The dotcom Bubble

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Stock markets in the United States and elsewhere rose strongly in the 1980s and 1990s, interrupted only briefly by the crash of October 1987 (which, in retrospect, fostered the illusion that any decline in stock prices would be quickly reversed). By 1996, the boom had reached the point where, with the Dow Jones index at 8000, Alan Greenspan warned of the dangers of "irrational exuberance" in asset markets. Greenspan never repeated the warning and soon returned to his customary role as a cheerleader for speculative markets. However, the catchphrase was adopted by economist Robert Shiller as the title of a penetrating analysis of the role of self-deception and collective over-optimism in stock market bubbles.

The bubbles had raised stock prices in general, but it was propelled to new heights by the arrival of the "dotcom" sectors. The Internet, developed as a public service by the U.S. government research agency the Defense Advanced Research Projects Agency and by the university sector worldwide, was opened to commercial use in the 1990s, just as its most popular manifestation, the Worldwide Web, was coming online.

In 1995, the Mosaic web browser, created at the publicly funded National Center for Supercomputing Applications, was converted into a commercial product named Netscape, which formed the basis of a spectacularly successful IPO. The stock was set to be offered at fourteen dollars per share. But a last-minute decision doubled the initial offering to twenty-eight dollars per share. The stock's value soared to seventy-five dollars on the first day of trading, nearly a record for a first day gain.

Never profitable on an annual basis, Netscape was acquired in 1998 by America Online (AOL) in a stock swap that valued Netscape at U.S. $4.2 billion. A couple of years later, in the biggest merger in history, AOL

merged with Time Warner. The deal gave AOL a market value of more than $100 billion. In December 2009, AOL was spun off again, with an estimated market value of $3.15 billion, less than the value imputed to Netscape alone a decade previously.

The Netscape IPO and AOL takeover set the pattern for a string of ever-more dubious "dotcom" ventures, producing huge gains for investors despite the absence of significant profits, and in many cases, even revenues or products. The history of Netscape and AOL was mirrored by thousands of firms that attached the dotcom suffix to businesses selling items as mundane as dog food and garden supplies. Some were as spurious as that of the pioneering entrepreneur of the South Sea Bubble in 1713 who sold shares in "a company for carrying out an undertaking of great advantage, but nobody to know what it is." Indeed, whereas Netscape and AOL had substantial revenues, and AOL had a profitable business as an Internet service provider, the typical dotcom company never made a genuine sale, let alone a profit.

Speculation on dotcoms centered on the NASDAQ stock exchange.15 The NASDAQ index rose from 800 in the mid-1990s, to more than 5000 at its peak in March 2000 when it collapsed suddenly, falling below 2000.16 Hundreds of dotcom companies failed or were taken over at prices far below those of the late 1990s.

Even more than the complex global crisis now underway, the NASDAQ bubble and bust provided a sharp test of the Efficient Markets Hypothesis, a test that was failed egregiously. It was obvious, and pointed out by many observers, that the prices being paid for dotcom investments could not be justified on the basis of standard principles of valuation. Even if some turned out to be the spectacular successes promised in their business plans, it was impossible that the sector as a whole could do so. In fact, only a handful of dotcom firms ever produced sustained profits.17

15 A competitor to the New York Stock Exchange that had been established by brokers including Bernard Madoff, who confessed in late 2008 to having operated the biggest Ponzi scheme in history.

16 As of 7 July 2010, the index stood at 2159.

17 The most successful, Google, was not traded on the stock market until 2004, so its gains did not offset the losses of those who invested during the dotcom boom.

Previous bubbles might have been dismissed on the basis that the markets concerned weren't fully informed and transparent, or that speculators were prevented from betting against the bubble assets and thereby bringing prices back to earth. The dotcom bubble showed that none of these defenses worked.

As regards transparency, no market in history has been subject to such intense scrutiny and obsessive coverage as the NASDAQ of the late 1990s. Stocks and the companies that issued them were assessed by investment banks, stockbrokers, and the financial press. The dubious projections on which they relied were set out in prospectuses that warned (in a pro forma fashion) that they might not be fulfilled.

Speculators did attempt to burst the bubble. Julian Robertson of Tiger Investments, speculated that grossly overvalued tech stocks would decline in the late 1990s and lost billions when the stocks rose even further in 1999. He quit managing other people's money, telling clients that he no longer understood the markets.

Although the dotcom bubble and bust was spectacular, the 20002001 crash was at least equally significant for the exposure of corporate fraud on a scale unparalleled (at the time) since the 1920s. The two biggest frauds, Enron and Worldcom offered a sharp contrast. The Enron frauds relied on a complex network of trading schemes, special purpose vehicles, and elaborate accounting devices. By contrast, the managers of Worldcom simply invented revenue numbers that made the company look massively profitable when it was actually losing money hand over fist.

The Crisis of 2008

The bursting of the dotcom bubble spelled, or should have spelled, the end of belief in the strong forms of the Efficient Market Hypothesis. On the other hand, by exposing weaknesses in the systems that were supposed to keep financial markets operating properly, it gave regulators and financial institutions a chance to clean up, so that future outcomes could be more like those predicted by theory.

Neither of these things happened. Advocates of the Efficient Markets Hypothesis ignored the dotcom fiasco, and went on as if nothing had happened. The accounting scandals at Enron and other companies produced the Sarbanes-Oxley Act, which sought to reform corporate governance. But the act was limited and largely ineffectual. Within a year or two, the conventional wisdom of the financial markets was that Sarbanes-Oxley was an overreaction to isolated cases of fraud, and that a new push for deregulation was needed.

Financial institutions could disregard the failures of the dotcom bubble because of the (seemingly) successful operation of the Greenspan put. Rather than let the financial sector suffer the consequences of the bursting bubble, Greenspan relaxed monetary policy and inflated a whole new bubble, this time in housing.

The housing boom in the United States was not spectacular by global standards. Its crucial characteristic was that both the boom and the subsequent bust took place in all major markets simultaneously. As with the LTCM disaster a decade earlier, the models used by financial instruments to rate the riskiness of mortgages and assets derived from those mortgages incorporated the assumption that separate housing markets in the United States were largely independent of each other. So, a diversified portfolio of U.S. mortgages was highly unlikely to suffer losses on all or most of its holdings at once.

But the very transactions justified by the models undermined the assumptions on which they were based. The demand for diversified portfolios meant that lenders lowered their standards in all markets at once. Whereas previous U.S. real estate booms had been based on local factors leading to optimism about the prospects for particular markets, the boom of the early 2000s was based on a general belief that real estate, as an asset, was bound to go up in value.

This assumption was embodied in the construction and pricing of an ever more complex range of financial derivatives. The process began with the observation that, if house prices kept on rising, the absence of a down payment was not a problem, since the borrower's equity would rise with the price of the house. That in turn meant that it would be possible to refinance a loan on more favorable terms.

So, on this assumption, it made sense to offer "negative-amortization" loans, in which, for an initial period of two or three years, the borrower did not pay down the debt at all, but added to it. After the initial

"honeymoon" period, these loans were set to revert to much more stringent terms, but it was convenient for everyone to assume that, when the time came, the loan could be refinanced.

Based on these assumptions, investment banks were prepared to buy securities based on loans made by mortgage lenders such as Countrywide. The resulting loss of market share by Fannie Mae and Freddie Mac led these institutions to lower their standards.

Beginning in 2004, Fannie and Freddie entered the subprime market on a large scale, relying on their implicit guarantee to hold down borrowing costs. Increasingly competitive securitization also reduced the incentive of the original lenders to monitor the creditworthiness of borrowers; once they had packaged the mortgages into securities they were no longer exposed to the risk of default, and the demand for securities was so strong that quality was not a major problem.

The growth in demand for mortgage-backed securities reflected a range of innovations, such as the rise of bond guarantors, and the development of collateralized debt obligations (CDOs). Using these devices, a portfolio of mortgage-backed securities was transformed into a set of assets some of which were supposed to pay off even in the event of a downturn in local housing markets. The possibility of a national downturn was excluded from consideration in the models used to rate these securities.

These and other devices, combined with optimistic assumptions about default and repayment rate, made it appear that the risks associated with lending could be made to vanish. With the blessing of ratings agencies such as Moody's and Standard & Poor's, loans to people who might have neither a regular income, nor a job, nor any asset except the house itself were transformed into "super-senior" bonds given the same AAA credit rating accorded to the U.S. government itself.18

By late 2006, loans to borrowers with weak or nonexistent credit formed the basis of an inverted pyramid amounting to trillions of dollars of spurious assets created by banks and hedge funds around the world. Some of these institutions were explicitly backed by national governments. Many others were "too big to fail" or, more precisely, too interconnected to fail. Given the complex and fragile web of financial

18 The acronym NINJA (no income, no job or assets) was used to describe these borrowers.

transactions built up since the 1970s, the breakdown of even a medium-sized player could bring the whole system to a halt.

The stage was set for a global economic meltdown. The crisis built up slowly over the course of 2007, as the growth in house prices slowed, and "subprime" borrowers faced foreclosure. By mid-2007, the problems had spread more widely, to classes of borrowers seen as less risky. CDOs and other derivatives, originally rated as AAA, were downgraded on a large scale and some went into default.

Throughout all this, the dominant view, informed by the Efficient Markets Hypothesis, was that nothing would, or could, go badly wrong. It was not until investment bank Bear Stearns was rescued from imminent bankruptcy in March 2008, that confidence started to crack. By this time, as the National Bureau of Economic Research subsequently determined, the U.S. economy had been in recession for several months. But as late as August 2008, the most common response from financial markets was that of denial.

The meltdown began with the sudden nationalization of the main U.S. mortgage agencies, Fannie Mae and Freddie Mac in early September 2008. Two months later, the investment banking industry had collapsed, with Lehman Brothers bankrupt, Merrill Lynch swallowed by Bank of America, and Goldman Sachs, and JP Morgan forced to seek the safety of government guarantees, by becoming bank holding companies. A year later, the list of casualties included banks around the world, whole countries such as Iceland, and the archetypal embodiment of corporate capitalism, General Motors.

Every bubble in history has come with a story to show why, in the worlds of Carmen Reinhart and Ken Rogoff, "this time it's different." But the current crisis has two features that should spell the end of the Efficient Markets Hypothesis once and for all. The first is that, in scale and scope, it is larger than any financial failure since the Great Depression. The estimated losses from financial failures amount to $4 trillion or about 10 percent of the world's annual income. Losses in output from the global recession are also likely to be in the trillions before the world economy recovers.

And, unlike the Great Depression, this crisis was entirely the product of financial markets. There was nothing like the postwar turmoil of the 1920s, the struggles over gold convertibility and reparations, or the Smoot-Hawley tariff, all of which have shared the blame for the Great Depression. Financial markets and major banks were lightly regulated by governments under systems that relied, in large measure, on risk assessments undertaken by the banks themselves, and based, in large measure on the ratings issued by agencies such as Standard & Poor's and Moody's.

All of the checks and balances in the system failed comprehensively. The ratings agencies offered AAA ratings to assets that turned out to be worthless, on the basis of models that assumed that house prices could never fall. This was not simple incompetence. The entire ratings agency model, in which issuers pay for ratings, proved to be fundamentally unsound. But, these very ratings were embedded in official systems of regulation. Thanks to the Efficient Markets Hypothesis, crucial public policy decisions were, in effect, outsourced to for-profit firms that had a strong incentive to get the answers wrong.

To these systemic failures was added the exposure of long-running fraud on a massive scale. The Ponzi scheme operated by Bernie Madoff, former head of the NASDAQ exchange and leading light of the New York financial sector, took place on a scale that matched the gargantuan growth of the financial sector itself.

The original Ponzi scheme, promoted by Charles Ponzi in 1920 on the basis of bogus investments in postal coupons, brought in an amount equal to $5 million in today's value. Madoff estimated the proceeds of his racket at $50 billion—ten thousand times Ponzi's take. And while Madoff put others in the shade, the collapse of the bubble brought to light a string of frauds involving tens or hundreds of millions of dollars.

The cases of Madoff and other frauds brings to mind J. K. Galbraith's idea of the "bezzle." The bezzle is the amount of undetected corporate fraud. As a boom continues, and everyone does well, people realize they can siphon off money and use it to make even more money. If they are threatened with detection, the original amount stolen can be returned to the till, and they are still ahead. But, in a crisis, this can't be done and, in any case, outside accountants are all over the books. So, embezzlers are caught and the bezzle shrinks. It stays small in the early stages of recovery when most decisions are being made by the cautious types who survived the crisis. But as the boom continues, hungrier and less risk-averse types come to the fore and the bezzle begins to grow again.

Under a system where the financial sector grows out of proportion to the real economy, and where, by virtue of the Efficient Markets Hypothesis, values recorded in financial markets are taken to be real, however absurd they may seem, the bezzle grew to unprecedented magnitudes.

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Responses

  • charlie
    What reversed the dot com bubble burst?
    25 days ago

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