by Eric Martin
Kevin Drum read Matt Taibbi's recent stemwinder on Goldman Sachs and has some harsh criticism:
I finally got around to reading it the other day, and my verdict is simple: it was terrible. Taibbi wrote a terrific article about AIG a couple of months ago, but the Goldman piece was just phoned in, a long series of blustery assertions with essentially nothing to back up any of them. If he wants to claim that Goldman was the wizard behind the curtain of everything from the dotcom boom to last year's oil spike, he really needs to produce some evidence for it instead of just saying so.
Unfortunately, Kevin doesn't actually discuss which assertions from Taibbi are mere bluster, and which aren't (if Kevin is even allowing that some of Taibbi's piece is an accurate portrayal of events). Nor does Kevin refute the evidence that is presented. So we're left to wonder at the...well, the evidence for his strident assertion.
That's not to say that Taibbi's over-the-top writing style is devoid of bluster, and it is true that Taibbi is laying too much at the feet of Goldman Sachs alone, but in terms of choosing Goldman as a proxy for Wall Street investment banks (and their serial malfeasance), it's as good a choice as any.
Further, in defense of Kevin, Rolling Stone hasn't made the full article available online, and the excerpts they've posted leave out many of the details and in-depth treatment. If Kevin only read the excerpted version, then his criticism would be valid - there isn't enough meat on those bones. Actually, it reads like a disjointed, non-sequitur, meandering piece of little substance (the full version is here).
While I'm not qualified to assess the validity of all of Taibbi's claims, I can say that he got the Tech Stocks section pretty dead-on (and used evidence to back up his key claims). I know because I worked on some of the legal cases that dealt with the various misdeeds of the investment banks during that era (I've written about them before), and in pursuit of that, I spent years poring over documents and other discovery. Actually, my main critique ofTaibbi with respect to this portion of the article is that he left out (or didn't delve deeply into) one of the sordid chapters of that bubble-bust story: the circumvention of the barrier between the research side of the banks, and the underwriting side and the mischief that ensued. More on that below, but first an extended excerpt from Taibbi:
The basic scam in the Internet Age is pretty easy even for the financially illiterate to grasp. Companies that weren't much more than pot-fueled ideas scrawled on napkins by up-too-late bong-smokers were taken public via IPOs, hyped in the media and sold to the public for megamillions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out 50-story windows and opening the phones for bids. In this game you were a winner only if you took your money out before the melon hit the pavement.
It sounds obvious now, but what the average investor didn't know at the time was that the banks had changed the rules of the game, making the deals look better than they actually were. They did this by setting up what was, in reality, a two-tiered investment system - one for the insiders who knew the real numbers, and another for the lay investor who was invited to chase soaring prices the banks themselves knew were irrational. While Goldman's later pattern would be to capitalize on changes in the regulatory environment, its key innovation in the Internet years was to abandon its own industry's standards of quality control.
"Since the Depression, there were strict underwriting guidelines that Wall Street adhered to when taking a company public," says one prominent hedge-fund manager. "The company had to be in business for a minimum of five years, and it had to show profitability for three consecutive years. But Wall Street took these guidelines and threw them in the trash." Goldman completed the snow job by pumping up the sham stocks: "Their analysts were out there saying Bullshit.com is worth $100 a share."
The problem was, nobody told investors that the rules had changed. "Everyone on the inside knew," the manager says. "Bob Rubin sure as hell knew what the underwriting standards were. They'd been intact since the 1930s."
Jay Ritter, a professor of finance at the University of Florida who specializes in IPOs, says banks like Goldman knew full well that many of the public offerings they were touting would never make a dime. "In the early Eighties, the major underwriters insisted on three years of profitability. Then it was one year, then it was a quarter. By the time of the Internet bubble, they were not even requiring profitability in the foreseeable future."
Goldman has denied that it changed its underwriting standards during the Internet years, but its own statistics belie the claim. Just as it did with the investment trust in the 1920s, Goldman started slow and finished crazy in the Internet years. After it took a little-known company with weak financials called Yahoo! public in 1996, once the tech boom had already begun, Goldman quickly became the IPO king of the Internet era. Of the 24 companies it took public in 1997, a third were losing money at the time of the IPO. In 1999, at the height of the boom, it took 47 companies public, including stillborns like Webvan and eToys, investment offerings that were in many ways the modern equivalents of Blue Ridge and Shenandoah. The following year, it underwrote 18 companies in the first four months, 14 of which were money losers at the time. As a leading underwriter of Internet stocks during the boom, Goldman provided profits far more volatile than those of its competitors: In 1999, the average Goldman IPO leapt 281 percent above its offering price, compared to the Wall Street average of 181 percent.
How did Goldman achieve such extraordinary results? One answer is that they used a practice called "laddering," which is just a fancy way of saying they manipulated the share price of new offerings. Here's how it works: Say you're Goldman Sachs, and Bullshit.com comes to you and asks you to take their company public. You agree on the usual terms: You'll price the stock, determine how many shares should be released and take the Bullshit.com CEO on a "road show" to schmooze investors, all in exchange for a substantial fee (typically six to seven percent of the amount raised). You then promise your best clients the right to buy big chunks of the IPO at the low offering price - let's say Bullshit.com's starting share price is $15 - in exchange for a promise that they will buy more shares later on the open market. That seemingly simple demand gives you inside knowledge of the IPO's future, knowledge that wasn't disclosed to the day-trader schmucks who only had the prospectus to go by: You know that certain of your clients who bought X amount of shares at $15 are also going to buy Y more shares at $20 or $25, virtually guaranteeing that the price is going to go to $25 and beyond. In this way, Goldman could artificially jack up the new company's price, which of course was to the bank's benefit - a six percent fee of a $500 million IPO is serious money.
Goldman was repeatedly sued by shareholders for engaging in laddering in a variety of Internet IPOs, including Webvan and NetZero. The deceptive practices also caught the attention of Nichol as Maier, the syndicate manager of Cramer & Co., the hedge fund run at the time by the now-famous chattering television rear end in a top hat Jim Cramer, himself a Goldman alum. Maier told the SEC that while working for Cramer between 1996 and 1998, he was repeatedly forced to engage in laddering practices during IPO deals with Goldman.
"Goldman, from what I witnessed, they were the worst perpetrator," Maier said. "They totally fueled the bubble. And it's specifically that kind of behavior that has caused the market crash. They built these stocks upon an illegal foundation - manipulated up - and ultimately, it really was the small person who ended up buying in." In 2005, Goldman agreed to pay $40 million for its laddering violations - a puny penalty relative to the enormous profits it made. (Goldman, which has denied wrongdoing in all of the cases it has settled, refused to respond to questions for this story.)
Another practice Goldman engaged in during the Internet boom was "spinning," better known as bribery. Here the investment bank would offer the executives of the newly public company shares at extra-low prices, in exchange for future underwriting business. Banks that engaged in spinning would then undervalue the initial offering price - ensuring that those "hot" opening price shares it had handed out to insiders would be more likely to rise quickly, supplying bigger first-day rewards for the chosen few. So instead of Bullshit.com opening at $20, the bank would approach the Bullshit.com CEO and offer him a million shares of his own company at $18 in exchange for future business - effectively robbing all of Bullshit's new shareholders by diverting cash that should have gone to the company's bottom line into the private bank account of the company's CEO.
In one case, Goldman allegedly gave a multimillion-dollar special offering to eBay CEO Meg Whitman, who later joined Goldman's board, in exchange for future i-banking business. According to a report by the House Financial Services Committee in 2002, Goldman gave special stock offerings to executives in 21 companies that it took public, including Yahoo! co-founder Jerry Yang and two of the great slithering villains of the financial-scandal age - Tyco's Dennis Kozlowski and Enron's Ken Lay. Goldman angrily denounced the report as "an egregious distortion of the facts" - shortly before paying $110 million to settle an investigation into spinning and other manipulations launched by New York state regulators. "The spinning of hot IPO shares was not a harmless corporate perk," then-attorney general Eliot Spitzer said at the time. "Instead, it was an integral part of a fraudulent scheme to win new investment-banking business."
Such practices conspired to turn the Internet bubble into one of the greatest financial disasters in world history: Some $5 trillion of wealth was wiped out on the NASDAQ alone. But the real problem wasn't the money that was lost by shareholders, it was the money gained by investment bankers, who received hefty bonuses for tampering with the market. Instead of teaching Wall Street a lesson that bubbles always deflate, the Internet years demonstrated to bankers that in the age of freely flowing capital and publicly owned financial companies, bubbles are incredibly easy to inflate, and individual bonuses are actually bigger when the mania and the irrationality are greater.
He's dead on about laddering and spinning. But what he left out (or only referenced in passing) was "pumping" and its origins. From an earlier piece:
Within the major investment banks, there are various divisions. One such division handles the underwriting duties, and another conducts market research on various companies on a sector by sector basis. In theory, and in practice for many years, the research and banking branches were separated by an internal firewall. After all, it is in the interest of investors, the markets, the companies themselves and our economy in general if there is a knowledgeable investor class that can rely on objective research and corporate transparency mandated by disclosures in filings made with the Securities and Exchange Commission. But with all that easy money churning around during the expansion of the Internet bubble, the wall began to crack. In fact, the I-Banking divisions began pressuring the research division to issue inflated "buy" ratings on stocks and author favorable reports of companies in order to acquire or maintain the banking business of the companies being lauded. There was a conspiracy to "pump" in order to keep the business relationship in order.
In many cases, the researchers were privately deriding stocks they were extolling to the unsuspecting public through institutional reports, TV appearances and other media. If you recall, this was the era of the celebri-analysts who began popping up on the cable TV outlets, the most notorious of which was probably Merrill Lynch's Henry Blodgett who infamously called a stock he was publicly recommending a "piece of shit" in a private email. Unfortunately, the unsuspecting American people trusted these "objective" analysts, and continued to pour money into companies that the analysts and I-Bankers themselves knew were hollow shells and lost causes. In the end, countless Americans were financially wiped out, or set back considerably, while the bankers and executives absconded with windfall profits.
Those are not assertions without support. That's simply what happened.