investors; greed that distorts capitalism and the character of those who administer it; a justice system that Wall Street malefactors know they need not fear; and, to personalize the problem, we are offered Alan Greenspan and his fellow conspirators, chief of whom were Clinton and his Treasury Secretary, Robert Rubin, who was a top exec at Goldman Sachs before joining Clinton’s Cabinet and a top exec at Citigroup after leaving it. In Lowenstein’s opinion, Clinton was, except for Ronald Reagan, “the most market-oriented president since the Roaring Twenties.”

If the crash proved anything, it was that crime pays. Sufficient tax credits were claimed to offset the measly $1.4 billion fine that J.P. Morgan, Morgan Stanley, Merrill Lynch, Credit Suisse First Boston, Citigroup, Goldman Sachs and four others agreed to fork over for misdeeds that, as Stiglitz says, “put most acts of political crookedness to shame…. The scale of theft achieved by the ransacking of Enron, WorldCom, and other corporations in the nineties was in the billions of dollars–greater than the GDP of some nations.”

Punishment of Wall Street’s brigands has been neither swift nor sure. As of late February, seven of Enron’s top executives had confessed to robbing the public, and eleven others were under indictment for that crime–but not one was behind bars. As for the top dog, Kenneth Lay, he seems to have been forgotten.

Lowenstein reminds us that at the start of the 1980s, 90 percent of the money managed by pension funds was invested in bonds, bills and cash. Stocks had had such a middling performance for half a century that they were considered to be just a little better than mattress stuffing. But “by the late 1990s, America had become more sensitive to markets, more ruled by markets, than any country on earth. This is the culture that led to prosperity and also to Enron. Markets became virtually sovereign–unchecked by corporate watchdogs or by government.”

Unchecked, indeed. Out of control is more like it. The root cause of the lawless boom and the crash that followed was the deregulating mania that started with Reagan and Bush I. For a dozen years their administrations, in the words of Stiglitz, “glorified free markets and demonized government regulations,” and this attitude was carried over into the Clinton Administration. Robert Pollin agrees that Clinton’s administration was defined by “virtually unqualified enthusiasm for…the deregulation of financial markets–with Alan Greenspan providing crucial leadership in granting to financial traders the leeway they had long sought to freely speculate with other people’s money.”

The deregulation tide that began in the 1970s became a huge wave. Electricity was deregulated.Telecommunications was deregulated. And Wall Street, of course. The most disastrous deregulation resulted from the killing of the venerable Glass-Steagall Act, which had been around since 1933. The purpose of Glass-Steagall was to maintain a wall between commercial banks and investment banks. The former take our deposits and lend money to people and corporations that can prove they have a good credit rating. The much more profitable investment banks dote on risks and get huge fees for helping corporations issue new bonds and stocks. The reason for the wall between the banks was obvious: If it were removed, the commercial side of the bank would be pressured to join the dangerous fund, lending money to companies that didn’t deserve more credit–even companies teetering on the brink of bankruptcy–so that the investment-banking side could continue getting their lush kickback fees.

That’s exactly what was done by many of the banks, including the banking sections of the giant brokerage firms, after Glass-Steagall was “reorganized” out of existence by the Clinton Administration. The lure of more mega-fees kept them propping up behemoth clients they knew were dying of their own excesses.

Another reason banks kept propping them up was that they feared that if the corporations did go bankrupt, the banks’ own nefarious participation would be exposed. As indeed it usually was.

Consider WorldCom’s support by Citigroup (an octopus including Citibank, Travelers Insurance and Salomon Smith Barney brokerage). That octopus, which lent many millions to WorldCom and was lead underwriter of a $5 billion debt, kept touting WorldCom stock as a “strong buy” almost to the day the company went under.

The investment banks’ advance troops in the assault on the gullible public were the analysts. Some of these extremely effective pitchmen, Doug Henwood reminds us, were “publicly recommending stocks that they privately disdained…stocks that no sane, fully informed persons would ever have bought.” Henry Blodget, an analyst at Merrill Lynch whom David Denby had the misfortune to befriend, gained notoriety for promoting a stock that he privately described as a “piece of shit.” Merrill Lynch, which must have known that sort of thing was going on, was fined a trifling $100 million for failing to stop the conflict of interest within its walls. As for Blodget, his punishment was to be banned for life from the securities industry, but that hardly reduced him to poverty or refilled the pockets of those, like Denby, he helped fleece.

And the same can be said for the closing-the-barn-door banning of Jack Grubman, whose allegedly fraudulent research brought tens of millions of dollars to Salomon and sometimes as much as $20 million a year to his own pockets. In his role as cheerleader for telecommunications, he foresaw a glorious future for WorldCom, Qwest and Global Crossing, now all wreckage.

Henwood’s quote from former investment banker Nomi Prins, describing what happened to the telecom industry in the second half of the 1990s, is the abbreviated morality tale of the decade:

Wall Street raised $1.3 trillion of telecom debt and sparked a $1.7 trillion merger spree, bagging $15 billion in fees for the effort. Then, the accumulation party ended. The industry collapsed amidst a $230 billion pile of bankruptcies and fraud, wiping out $2 trillion in market value and defaulting on $110 billion of debt (half of all defaults). Telecom execs pocketed $18 billion before they cut 560,000 jobs. And in 2003, over 96% of the capacity built lies dormant.

The Accounting Game

Much of the genius behind the bubble’s inflation must be credited to crooked accounting practices. To sucker the public into buying their stock, corporate accountants juggled the books so that profits seemed much higher than they were and losses could be hidden.

Enron, for example, entered into contracts that would have produced profits many years ahead, if ever, and claimed them as current profits. And many millions of dollars in stock options that corporate executives gave themselves should have been counted as expenses, but usually weren’t. Paul Krugman gives an example: “In 1998 Cisco reported a profit of $1.35 billion; if it had counted the market value of the stock options it issued as an expense, it would have reported a loss of $4.9 billion.”

This kind of crookedness had gone on for years, but in 1993 the Financial Accounting Standards Board (FASB) recommended a rule that would have ended it. The rule was immediately and fiercely opposed in Congress by members who had received bountiful gifts from both Wall Street and the accounting industry. None were more grateful for their largesse than that odd Democrat from Connecticut, Senator Joseph Lieberman.

He sponsored a resolution condemning the FASB’s proposal on humanitarian grounds, even though, throughout the corporate world, “75 percent of options went to people who ranked in the top five in their companies. More than half of the remainder went to the next fifty managers…an unprecedented accumulation of private wealth,” writes Lowenstein. But Senator Lieberman made it sound like “millions of ordinary workers would now be cast into a cold, optionless world…back to breadlines and hawking apples.”

The FASB surrendered.

Why, sometimes it almost seemed that those seeking deregulation were selfishly motivated. Even as his wife sat on Enron’s board, Senator Phil Gramm pushed through legislation exempting the corporation’s practices from regulation. And when Gramm left the Senate, says Krugman, he joined UBS Warburg, the company that bought Enron’s trading operations.

Speaking of corruption, what happened to Arthur Andersen, one of the most venerable of the Big Five accounting firms (established in 1913), really shook Wall Street. If the Big Five couldn’t be trusted to give reliable accounting, the stock market had truly become a gambling den. There had been whispers of Arthur Andersen’s unreliability ever since its part in the savings and loan scandal. Actually, these whispers made it more attractive to some clients. Pollin points out that in 1990 George W. Bush had successfully called on Arthur Andersen to OK his questionable books at the Harken Energy Corporation; and in a promotional video in 1996, Dick Cheney, then chairman of Halliburton, had come straight to the point, praising Arthur Andersen for giving him “good advice…over and above the just sort of normal by-the-book auditing arrangement.”

Enron, WorldCom, Global Crossing and Tyco International also got more than “normal by-the-book” auditing on their way into oblivion, and Arthur Andersen soon felt the flames as well.

The Good Old Reliable SEC

Having killed Glass-Steagall, the deregulators would have liked to kill the Securities and Exchange Commission, too. But they knew they couldn’t dare even suggest that. The SEC had been an almost sacred regulator of the securities market since its founding in 1934, when it became the cop on the corner empowered with regulations that were meant to build a sense of ethics among market professionals and give the public confidence that somebody was trying to protect them from the hustlers.

But if they couldn’t kill it, they could sure weaken it. The SEC has always been “ludicrously underfinanced,” Krugman says quite accurately. “Staff lawyers and accountants are paid half what they could get in the private sector, usually find themselves heavily outnumbered by the legal departments of the companies they investigate, and often must do their own typing and copying.” George W. Bush would see that this continued.

The public’s outrage over the stock-market collapse and the accounting scandals forced Congress in the summer of 2002 to pass the Sarbanes-Oxley Act, which was aimed at increasing regulation of public corporations’ accounting practices. The SEC would implement the act. Bush grudgingly signed the act into law, but (according to Pollin’s view of the episode) the President got to strike his customary low blow by slashing the SEC’s budget 27 percent below what the legislation had proposed.

More accurately, that was the first low blow of the day. His second was to appoint William Webster to head the auditing oversight board set up by Sarbanes-Oxley. Obviously, if Bush wanted the board to fail, he chose the right man. Webster had previously directed two failed agencies, the FBI and the CIA, and was currently, writes Pollin, “a board member of a company under investigation for securities fraud.” Press contempt for that appointment forced a mediocre replacement, and all things point to the SEC’s withering away.

And Then There Was the Fed

There has been no bureaucrat more exalted by the business world, by Congress, by Clinton and his predecessors, and by the press than Alan Greenspan, chairman of the Federal Reserve Board. And there is no stranger phenomenon in recent history than that exaltation, for Greenspan has proved himself to be a very anti-everything that keeps us going.

He is an anti-inflation, antitax, antispending, antiregulation, antigovernment nut. Admittedly, his mistakes have sometimes been fortuitous. In 1974, as chairman of the Council of Economic Advisers, he was so eager to fight inflation (which wasn’t really high) that he persuaded President Ford to cut government spending right in the middle of a sharp recession, which just made the recession worse. Angry voters dumped Ford in 1976.

The Federal Reserve System, which was set up in 1913, is the most undemocratic part of our government. Although its actions affect every legal or illegal resident of the country, it has no input from the general public. The Fed is literally owned by the largest national banks, and the Fed’s board, which meets in secret, has never had a member who came from the labor movement or at least momentarily entertained a populist thought. The Fed has two mandates from Congress: Adjust the interest rates in such a way as to maintain a healthy economy, and promote employment. A moderate amount of inflation–meaning more money in circulation–is good for employment. But banks hate it because it lowers the value of the dollar. So the Fed has always ignored the second half of its mandate. Consequently, says Stiglitz, “there is little doubt that many of the postwar recessions have been caused by the Fed, as it has stepped on the brakes too hard in its fixation that unless it does so, inflation will break out.”

Chairman Greenspan has religiously followed that absolutely-no-inflation dogma as it affected money (creating the recession

that doomed the elder Bush at the polls). But he has not minded the inflation of asset values on Wall Street, and by ignoring them he helped create the boom-bust.

In 1996, when the Standard and Poor’s Index stood at 740, Greenspan asked, “How do we know when irrational exuberance has unduly inflated asset values?” But three years later, when the S&P had doubled and signs of the bubble were everywhere, he still took no action. In a 2002 speech to his chums at Jackson Hole, he tried to defend his inaction, claiming “it was very difficult to definitively identify a bubble until after the fact–that is, when its bursting confirmed its existence.” And there was nothing he could have done about it anyway, he said. “Is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout?… The answer appears to be no.'”

Actually, the answer appears to be yes, and he knew all along what it was. He could have raised the market’s margin requirements, thereby reducing how much stock people could buy with borrowed money. Krugman reminds us that at the September 1996 meeting of the Federal Open Market Committee, Greenspan told his colleagues, “I recognize that there is a stock market bubble problem at this point” and that it could be solved by “increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”

But he didn’t do it. Nor did he lobby behind the scenes against the huge capital gains tax cut of 1997, which fed the market with another torrent of investor money. Not only did he do nothing to tame the market, writes Stiglitz, “he switched to becoming a cheerleader for the market’s boom, almost egging it on, as he repeatedly argued that the New Economy was bringing with it a new era of productivity increases.”

Readers who pay attention to these books will have to conclude that the system is broken. Or maybe they won’t. If, despite what happened to their 401(k) last time, they still want to try the market, then they will probably agree with what Henry Blodget told David Denby at their last tête-à-tête in 2001:

People have now lost a lot of money. They can say, “I made a mistake, I lost a lot,” or they can say, “Somebody fucked me.” It’s so much easier to say the latter. In two years, the revisionist view will be that nothing bad would have happened if the system weren’t broken. But nothing would be further from the case. It was a bubble. This is just the way the markets behave and the way that people behave.

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