"Buy, Lie and Sell High"

How investment banks sold the American economy down the river.

Published August 6, 2002 7:30PM (EDT)

The U.S. markets' precipitous decline over the past two years has erased trillions of dollars from the country's economy since the heady peak of spring 2000, when the NASDAQ hovered at the 5,000 mark, the Dow was flirting with 12,000, and the advantages of a Porsche Boxster and Aeron chair seemed within reach for even the humblest of investors.

Stories of scandal and loss -- big and small, international and local -- have filled the business pages ever since. But lost in the shuffle of the headlines made by the likes of Enron, WorldCom and Global Crossing was an earlier wave of failures, the once promising online startups that crashed to earth with the bursting of the Internet bubble.

Public attention has been fixated on the sorry images of one CEO and CFO after another making a solemn pilgrimage to Congress to account for the loss of billions of dollars in shareholder equity in huge publicly traded companies. But precious little has been offered to explain the social and economic forces that set the stage for their collapse.

In his new book," Buy, Lie and Sell High: How Investors Lost Out on Enron and the Internet Bubble," D. Quinn Mills sets out to analyze what happened. A professor of business administration at the Harvard Business School and the author of a number of books on the high-tech industry, Mills argues that the bubble in Internet and technology-related stocks that developed in the U.S. and international stock markets during the late 1990s was evidence, not of the "irrational exuberance" of ordinary investors, but of a complete ethical collapse on the part of major investment banks, brokerage houses and even the Federal Reserve.

Instead of serving as gatekeepers to the financial markets and shepherds for young companies, as they had traditionally done, Mills says, investment banks such as Merrill Lynch and Salomon Brothers rushed scores of fledgling technology and Internet-based commerce companies to market knowing full well that their business models were suspect and their prospects for success dim.

The reason, he says, was simple: Investment banks collected substantial fees for taking companies public -- more than $600 million in fees for companies whose stocks are now trading below $1, according to one report. Even more, the huge opening-day "pops" in share value that accompanied so many dot-com IPOs became a commodity in themselves, which investment banks could mete out to their clients, business partners and other privileged insiders for a quick return. The net effect, Mills says, was a massive redistribution of wealth from the hands of the many ordinary -- or "retail" investors -- to the pockets of financial insiders, venture capitalists and the moneyed elite.

Mills spoke to Salon by phone from Maine:

You take the title of your book from a quote that the SEC chairman used to describe Jonathan Lebed, the New Jersey teenager who was accused of posting erroneous information on the Internet to manipulate stock prices. Is his story emblematic of the ills of the Internet mania?

Well, yes, I thought it was emblematic because in a certain sense, that's what very sophisticated financial institutions were doing. They were getting control of stock in any of a number of ways, touting it -- saying it was great -- selling it to the public and walking away with a bundle. The problem is what they were saying about the companies was not true.

A point you call attention to throughout this book was the willingness of otherwise sophisticated business people, investors and bankers to ignore or discount established business practice and rules of thumb. With eToys.com, for example, you point out that it didn't take much to see that the company would face serious competition from entrenched brick-and-mortar companies like Toys 'R' Us -- competition that would make their sales goals ($900 million in sales before eToys could turn a profit) difficult to attain. How do you account for this?

I think it was self-interest. The investment bankers made their money, not on the stock, but on the fees they made in taking the companies public. So they were not long-term investors. And I think they ceased to care whether or not the companies had a real future.

As for the venture [capitalists], they were prepared to try to get out early. They saw an opportunity to build a company and then to sell it quickly and take their profits and run.

What happened was a complete collapse -- almost an ethical collapse -- of their feeling of responsibility toward shareholders, the public who would buy shares in the companies.

Now some of them will say that they believed in the companies -- that they believed in eToys, that they thought it could be successful, that they liked its leadership. But if you look at the way that they behaved -- in the [case of eToys] and of the Internet bubble generally -- it was quite different. If they really had confidence in these companies, it wasn't based on their past experience, because in the past they hadn't done things in the same way. They hadn't looked for the same kind of leadership. They hadn't looked for the same kinds of business plans or business models. They hadn't taken the same time frame.

Was there a kind of "Aha!" moment at which the rules of thumb and the knowledge that was built on years of experience was thrown out?

It happened about 1997, and it was a combination of things rather than a single moment. It was the success of Amazon.com in building their business fast and getting a very substantial valuation even though [Amazon] was not at all profitable. I think a lot of people [in the financial field] looked at that and said, "My god. If they can sell that kind of stock to the public, why can't we do it?" And as more people began to bring these kinds of companies public, the people within the industry who had held back -- the people who didn't think this was proper, or that it wasn't going to work in the long term, or that it wasn't legal, or whatever -- began to say, "Everybody else is doing it, so if we don't do it, we're not in business." So rather than a single moment, it was more of a steady buildup over a period of time.

When many people think of "dot-com IPO" they tend to think of sky-high valuations, but you actually contend that investment banks undervalued dot-com shares that were offered to the public. Could you explain this?

In the midst of the Internet bubble, you had two things going on. The sales forces of large brokerage houses and mutual funds, along with the business media -- and even the chairman of the Federal Reserve -- were hyping the idea, very strongly, that this was a new economy. New rules applied. There was a permanently higher level of valuation. Et cetera. So there was a willingness to pay substantially for shares in these companies.

Now you have an investment bank that brings a new company public. In that kind of an environment, with a major investment bank sponsoring that company and a major venture firm standing behind it, people would be willing to pay a great deal.

The investment banks were slow to understand, I think, how much the demand had increased for these things. There weren't a lot of shares available, if you look at the total demand, and so they were pricing them high by the standards of the investment banks -- and by the way, the investment banks actually knew a good bit more about these companies than the people they were selling [the companies] to, and they weren't telling them what they knew. The banks knew the companies were much weaker than they were representing them to be. So the banks were setting the initial offering prices somewhat more modestly than the circumstances provided.

The result of that was that there was a big rise in the value of the shares the minute they went public. So if you took it public at $10, the initial trades would be at $20 and $25. That created a huge amount of value that could be handed to friends of the investment banks.

Who were in turn "flipping" the stock?

Yes. If you got the stock at $18 and sold it immediately, you could double your money. That was an asset, if you will. And the investment banks began allocating those assets to their friends. And that's one of the practices that is being investigated today.

Why was that bad for the companies involved?

The companies got money in their IPO based on the [initial offering price of] $18. If the stock is immediately selling for $36, the companies could have gotten the difference, not friends of the investment banks. In a sense, the companies were being robbed. This wasn't discussed in the press, but it was a huge issue with the management of these companies. Because, in a sense, suppose they took 2 million shares out at $10 a share. They get $20 million back less what they pay to the bank. But if the stock is selling immediately at $20 a share, they would have gotten $40 million for the company to use and have paid essentially the same fees.

This is evidence of colossal wrongheadedness on the part of institutions that most Americans thought were pillars of our economy. Do you see any evidence that these institutions are chastened by what has happened?

Investment banks are chastened and some are downright frightened. They think they may have peripheral liability. On the other hand, all the incentives remain in place for institutions to continue to do what they did. I think its certain that this will happen again -- and maybe even on a bigger scale. I don't know exactly when and I don't know what form exactly it will take. It could be another Internet bubble. It could be another technology bubble, just not the Internet -- something in the biotech industry, maybe. On the other hand it could be something quite different. The incentives to make a great deal of money without the likelihood that you're going to have to give much of it back -- the reality is our laws have neither stopped this nor punished it.

How does Washington's reaction compare to its reaction to previous bubbles? I'm thinking about 1929, in particular, but there have been others as well.

Well, there was a huge difference in the government's reaction in '29. Back then we set up a whole new regulatory scheme and a whole new and substantial body of law. The difference now is that same body of law is still in effect and people have figured out how to get around it. People do that in 70 or 80 years. And the law was not effective in preventing this [Internet bubble] at all.

The changes to the law that are being debated now in Congress are useful, but they're very limited. They do not address the crazy-quilt pattern of regulations that we have, which has huge gaps in it that often protect the most sophisticated investors and leaves the least sophisticated to the whims of the market, which is exactly the opposite of what its supposed to do. [Congress] is not really trying to make any sense of that. They're proposing some additional regulations in some areas -- regulations that in many instances we're not even certain are going to be effective. So the response out of Washington this time thus far is much less than is merited and much less than happened [in the wake of previous crashes].

Alan Greenspan famously frowned on the run-up in stock prices as "irrational exuberance," a term that is likely to go down in history. What are the history books going to say about what he actually did to prevent any of this?

I think they're going to say that he did very little to prevent it and a lot to encourage it.

[Greenspan] spoke about "irrational exuberance" I think in 1996, and then really did not return to that theme -- the Fed did really not tighten money as it should have to slow down this asset bubble. The Fed debated this continually; the regional Fed banks debated it. The national Fed debated it -- whether or not the Fed should intervene to stop this bubble from inflating, and they chose not to do it. In fact, Greenspan was continually heaping praise on the new economy and talking about a "new plateau of low inflation and high productivity in the American economy" -- all of which he knew perfectly well was being interpreted as an endorsement of the [Internet] bubble.

You group Enron with the rest of the dot-com companies, not because it was a technology company per se, but because it used the enthusiasm of the bubble to its own ends. Could you explain that?

Enron was the old-economy company -- a kind of slow-moving energy company -- which was most effective in the capital markets at turning itself into a new-economy company. It became an Internet-based trader in energy, futures and that sort of thing. It reinvented itself as an Internet company. And that's the reason [it is included in the book]. It's the bridge between the old economy and the new economy in the period of the Internet bubble. It did most successfully what a whole lot of other companies wanted to do.

What they didn't know then -- and I didn't fully understand because we're learning more about it day by day -- was the degree to which that wasn't real but was based on fraud.

You look at and profile a number of German dot-coms in your book in addition to American companies. Where did the idea to mirror the bubble in Germany and the U.S. come from?

It had been remarked on a number of times that the same kind of bubble was going on in Europe and particularly in Germany. Dot-com companies, Internet companies, et cetera. And so I got interested in -- since that had happened -- in what had been the consequences. Had they been the same as the United States'?

The answer is that they had largely been the same in terms of the volatility of the market. They had been largely the same in terms of their impact on the companies -- the dot-com entrepreneurs. They had been largely the same in terms of the causes, the way that the banks and the venture firms had changed what they were doing.

Where they had been different was in their consequences for investors, because Germany does not permit anywhere near the amount of pension money and life savings of people to go into the stock market as we do here. And we only started that a few years ago, where we started to allow people to seriously manage tax-protected pension funds on their own. So what we did was essentially to draw all these people in. A much larger percentage of the American population is in the stock market than in Germany: almost 50 percent [of Americans], which is enormous. In Germany it's much lower than that -- back where we used to be -- and they have much stronger controls and regulations.

You note early on in your book that the Internet bubble amounted to a huge redistribution of wealth from the many [retail investors] to the few [VCs, investment banks and other insiders]. What do you think the long-term consequences of that redistribution will be?

Very hard question. Two or three things. I think [the Internet bubble] was something that the financial markets or institutions liked. In my book, I quoted one industry insider as saying that the problem wasn't the bubble -- it was its aftermath. So there will be tremendous incentives to try to do the same thing again. No matter how much people are now wringing their hands and saying, "Oh, we have a hangover. We shouldn't have done that." The reality is that there are tremendous incentives to try to repeat it because it was so successful for them.

The second thing is that it has created a huge crisis of confidence in the capital markets. That's the reason that the president and the Fed can't get this thing under control and why these bills that are being reconciled in Washington are not stopping the slide of the market. It's taken people a while to understand that the money they lost in the markets is not coming back. That many of those companies are gone for good -- and so is their money. They're only really beginning to understand that now, as you see people [who were retired] going back to work, et cetera. And I think [ordinary investors] now feel like the markets are a deck that's stacked against them.

What do you think the 1990s would have looked like had investment banks and stock analysts and venture capitalists stuck to their "principles" and to conservative business practices, rather than throwing all those things out the window?

Same level of economic growth. Same or a little less inflation. There would have been a better economy and you wouldn't have had the economic recession we're in now with the risk of a substantial decline behind it. So you would have simply have had better economic growth. [The Internet bubble] did not contribute to the success of the American economy during [the 1990s]. In fact, if anything, it constrained it. And when it bust, it risked it entirely.

By Paul Roberts

Paul F. Roberts is a writer living in Watertown, Massachusetts.

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