Gucci Little Piggies

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.

Comments

[Model 62]

I don't think I ever expected to see Obsidian Wings linking to the SA Forums.

[Eric Martin]

They're the ones with the contraband...

[cleek]

WebSense at work hates SA. :(

in protest, i wore my SA t-shirt to work last week.

[scott]

I posted a similar comment to Eric's on Kevin's post, especially the blustery assertion aspect. It seems to me that a lot of left-of-center people, including Kevin, have a surprising amount of defensive sympathy for some really bad financial actors, and an equally surprising amount of dismissiveness toward those who might get angry about it. The basic point of Taibbi's post was that GS had an outsized and unhealthy effect on the evolution of our economy over the last 10-20 years. I'm still not sure why Kevin disputes that and why he apparently thinks that Taibbi's objectionable tone trumps the value of this essential point. Then again, when the AIG bonuses flap hit, KD was one of the "progressive" voices cautioning us not to pile on. I suppose we're never allowed to have any populist anger about the ecomnomic and social abuses to which we've been subjected, no matter how significant they might be. It's a good recipe for fiddling around the margins of a dysfunctional system in an approved, "reasonable" way while discounting any possibility of a fundamental critique and reform.

[Point]

Interesting to read how the recent financial problems aren't really that recent -- but date to the Clinton era, of all things!

This seems like more evidence that the basic mistake was getting rid of perfectly sensible FDR era financial regulations, like this.

[Eric Martin]

Point: I think it's probably Clinton's biggest failing - at least when judged in terms of the art of the possible.

[bob mcmanus]

Goldman Sachs Tax ...Barry Rittholz discusses the persistent rumours of Goldman Sachs cheating on market trades. Pretty technical, but I think what they are accused of doing is watching other traders...well, I'll let someone else describe it. 94 comments, which is a lot for Rittholz.

Paul Craig Roberts ...BR

"Max Keiser: “Does the US Secretary of the Treasury work for the people or does he work for the banking system on Wall Street?”

Dr. Paul Craig Reports: “He works for Goldman Sachs.”

As does Obama.

[Eric Martin]

Yeah, Obama picking Summers and Geithner was telling.

[Blar]

I'm trying to understand how these scams work (what makes it profitable for Goldman, why everyone involved goes along with it, who pays the price, and what the effects are on the market as a whole), and I don't think I get it all.

I think I can follow pumping. The company is essentially buying good publicity from Goldman. The company buys services from Goldman's underwriting division, and in exchange Goldman's research division gives them good ratings. Goldman makes money from their business, the company benefits from having their stock price inflated by the good publicity, and the investors who listen to the advice of Goldman's research division get screwed into overpaying for the stock. This also leads to bubbles, since the research division is always being paid to drive prices up with good publicity.

I'm less sure about spinning. Is the idea just that Goldman is paying the CEO to do business with them? The CEO takes their company's business to Goldman, and in return Goldman personally gives the CEO a sweet deal on their company's stock. Goldman benefits by getting their business, the CEO benefits personally from the stock, and the CEO's company gets screwed because the CEO's personal profit is coming from the company (since company is basically selling stock to its CEO at a below market price). Is that all there is to it? If so, I don't see the connection to the bubble, or how ordinary investors are getting screwed.

With laddering I'm even less sure. It sounds like Goldman is getting the company to offer its stock at below market price, and Goldman is getting some buyers to agree to later buy some of the stock at above market price in exchange for getting some of the below market stock. This makes sense for the buyers, as long as the average of the two prices that they pay is a little bit below market value. But how is this profitable to Goldman? Is Goldman buying some of the stock at the below market price & then reselling it at the higher price? Do their fees depend on the later, higher price and not on the initial lower price? Or what? And why is the company going along with this? It seems like they're the ones getting screwed, by having some of their stock sell for below market price. Finally, how does this create a bubble, or harm ordinary investors? The stock price will be temporarily inflated above market value by the rush of buyers who promised to buy more, but after that the stock will be out there on the market for people to buy or sell as they choose.

I hope that someone can either correct my mistakes & fill in my confusions, or just start fresh and write a simple explanation that I can follow.

[Shinobi]

Zero Hedge also has the full article posted here: http://zerohedge.blogspot.com/2009/06/goldman-sachs-engineering-every-major.html

But it is not quotable.

Also, Matt Taibbi's response to his detractors was classic:
http://trueslant.com/matttaibbi/2009/07/07/on-the-everyone-was-doing-it-excuse/

[Eric Martin]

If so, I don't see the connection to the bubble, or how ordinary investors are getting screwed.

If Goldman gives the CEO of NewCo a lower price in a stock offering than it is giving to the public, that represents money that should be going to the corporate coffers but which isn't.

For example, if the offering price is $20, but they give the CEO the option to buy 100,000 shares at $10, that's $1 million in revenue that has been diverted from the company. That hurts the shareholders.

In terms of connection to the bubble, it's tangengtial, but part of a culture of corruption that led to the bubble generally speaking.

[Eric Martin]

It sounds like Goldman is getting the company to offer its stock at below market price, and Goldman is getting some buyers to agree to later buy some of the stock at above market price in exchange for getting some of the below market stock.

No, they're offering it at market price.

Is Goldman buying some of the stock at the below market price & then reselling it at the higher price?

Yes, usually the I-Bank will take a large tranche of a public offering.

This makes sense for the buyers, as long as the average of the two prices that they pay is a little bit below market value.

What it did was create artificial demand, a feeding frenzy pushing the price higher and higher - above where it should be. Thus, the buyers were likely to make gains even on their secondary purchases.

[Eric Martin]

Finally, how does this create a bubble, or harm ordinary investors?

That's exactly what a bubble is, and in this case, it was a manipulated bubble. Specifically illegal. Ordinary investors hopped on the bandwagon not realizing what was going on, and then got left holding the bag when the music stopped. The insiders got out right away because they knew what was up.

[Eric Martin]

This is how I described it in an earlier piece (I was using pumping and dumping as broader categories of behavior fyi):

Laddering is when an I-Bank requires an investor in an IPO to agree to purchase more of the stock throughout the week at predetermined prices. So, in order for investor X to get 1,000 shares of the IPO at $5, X has to agree to buy 500 more shares in the aftermarket at, say, $10 a share. The reason the I-Banks did this was to create artificial demand for the stock that would inflate its price beyond what the free market would normally pay. All of a sudden, as the stock price would normally be hitting its natural equilibrium, there would be an injection of overly zealous buyers willing to pay a premium. This created a feeding frenzy, a self-sustaining upward cycle. They were "Pumping." But eventually, before the dust settled, the I-Banks and investors in the know would be "Dumping" - one step ahead of the suckers.

[hairshirthedonist]

I can remember being told in 1998 what a fool I was by now-former co-workers 5-10 years my senior for paying down my 8% FHA mortgage and not throwing that money into the roaring stock market. I would argue that a guaranteed 8% return, as risk-free as it gets, was excellent. If I could put all my money into a guaranteed 8%-return investment, it would be the only investment I would ever need to retire a rich man. They shook their greedy little heads at me.

I wish I knew what happened to their money come 2000. Why isn't it obvious to people that every jerk with a few extra bucks to invest can't expect to make in excess of 15% on their investments for an extended period of time - that there's something inherently wrong with that picture?

It's not that I'm trying to blame all the little guys like the ones I knew. It's just that I can only feel so sorry for them, because they were victims of their own greed as much as they were victims of GS and their ilk. And it's not that I'm trying to excuse the investment banks for what they did. It's just something I remember very distinctly about the dot-com bubble. It's nice now to know more about what was behind it all.

[Blar]

So the key to laddering is that it creates momentum? The folks who promised to buy all buy at once and drive the price up. Clueless investors see the rising stock prices and think that it must be something good, so they start buying too. Then Goldman and their accomplice buyers all sell while the price is elevated, and when the price finally falls back to where it should be the clueless investors who joined the bandwagon get screwed.

I'm still trying to figure out how to connect this micro picture of a single stock that's temporarily inflated to the macro picture of the tech bubble. Is the idea that lots of stocks got inflated in this way (and in other nefarious ways), and a bunch of them stayed inflated for a long time, so that they combined to form a bubble? (But the time scale seems wrong for that. The tech bubble grew for years, and this scam seems like it would finish & send the stock price back down a lot quicker than that.) Another possible connection is that the bubble psychology, which led clueless investors to buy stocks based on hype, is what allowed this scam to be so successful, since that is what led the market to drive the stock price up even higher after the conspirators had inflated the price. But that places the causal arrows in the other direction. It would mean that places like Goldman were taking advantage of the bubble & the accompanying mania to scam money out of ordinary investors, but it's not clear how much they were adding to the bubble or the mania by doing so.

[jack lecou]

...the time scale seems wrong for that. The tech bubble grew for years, and this scam seems like it would finish & send the stock price back down a lot quicker than that.

That's kind of what I was thinking too, but there's definitely some herd psychology and other things going on that make it plausible to see how it might last longer.

Especially because, at least in the early days, there was a big novelty factor. When this "internet" stock shoots up past where the old valuation formulas think it should be, well, what do they know?

Once these things start taking off, it's very easy to start wondering if something brand new is happening. There were some real things going on with productivity, and sound tech companies, and so forth that made that seem very plausible. Combine that with the herd psychology, and watch out.

And I don't see that that causes any problem with the causal arrow. Once you start kicking off enough of these at once (and presumably it's not just Goldman, but most of Wall Street doing this type of stuff), you get a sort of ignition temperature. At some point it becomes somewhat self sustaining, it's true, but someone still had to light the fire.

[Eric Martin]

Blar,

It was also the ridiculous overvaluations that occurred regardless of the laddering. As Taibbi points out, they didn't used to underwrite companies with no record of profitability, or likelihood thereof. But then they switched the rules, started touting the sh*t out of the sh*t stocks they were bringing to market (when they shouldn't have even brought them to market in the first place) and then, through laddering, shooting those sh*t stocks through the roof.

Sometimes they took a while to fall back to earth. But the savvy insiders were long gone by the time that happened.

It was the same playbook that led to the massive stock market crash in the 1920s.

[Ann]

"The problem was, nobody told investors that the rules had changed."

Nobody told investors that the companies hadn't been in business at least 5 years? No one told investors that the companies didn't have at least 3 years (or one year, or one quarter) of profits behind them? Wow, that's pretty bad.

Maybe we should have companies put out some sort of document (we could call it a Prospectus) giving basic information such as what the companies do and how long they've been doing it. We could even have companies provide audited financial statements, and then investors could do their own homework before investing their own money. Funny no one ever thought of that before...

[Barry]

Posted by: Shinobi:

"Also, Matt Taibbi's response to his detractors was classic:
http://trueslant.com/matttaibbi/2009/07/07/on-the-everyone-was-doing-it-excuse/"

Matt pointed out that the response was *not* to deny the charges. Rather incriminating.

[Ann]

"Is Goldman buying some of the stock at the below market price & then reselling it at the higher price?"

"Yes, usually the I-Bank will take a large tranche of a public offering."

If an IPO is underwritten, then obviously the underwriter buys all of the shares and then resells them at a higher price (at least in the US; other countries instead use standby agreements). That's how the investment bank's fee is paid - through the spread. This is all clearly laid out in the Prospectus, but the fees aren't unlimited, and the underwriter isn't allowed to sell the shares for more than the official offering price. If things go badly, they have to sell the shares for less and lose money, but they're not allowed to just sell them at whatever premium the market will pay.

As for spinning in general, how on earth could an underwriter "offer him a million shares of his own company at $18 in exchange for future business"? Spinning was where investment banks, when allocating shares in IPOs in general, sold some of the shares to CEOs of other companies (not the company going public!) as part of the offering. They paid the same price as everyone else, i.e. the offering price. But since IPOs are usually underpriced on average and had particularly ridiculous first day pops during the bubble, being allowed to be one of the investors that purchased in the IPO was a highly valued privilege.

Presumably this made the CEOs of various companies feel favorably toward that investment bank, so that hopefully when the time came for those CEOs' own companies to need an underwriter, they'd work with the one that gave them access to IPO shares. That was the idea, and I agree that they shouldn't allow it, but it's not even close to the description given here.

[bobbyp]

"Nobody told investors that the companies hadn't been in business at least 5 years? No one told investors that the companies didn't have at least 3 years (or one year, or one quarter) of profits behind them? Wow, that's pretty bad."

Yes, Ann. We were told...in the fine print. The question then becomes how and why was such dreck brought to market? What could possibly sustain such lunacy? Why would investment banks seemingly take such huge risks--holding inventories and making a market in such crap?

It's a classic question, who did the crime... P.T. Barnum or the suckers?

[nnyhav]

"... 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."

That's one of the problems with the piece, blithely shifting synecdoches around. On the dotcom bubble, CSFB & MER were more egregious. GS wasn't at the forefront on CDO issuance, esp wrt MBS, which they weren't originating unlike some other players, and "betting against" it didn't take place until mid-2007. Using GS as proxy also elides the effects of Glass-Steagall repeal (lots of capital capacity injected into the markets, and more competition for GS) and of the underlying free-market ideology prevalent regardless of party label (driving eg financialization of the commodities markets). While GS has adapted to and navigated through changing circumstances better than its peers, it was not controlling them: LEH went down for gaming the Bernanke put (eg attaching conditions to Korean capital injection the week prior), with immediate negative effect to GS & MS. Subsequent actions were predicated on the notion that it was better to have a financial system than not, not that it was better for GS.

I'm a Taibbi fan, but this'un doesn't meet his usual standard. But hey, even Hunter S. Thompson had off days. (Yeah, I know Kevin Drum backpedaled, having seen only the RS excerpts.)

[Ceri B.]

Ann: Investors at large were told by the people with most information, most money directly at stake, and a long history of success that the boundaries of the feasible and profitable had changed. And this isn't crazy - think of how much routine business has changed because of cell phones and e-mail, of the role in the web in advertising and changing who governs access to what. In that context, when the people who are staking their reputation and continued operations on a deal say that new considerations apply in IPOs as well...it turns out to be a lie, but it's not stupid to have been taken in by it.

[jrudkis]

It is stupid to bet the farm on it (unless the farm is worthless anyway).

[julia]

Maybe it is .

http://www.madnike.com

[Sam Simple]

There is a reason I never read Kevin Drum's blog anymore - he used to be edgy and take on the powerful. No more. Drum has become sclerotic and weak-kneed. Screw him. Boycott his blog and let him find a real job.

[Eric Martin]

Ann,

Yes, the prospectus was there, but so where the analysts from the research division putting ratings on stocks that didn't deserve those ratings. So, if the public is listening to the vaunted bank analysts - the experts - they would have been totally snowed. By people who were, in essence, trying to con them.

That's illegal, and it's not OK because there's a prospectus out there.

[matttbastard]

Sam Simple: "There is a reason I never read Kevin Drum's blog anymore - he used to be edgy and take on the powerful. No more. Drum has become sclerotic and weak-kneed."

Hmm. I've been reading Drum on and off since he was CalPundit. He's never had an edge of any sort -- "sclerotic and weak-kneed" is his bread and butter. Back in the good ol' days of the nascent VLWC, Drum, along with Yglesias and Josh Marshall, were the token 'moderates'.

[Doctor Science]

And then there's the question of whether Goldman was front-running the whole market -- basically, having automated buy/sell programs that see big orders coming through their pipeline and then jump in the queue ahead of them, to catch that little bit of price increase or decrease before anybody else.

[Ann]

"the analysts from the research division putting ratings on stocks that didn't deserve those ratings"

It's easy to look back now, with the benefits of hindsight, and say that the stocks didn't deserve those ratings, but there were analysts that weren't as optimistic about internet stocks, and their careers suffered because investors didn't believe them. After all, those less optimistic analysts were "wrong" in the sense that their recommendations lost clients' money, up until spring of 2000. Out of many competing voices, investors chose who they wanted to believe.

Investors have no business buying individual stocks if they're too lazy to think for themselves. And no, the age and profitability of the company were NOT hidden in the "fine print"!

Many of you seem to believe in a system where most of us are allowed, even encouraged, to shut off our brains and expect the experts to always have the right answer, so that we all rake in huge amounts of money with no work and no risk. Well, the experts in this are never going to be all that much smarter, not enough so that the rest of us can coast and yet still outperform.

I can remember what it was like to teach finance to MBAs in spring semester 2000, and they were impossible in the first part, wanting to hear only about the "new economy", because "everything had changed". In vain, I gave them past examples of similar times of explosive growth due to technology shifts (for example, ordering over the internet has similarities to the time when the first catalogs came out - shop from the convenience of your home and have it delivered - and that led to explosive growth in the first few years, followed by a substantial slowdown in the growth rate). People who should have known better got carried away and didn't want to listen to reason.

There were plenty of us claiming that this was a bubble, but investors only wanted to listen to the cheerleaders. The bubble was driven by investors, although the professionals also got carried away and yes, they should have known better.

If we want to be prepared for the next bubble, we need to hold responsible everyone that played a major role, rather than rounding up just a few scapegoats so that the rest of us can pretend to have been innocent. If you're too lazy to think for yourself, then invest through index funds!

[ScentOfViolets]

There were plenty of us claiming that this was a bubble, but investors only wanted to listen to the cheerleaders. The bubble was driven by investors, although the professionals also got carried away and yes, they should have known better.

The problem with this narrative is the way in which it benefited various agents. If you were a grunt investor, the odds are good that your assets decreased in value from some time dated around 2002. If you were a professional, well, let's say that the odds aren't so good, and that even if many of these so-called professionals complain that their personal worth is down from some high in 2007 or 2008, it's still far, far higher than it was in 2002.

You also seem to be saying that outsiders should have been savvy enough to realize that an AAAA rating wasn't what it used to be, which seems to be pushing the 'they shoulda known better' meme to extremes. It's also inconsistent with the notion of the superior cognitive abilities of the Masters of the Universe.

[Eric Martin]

It's easy to look back now, with the benefits of hindsight, and say that the stocks didn't deserve those ratings

No, I'm talking about analysts that were emailing each other about how bad the companies were that they were telling the public were great. They were telling one story to the public to get the i-banking biz of the companies in question, while behind closed doors they were talking about just how bad those companies were.

That's not a question of hindsight. That's a question of fraud.

[Ann]

"No, I'm talking about analysts that were emailing each other about how bad the companies were that they were telling the public were great."

Can you be specific? I assume you mean Henry Blodget, but the e-mails I've been able to find (used by Spitzer to fuel his political campaign) were from summer of 2000. Remember that the 2000 crash wasn't like Oct. '87, where there was one very, very bad down day. In 2000 the market trended down from about March or April all the way through October or November, if I recall correctly. In summer of 2000, you're giving analysts way too much credit if you think that they "knew" whether the climb would start again or the fall would continue.

From the Henry Blodget e-mails I've been able to find, there was an internal debate where other analysts were recommending stocks that Blodget thought should be downgraded. Some analysts thought that the market would take off again, while others thought that it was time to get out of many of the stocks that had looked good a year earlier.

If you have other specific evidence or know where I can find the complete set of Blodget e-mails used by Eliot Spitzer, I'd be interested in learning more. But it's not enough to quote vague rumors or the politically motivated claims of Spitzer, who clearly had his own biases and agenda.

[Eric Martin]

Ann,

I'm not quoting vague rumors.

I worked on some of these cases, and saw dozens of emails from analysts other than Blodgett. There were also discussions amongst senior bank reps about the importance of not alienating clients with negative research reports dating to pre-2000 - and to assign research teams to cover companies whose biz they wanted to solicit. Surprisingly, those targeted companies always got Buy or Accumulate ratings.

As for Blodget, in one of the more infamous emails he describes a stock that he was giving buy ratings to as "piece of shit."

Also, these emails and other correspondence were not used to fuel a political campaign, but to build legal cases against these banks. Successful legal cases I might add.

Here's some of that evidence:

http://www.sec.gov/litigation/complaints/comp18115b.htm

[Eric Martin]

Frex:

On November 15, 2000, a junior analyst e-mailed Blodget and stated, "[another firm] initiated on GoTo.com with a buy . . . i guess they are angling for the M&A [mergers and acquisitions] business too!"

What do you think he meant by that? Angling for their business too? Odd.

Later that day, same analyst:

who are we trying to please by doing a 2-2 ? I don't want to be a whore for f-ing mgmnt. if 2-2 means that we are putting half of merrill retail into this stock because they are out accumulating it, then I don't think that's the right thing to do. we are losing people money and I don't like it. [hypothetical retail clients] john and mary smith are losing their retirement because we don't want [GoTo's CFO] to be mad at us. [Merrill Lynch's investment banking relationship manager for GoTo] said he is fine with a 3-2 (I said to him the whole idea that we are independent from banking is a big lie — without banking this would be a 3-2 and he said "no-you guys are independent you can do what you want — I'm fine with that["] -I would put it back to the company to convince you that there is a reason you should own this at 54x [year 2002 earnings per share]. . . so that's my feeling. . . .

What do you think he meant when he said they were shaping their ratings to please the CFO of GoTo.com?

What do you think he meant when he said that research wasn't independent? That it was a lie?

[Eric Martin]

More:

an institutional client e-mailed Blodget to ask, "What's so interesting about Goto except banking fees????" Blodget replied, "nothin."

What do you think that client meant? Why would the client suggest that banking fees would influence ratings, and why would Blodget confirm that?

And on, and on, and on...

[Rebecca]

The idea that if-I don't-do-X-than-someone-else-will doesn't exempt the actor from having done something shady and/or illegal.
Those of us with an actual moral compass get out of the business when put in that situation.

[Ann]

Thank you for posting the link to the legal case against Blodget. I'm not questioning the idea that the "Chinese wall" is imperfect, and that analysts consider the implications of their ratings on underwriting business, as well as on their own personal ratings, the desires of investors and future access to the company management. The practice of tying analyst bonuses directly to underwriting business was a very bad idea.

But what’s most striking about the case against Blodget is how little you came up with regarding what he and other analysts believed and said about the stocks. I’m assuming that he was singled out because the case was strongest against him, and you say you went through dozens of e-mails, and yet this was all you could find?

On the example you mentioned about Lifeminders, Blodget recommended the stock when it was trading at over $22 in Sept. 2000, but by December, just a few months later, the price had fallen to around $4. You quote an e-mail from him indicating that he’s not happy that the price has fallen by that amount, but is that odd? Are you concluding from this that he “knew” that the price was likely to go from $22 to $4 but recommended it anyway? Or are you questioning why he would think that it was a good buy at $4, given that he had earlier thought that the future prospects of the company justified a price significantly higher than $22?

On GoTo.com, Blodget gave a cynical comment when someone asked him what was so interesting about it (“nothin”), but how is that inconsistent with the rating he gave, which was neutral (3) in the short term as well as high risk (D)? His report initiating coverage said “Given the current weak environment for online advertising, we do not see any near term catalysts. We expect the market to improve in 2H 2001, however, and we believe that GoTo will be a survivor.” This is what the case alleges is “contrary to privately expressed negative views”?

Blodget initially gave GoTo a 3-1 (neutral-buy) rating, probably one of the lowest ratings he gave (since there is, after all, no reason to waste time covering 4’s or 5’s when there’s not enough time to cover all the 1’s through 3’s). The only possible support for the legal case against him is that long term 1 rating, but after all, the stock later went up in price, so the rating in that sense was justified. GoTo did, in fact, turn out to be a survivor, as predicted.

In other words, the case took a few cynical comments that were part of the internal debate, and tried to turn them into some great widespread outstanding truth. The truth is that these stocks were very hard to value, and that the analyst’s job wasn’t to find the underlying fundamental value, it was to predict what would happen to the trading price, which often meant guessing what the day traders would pounce on next. A stock could, in fact, be a POS and yet worth buying from an investment standpoint, since the analyst's job was to predict what the herd would run for.

You totally exonerate the greedy, lazy day traders but expect analysts to perfectly predict the future actions of those day traders and yet at the same time to totally ignore the likely response of those day traders. The general conclusions on IPOs during the bubble is that they should have been priced higher, to avoid leaving money on the table, and at the same time they should have been priced lower, so that their long term performance would have been better. How does blaming everything on the analysts while excusing the lazy free-riding investors give us a system that will work better in the future?

Basically, these analysts were expected to be able to predict the future. You combed through all of their internal memos to find every internal debate and difference of opinion, and then you pounced on every expression of doubt without any attempt at a balanced look at what they were actually doing. You attacked Blodget because he had the intelligence and honesty to wonder if the bubble could really go on forever, but Mary Meeker was safe because she was even more naïve than the herd following her. The lessons that I give my students from all this are that 1) they should try not to get caught up in bubbles, but 2) if they ever are caught up in one, they shouldn’t express doubts or try to fix things, because the prosecutors go after the people that express misgivings and concerns, not the ones that are stupid to the end!