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Origins of the Crash by Roger Lowenstein (Penguin Press, 259 pages, $24) Sometime in the late 1990s, the economy acted out an old joke in which the entrepreneur claims to offer prices so low, they’re below cost. An accountant asks, “So how do you expect to make money?” The entrepreneur, grinning, says, “Volume.” Or perhaps a better illustration is the classic “Road Runner” cartoon: Wile E. Coyote is always running straight off a cliff, yet still charges forward until he finally looks down and notices that the ground is a thousand feet below. Only then does he fall. In the heady six years between the rise of Netscape and the fall of Enron, the market for high-tech stocks charged ahead like the coyote in midair, and some ventures literally tried to profit by volume on transactions that created no value. By 2001, the coyote was looking down. Philip Gourevitch said it best in a February 2004 article in The New Yorker, describing the Internet stock bubble as “insular and sustained by collective belief rather than by any objective external reality.” (Actually, Gourevitch was describing Howard Dean’s presidential bid as “a political Internet bubble” on the basis of those attributes, and the analogy stands.) Wall Street Journal veteran Roger Lowenstein deconstructs the ’90s boom and 2001 bust in Origins of the Crash: The Great Bubble and Its Undoing. His thoughtful history of the “bubble” offers explanations, not excuses; if anything, Lowenstein leaves the reader stunned by the joint and several recklessness, even foolishness, of a whole generation of CEOs with nine-figure packages. The trouble began with the insularity, the clubhouse atmosphere, of the boardroom. Directors are supposed to manage, evaluate, and even discipline the CEO — but by the late 20th century, as Lowenstein observes, “the typical board was larded with the CEO’s cronies, even with his golfing buddies. They were generally as independent as a good cocker spaniel.” Congressional hearings in the 1930s traced the crash of 1929 to a long and stunning pattern of insider trading and stock price manipulation, and “it is startling,” Lowenstein writes, “how similar these stunts were to episodes of the ’90s.” Congress had responded in the ’30s by creating the Securities and Exchange Commission, but half a century later, “so much recurred that one almost wondered if the government had adopted any protections at all.” Despite the attention they command on the evening news, stock market averages are meaningless on a day-to-day basis, or even on the scale of years; only in the long term — looking back on the 20th century, for instance — do stock averages reflect useful information about economic trends. If you plan to cash out a mutual fund next week, a crash tomorrow will hurt, but stock market averages have never declined over the long term. In the 1980s, some executives tried to downplay the role of stock prices in strategic planning. U.S. companies flirted with the Japanese business model, emphasizing quality output and looking “toward relationships, not markets; toward deeper strategy, not daily stock quotes.” Wall Street laughed — and responded with a spate of leveraged buyouts. Relatively small-time traders could suddenly borrow billions of dollars against junk bonds and acquire established corporations. Lowenstein recounts the paradigm case of Ronald Perelman buying Revlon with the anticipated value of Michael Milken’s bonds; “with the raiders armed with debt,” he writes, “no company was safe.” In the boardroom, if not in the econ classroom, stock prices mattered a lot. And as stock prices rose, so did CEO bonuses and options — set by directors who, in turn, served as CEOs of other companies and enjoyed compensation packages based on those of their peers. Often, the dual roles of executive and director were vested in the same person, a “Chairman and Chief Executive” — a distinctly American twist on corporate structure. “But think how inappropriate would the description President and Chief Justice sound,” notes Lowenstein, “or Head Coach and Quarterback. The board’s job, like that of the coach, is to monitor those on the field.” The inbred society of the boardroom convinced itself that “stock options were free” and could be lavished on executives without affecting the bottom line. But, Lowenstein explains, “when executives exercised options, many companies turned around and repurchased an equivalent number of shares at the higher prices prevailing in the market, an expenditure that cost corporations such as Microsoft billions. But since it did not appear in the earnings statement, it had no effect on the number watched by Wall Street. Stock options were not costless; it was just that their cost went unaccounted for.” Companies did recognize the cost of options and claim the appropriate tax deductions, but the cost was not reflected in reports to shareholders. In 1993, the Financial Accounting Standards Board proposed new rules that would have reflected options in a company’s statement of earnings, and the outcry against such disclosures ranged from a Senate resolution sponsored by Joseph Lieberman (D-Conn.) to a rally where the California state treasurer chanted, “Give stock a chance.” (Lowenstein surmises that it was the only protest rally ever held against a proposed accounting standard.) In the end, the cost of options was added to shareholder reports as a required footnote. Increasingly popular as an alternative place to hide liabilities was the “special-purpose vehicle,” a legally distinct holding company that purchased some of a corporation’s assets and obligations. For example, Lowenstein recalls, “Dura Pharmaceuticals . . . used an SPV to move the cost of research and development off its books, so that investors saw only the benefits of selling drugs, not the burden of developing them.” The practice wasn’t exactly illicit, but some auditors expressed concerns — and corporations responded by shopping around for auditors who didn’t express concerns. The chain of events that led to the Arthur Andersen scandal was set in motion. (It progressed through the growth of consulting services provided by accounting firms, a conflict of interest most brazenly reflected in an accounting industry pamphlet called “Make Audits Pay: Leveraging the Audit into Consulting Services.”) The use of SPVs to improve a company’s balance sheet won Enron Chief Financial Officer Andrew Fastow a finance industry award in 1999 — an award given to Scott Sullivan of WorldCom the previous year and to Mark Swartz of Tyco the following year. “That all three winners were eventually indicted,” notes Lowenstein, “testifies to Wall Street’s weakness for (too-) clever financiers.” Still, Lowenstein does not accuse CFOs or auditors of premeditated fraud. He compares them to a bank teller who borrows a few bucks with every intention to pay it back, and one obfuscation leads to another until executives are shown on the evening news in handcuffs. Moreover, the transgression is not the practice of handing out stock options like popcorn or of stashing liabilities in SPVs — the transgression is the failure to disclose real costs and liabilities to shareholders. The essence of the New Deal reforms was not regulated conduct, but regulated accounting; transparency is described in a 1996 Columbia Law Review article quoted by Lowenstein as “an eleventh commandment of American life generally, not just of financial markets.” If huge CEO bonuses and SPVs are good for the bottom line, inform the shareholders and invite their vote of confidence in the form of continued investment. But the rising tide did not lift all boats — just the yachts. Lowenstein cites The New York Times’ Paul Krugman reporting that the boom did not trickle down, that median household income rose in real purchasing power by just half a percent a year. “In other words,” Lowenstein explains, “the Americans who constituted the lower half — not the lowest tenth, not just the jobless or the people on society’s margins but the lower half — librarians, checkout clerks, forest rangers, and so on, did not participate in the boom at all.” The insular and self-serving culture of the ivory tower had set the stage, but wasn’t the tragedy itself. The tragedy played out as a “mania” for stock in Internet companies with no earnings — and Lowenstein defines mania as “a mass refusal to acknowledge reason — even a mass indifference to reason.” Case in point: In September 1998, eBay went public at $18 a share and was trading at $48 that afternoon and $241 at the end of the year, with a market capitalization 1,800 times its earnings. And eBay survived the bubble; a more typical venture, Theglobe, earned $2.7 million in its first nine months, went public, and amassed a market cap of $1 billion in a matter of minutes, but didn’t survive. Venture capital companies rushed startups into IPOs, where the public would pay stock prices inflated by whole orders of magnitude. Investors backed Internet companies “almost irrespective of their prospects for success, for it was apparent that, with the help of Wall Street, they could readily sell at a higher price.” Of course, nobody ever saw a Theglobe truck pull up and unload a fresh batch of Theglobe products. A growing bulk of American capital was misdirected, invested in ventures that would never net a dime. The market value of the startup eToys was two to three times that of Toys ‘R’ Us, a point Lowenstein cites to illustrate Wall Street’s sudden allergy to traditional business models. In 1999, the Dow Jones Industrial Average gained 25 percent, but “the median stock was flat, meaning that half of all stocks were falling or failing to rise. And those, of course, were the half in the old economy.” The merger of Time Warner and AOL in January 2000 seemed like the definitive passing of the torch from the old economy to the new; it turned out, instead, to be the peak of the boom. Two months later, Internet stocks began to slip, and the coyote glanced down: “Stripped of the element of belief, dot-coms had nothing to sustain them.” Internal alarms went off at Enron, too, in the spring of 2000, but it would be another year before Fortune reporter Bethany McLean asked the quietly devastating question: How did Enron make money? It seemed almost churlish to notice that the new economy was based on fiat value, not on actual stuff. Economic history as a field of study carries a unique burden, as Lowenstein cites John Kenneth Galbraith: the point is to illuminate whether specific events or trends are likely to recur. And stock is a unique asset, as its value is derived from hopes and expectations, not from concrete properties. Lowenstein’s most compelling message here is that stock booms, by their nature, tend to elude the mechanisms that could construct a safety net — there will always be extremes in the business cycle, but the time to brace for them is in the relatively tranquil intervals. It’s early in the book, in a look at the politics of regulation in the early Bill Clinton years, that Lowenstein makes the point to take home: “Driving at thirty miles an hour a man accepts the speed limit without hesitation; at eighty miles per hour he yearns for freedom. Unfortunately, this is when regulation is needed most. History has shown that Wall Street is most apt to cross an ethical line when seven-figure bonuses abound. But good times are precisely when the public is least interested in regulation.” Oops. Maybe next time. Mike Livingston is a free-lance writer based in Takoma Park, Md. He is the lead author of The Newcomer’s Handbook for Washington, D.C., 3rd edition, published by First Books in 2002. His next book, The Newcomer’s Handbook for the USA, is due later this year from First Books.

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