Why Wall Street Always Blows It
Excerpt:
Well, we did it again. Only eight years after the last big financial boom ended in disaster, we’re now in the migraine hangover of an even bigger one—a global housing and debt bubble whose bursting has wiped out tens of trillions of dollars of wealth and brought the world to the edge of a second Great Depression.
Millions have lost their houses. Millions more have lost their retirement savings. Tens of millions have had their portfolios smashed. And the carnage in the “real economy” has only just begun.
What the hell happened? After decades of increasing financial sophistication, weren’t we supposed to be done with these things? Weren’t we supposed to know better?
Yes, of course. Every time this happens, we think it will be the last time. But it never will be.
First things first: for better and worse, I have had more professional experience with financial bubbles than I would ever wish on anyone. During the dot-com episode, as you may unfortunately recall, I was a famous tech-stock analyst at Merrill Lynch. I was famous because I was on the right side of the boom through the late 1990s, when stocks were storming to record-high prices every year—Internet stocks, especially. By late 1998, I was cautioning clients that “what looks like a bubble probably is,” but this didn’t save me. Fifteen months later, I missed the top and drove my clients right over the cliff.
Later, in the smoldering aftermath, as you may also unfortunately recall, I was accused by Eliot Spitzer, then New York’s attorney general, of having hung on too long in order to curry favor with the companies I was analyzing, some of which were also Merrill banking clients. This allegation led to my banishment from the industry, though it didn’t explain why I had followed my own advice and blown my own portfolio to smithereens (more on this later).
I experienced the next bubble differently—as a journalist and homeowner. Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early. Figuring that the roaring housing market was just another tech-stock bubble in the making, I rushed to sell my house in 2003—only to watch its price nearly double over the next three years. I also predicted the demise of the Manhattan real-estate market on the cover of New York magazine in 2005. Prices are finally falling now, in 2008, but they’re still well above where they were then.
Live through enough bubbles, though, and you do eventually learn something of value. For example, I’ve learned that although getting out too early hurts, it hurts less than getting out too late. More important, I’ve learned that most of the common wisdom about financial bubbles is wrong.
Who’s to blame for the current crisis? As usually happens after a crash, the search for scapegoats has been intense, and many contenders have emerged: Wall Street swindled us; predatory lenders sold us loans we couldn’t afford; the Securities and Exchange Commission fell asleep at the switch; Alan Greenspan kept interest rates low for too long; short-sellers spread negative rumors; “experts” gave us bad advice. More-introspective folks will add other explanations: we got greedy; we went nuts; we heard what we wanted to hear.
All of these explanations have some truth to them. Predatory lenders did bamboozle some people into loans and houses they couldn’t afford. The SEC and other regulators did miss opportunities to curb some of the more egregious behavior. Alan Greenspan did keep interest rates too low for too long (and if you’re looking for the single biggest cause of the housing bubble, this is it). Some short-sellers did spread negative rumors. And, Lord knows, many of us got greedy, checked our brains at the door, and heard what we wanted to hear.
But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.
To understand why bubble participants make the decisions they do, let’s roll back the clock to 2002. The stock-market crash has crushed our portfolios and left us feeling vulnerable, foolish, and poor. We’re not wiped out, thankfully, but we’re chastened, and we’re certainly not going to go blow our extra money on Cisco Systems again. So where should we put it? What’s safe? How about a house?
House prices, we are told by our helpful neighborhood real-estate agent, almost never go down. This sounds right, and they certainly didn’t go down in the stock-market crash. In fact, for as long as we can remember—about 10 years, in most cases—house prices haven’t gone down. (Wait, maybe there was a slight dip, after the 1987 stock-market crash, but looming larger in our memories is what’s happened since; everyone we know who’s bought a house since the early 1990s has made gobs of money.)…
….By the spring of 2007, we’ve finally caught up to the market reality, and our luck finally changes: We make an instant, aggressive bid on a huge house, with almost no money down. And we get it! We’re finally members of the ownership society.
You know the rest. Eighteen months later, our down payment has been wiped out and we owe more on the house than it’s worth. We’re still able to make the payments, but our mortgage rate is about to reset. And we’ve already heard rumors about coming layoffs at our jobs. How on Earth did we get into this mess?
The exact answer is different in every case, of course. But let’s round up the usual suspects:
• The predatory mortgage broker? Well, we’re certainly not happy with the bastard….
• Our sleazy real-estate agent? We’re not speaking to her anymore,…
• Wall Street fat cats? Boy, do we hate those guys,…
• The SEC? We’re furious that our government let this happen to us,…
• Alan “The Maestro” Greenspan? We’re pissed at him too…
• Bad advice? Hell, yes, we got bad advice…
Still, except in cases involving outright fraud—a small minority—the buck stops with us. Not knowing that the market would crash isn’t an excuse. No one knew the market would crash, even the analysts who predicted that it would. (Just as important, no one knew when prices would go down, or how fast.) And for years, most of the skeptics looked—and felt—like fools.
Everyone else on that list above bears some responsibility too. But in the case I have described, it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone on that list acted just the way you would expect them to act under the circumstances…
…Those are said to be the most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street…
When I was on Wall Street, the embryonic Internet sector was different, of course—at least to those of us who were used to buying staid, steady stocks that went up 10 percent in a good year. Most Internet companies didn’t have earnings, and some of them barely had revenue. But the performance of some of their stocks was spectacular.
In 1997, I recommended that my clients buy stock in a company called Yahoo; the stock finished the year up more than 500 percent. The next year, I put a $400-a-share price target on a controversial “online bookseller” called Amazon, worth about $240 a share at the time; within a month, the stock blasted through $400 en route to $600. You don’t have to make too many calls like these before people start listening to you; I soon had a global audience keenly interested in whatever I said.
One of the things I said frequently, especially after my Amazon prediction, was that the tech sector’s stock behavior sure looked like a bubble. At the end of 1998, in fact, I published a report called “Surviving (and Profiting From) Bubble.com,” in which I listed similarities between the dot-com phenomenon and previous boom-and-bust cycles in biotech, personal computers, and other sectors. But I recommended that my clients own a few high-quality Internet stocks anyway—because of the ways in which I thought the Internet was different…
The bottom line is that resisting the siren call of a boom is much easier when you have already been obliterated by one. In the late 1990s, as stocks kept roaring higher, it got easier and easier to believe that something really was different. So, in early 2000, weeks before the bubble burst, I put a lot of money where my mouth was. Two years later, I had lost the equivalent of six high-end college educations.
Of course, as Eliot Spitzer and others would later observe—and as was crystal clear to most Wall Street executives at the time—being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear.
WHICH BRINGS US to the last major contributor to booms and busts: self-interest…
Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.
In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.
The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational…
…Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the rest of an ever-growing Wall Street hall of shame take so much risk that they ended up blowing their firms to kingdom come? Because in a bull market, when you borrow and bet $30 for every $1 you have in capital, as many firms did, you can do mind-bogglingly well. And when your competitors are betting the same $30 for every $1, and your shareholders are demanding that you do better, and your bonus is tied to how much money your firm makes—not over the long term, but this year, before December 31—the downside to refusing to ride the bull market comes into sharp relief. And when naysayers have been so wrong for so long, and your risk-management people assure you that you’re in good shape unless we have another Great Depression (which we won’t, of course, because it’s different this time), well, you can easily convince yourself that disaster is a possibility so remote that it’s not even worth thinking about.
It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.
As we work our way through the wreckage of this latest colossal bust, our government—at our urging—will go to great lengths to try to make sure such a bust never happens again. We will “fix” the “problems” that we decide caused the debacle; we will create new regulatory requirements and systems; we will throw a lot of people in jail. We will do whatever we must to assure ourselves that it will be different next time. And as long as the searing memory of this disaster is fresh in the public mind, it will be different. But as the bust recedes into the past, our priorities will slowly change, and we will begin to set ourselves up for the next great boom.
A few decades hence, when the Great Crash of 2008 is a distant memory and the economy is humming along again, our government—at our urging—will begin to weaken many of the regulatory requirements and systems we put in place now. Why? To make our economy more competitive and to unleash the power of our free-market system. We will tell ourselves it’s different, and in many ways, it will be. But the cycle will start all over again.
So what can we learn from all this? In the words of the great investor Jeremy Grantham, who saw this collapse coming and has seen just about everything else in his four-decade career: “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.” Of course, to paraphrase Keynes, in the long term, you and I will be dead. Until that time comes, here are three thoughts I hope we all can keep in mind.
First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.
Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity…
Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.
Full article here.
