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These words seem strangely familiar to what we heard from Hank Paulson.
Greenspan ruled out direct regulation of hedge funds, saying it was possible to monitor the fund's activity and act when necessary. Moral hazard was born during this crisis. Well meaning members of the Congressional committee had a different opinion. The rescue raised "troubling questions of financial concentration and antitrust," Mr Leach said at the hearing. "As a group working together, the new owners can have a greater impact on markets than in competition with one another." Representative Bernard Sanders of Vermont, the House's lone independent, called it a "bailout for billionaires" that rewarded "the gambling practices of the Wall Street elites."
This first Black Swan event should have been a warning to the ruling elite of Wall Street, Congress, Greenspan, and the American people. No one heeded the warning. Firms were allowed to get bigger, the CEOs of the firms took on greater risks, Greenspan and Congress delegated their regulator responsibilities to the free market. Ten years later, the same problems have occurred to a much greater degree. The government is trying to avert worldwide financial collapse on a daily basis.
Dot Com Bubble
The NASDAQ market, consisting of smaller growth companies, in January 1995 was at the 750 level. On March 10, 2000 the market peaked at 5,132, an increase of 584% in five years. On January 1, 1995, I can assure you that no one predicted this rise. It was an extreme outlier and the reasons for the rise were concocted after the bubble popped. In a speech during 1996 Alan Greenspan warned that the U.S. economy was suffering from “Irrational Exuberance”. The following day, the stock market dropped significantly. Mr. Greenspan never used the term again. As the economy heated up in the late 1990’s and Wall Street started pushing IPOs like Pets.com, Greenspan did not do what a Federal Reserve Chairman should have done, take away the punch bowl before the party got out of hand. If he had increased margin requirements, day traders wouldn’t have had the money to propel the markets to ridiculous heights. As a political animal, Greenspan did not increase interest rates leading up to the November 1999 Presidential elections in support of the current Clinton administration. As the year 2000 approached and the ridiculous fears of computers around the world no longer functioning led people to hoard cash and supplies of water, Mr. Greenspan opened up the spigots and flooded the economy with cash. This cash immediately flowed into Dot.com stocks and pushed the NASDAQ to its epic peak, a level that not will be seen again for decades.
Robert Shiller, professor at Yale, published his book Irrational Exuberance in early 2000. In this book he poked holes in all of the Wall Street rational for stocks being as high as they were. His contention was that a feedback loop based on emotion led to this dramatic rise in the stock market. He effectively concluded that the “efficient market theory” was a load of crap. His own words were a little more professorial.
"The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgment of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom."
In the real world, people are not rational machines like Merton and Scholes believed. You can not model human behavior and capture the emotions that drive people to do certain things. This is very disappointing to academics and “scientists” at investment banks. Wall Street gurus declared that it was different this time. The internet era would usher in permanently higher profits and productivity. Once this lie had been perpetuated, Wall Street proceeded to fleece the public by doing initial public offerings of any ridiculous concept with a .com at the end of its name. Many of the IPOs soared by 500% to 1,000% on the day they were issued as day traders used margin to pump and dump these stocks. Average people gave up their jobs to day trade. Amazon.com backed Pets.com raised $82.5 million in an IPO in February 2000 before collapsing nine months later. Online grocer Webvan raised $375 million in an IPO. Webvan came to be worth $1.2 billion (or $30 per share at its peak). The company closed in July 2001, putting 2,000 out of work. eToys.com raised $166 million in a May 1999 IPO, but in the course of 16 months, its stock went from a high of $84 per share in October 1999 to a low of just 9 cents per share in February 2001. The event that marked the top was the acquisition of Time Warner by AOL in January 2000.
Professor Shiller’s opening question was: "Are powerful fundamental factors at work to keep the market as high as it is now... or is the market high only because of some irrational exuberance -- wishful thinking on the part of investors that blinds us to the truth of our situation?"
Professor Shiller then proceeded to methodically and convincingly prove that the market was grossly overvalued by every measurement used throughout the history of the stock market. The PE of the market reached 45 in early 2000. At the peak before the 1929 Crash, the PE had reached 35. There was absolutely no doubt that this bubble would pop. S&P earnings had fluctuated in a fairly narrow range throughout history, and have always reverted to the mean. By 2000, a complete disconnect had occurred between earnings and the level of the stock market. Shiller argued that “positive feedback loops” among investors led to herd like behavior and created a “naturally occurring Ponzi process”.
All previous speculative peaks in 1901, 1929, and 1966 had resulted in subpar stock returns for the two decades following the peak. The peak reached in March 2000 far exceeded any previous peak in history. Millions of people piled into the stock market because they saw the media touting the success of others. A sort of collective delusion overcame the country. Shiller concluded that "The high recent valuations in the stock market have come about for no good reasons." He was right. The Dot-com bubble crash wiped out $5 trillion in market value of technology companies from March 2000 to October 2002. Communications companies overburdened by massive amounts of debt filed for bankruptcy. WorldCom, run by Bernie Ebbers, was found to have used illegal accounting practices to overstate its profits by billions of dollars. The company's stock crashed when these irregularities were revealed, and within days it filed the largest corporate bankruptcy in U.S. history. Ebbers went to prison. Wall Street “analysts” were discredited and some were prosecuted for touting worthless stocks as buys.
The trigger for the collapse was the six interest rate increases by Alan Greenspan in late 1999 and early 2000. He continued to increase rates until they reached 6% by late 2000. The collapse of the internet bubble, the resulting reduction in business activity, and the increase in interest rates combined to push the country into recession. Alan Greenspan and George Bush have one thing in common, they don’t believe in recessions. Greenspan rapidly decreased the Fed discount rate from 6% to 3.5% by September 2001.
9/11 Attack
As Nicholas Taleb points out, human beings always try to rationalize a Black Swan event after the fact. If it was predictable, it wouldn’t happen.
“A vicious black swan has an additional elusive property: Its very unexpectedness helps create the conditions for it to occur. Had a terrorist attack been a conceivable risk on Sept. 10, 2001, it would likely not have happened. Jet fighters would have been on alert to intercept hijacked planes, airplanes would have had locks on their cockpit doors, airports would have carefully checked all passenger luggage. None of that happened, of course, until after 9/11”.
