Infectious Greed (47 page)

F
rank “Frankie” Quattrone grew up in a small, two-story row house in a working class neighborhood in south Philadelphia, where the movie
Rocky
was filmed.
¹
As Rocky Balboa was running past Quattrone's home, and up the seventy-two steps of the Philadelphia Museum of Art, on his way to winning the heavyweight boxing championship, the bookish Quattrone was acing his high school exams and standardized tests, on his way to winning a scholarship to Wharton—the same school Michael Milken, Charlie Sanford, Allen Wheat, and Andy Krieger had attended. After Wharton, Quattrone worked for two years as an investment banker at Morgan Stanley in New York,
²
moved to Palo Alto, California—where he graduated from Stanford's business school—and then returned to Morgan Stanley, this time in the firm's California office, not far from Stanford. It was 1983.

At the time, a group of technology “nerds” in the Silicon Valley area—many from Stanford—were starting up companies with strange and unfamiliar names, such as Cisco and Netscape. Quattrone fit right in, befriending and advising hundreds of these young entrepreneurs. They loved the fact that a Wall Street banker would wear ugly sweaters instead of expensive suits, and entertain clients at karaoke bars by singing “Rocky Raccoon.”
³
Quattrone was smart and offbeat, and his thick, black, center-parted hair and bushy mustache were about as far as it got from a Wall
Street look. As Will Clemens, CEO of
Respond.com
, put it: “He looks like a guy who could be towing your car.”
⁴

Many start-ups in Silicon Valley hired Quattrone, and Morgan Stanley promoted him to managing director in 1990, the year the investment bank did Cisco's IPO—the Initial Public Offering in which the privately owned technology firm first sold shares to the general public. In 1995, Quattrone did the IPO for Netscape—the software company that created Netscape Navigator, which enabled individuals to access the Internet—and this deal marked the beginning of the Internet boom. By that time, Morgan Stanley was involved in the lion's share of technology deals, and Quattrone reportedly was making $10 million a year.
⁵

After a few control-related disputes with Morgan Stanley's president, John Mack, and a run-in with a Morgan Stanley technology research analyst who had rated one of Quattrone's clients a “hold” instead of a “buy,”
⁶
Quattrone quit in 1996 to join Deutsche Bank's investment banking division (called Deutsche Morgan Grenfell). Deutsche gave Quattrone everything he wanted, including more staff, a greater share of profits, and control of research analysts.

Quattrone's success and offbeat approach continued at Deutsche. His “pitch book” for the IPO of
Amazon.com
, an Internet bookseller, looked like a real hardcover book; Deutsche won that deal—and many others. But like Rocky Balboa, Quattrone was a restless superstar. Notwithstanding the fact that he had doubled his annual pay to a reported $20 million, he considered moving to another firm.
⁷
When rumors spread in 1998 that he might leave Deutsche, he wrote a letter to clients assuring them, “We are here to stay. Please trust us.”
⁸
Then he promptly quit to join CS First Boston—Allen Wheat's firm—taking along the best bankers from his group, capturing even greater control and an even more lucrative pay package.

At CS First Boston, Quattrone dominated the market for technology IPOs, and CS First Boston made $718 million in fees for IPOs of technology companies alone, much more than any other bank.
⁹
(Incredibly, as it would turn out, that amount included just the firm's
disclosed
fees, which were only a fraction of the money it really made from those IPOs.) In two years, Quattrone took CS First Boston from the 19th-ranked technology investment bank to number one.
¹⁰

Quattrone also continued his antics. When Peter Jackson, the CEO of Intraware, complained that soliciting investors during his company's IPO was going to make him “feel like a mule,” CS First Boston actually
delivered a live mule to Intraware's lobby the next morning, complete with a sign urging the company to hire CS First Boston. Intraware hired Quattrone, and Jackson later admitted that the mule “may have made the difference.”
¹¹
Quattrone bristled when others attempted to grab the limelight. When Katrina Garnett, the 38-year-old Australian founder and CEO of CrossWorlds Software—whose board Quattrone served on—tried a marketing gimmick of her own—appearing in advertisements in
Vanity Fair
and
The New Yorker
magazines wearing a black size-4 cocktail dress and a seductive pose, as part of a million-dollar advertising campaign—Quattrone resigned in a huff, protesting that he had not been informed of the campaign.
¹²

During the late 1990s, Quattrone was the highest-paid person on Wall Street, at a reported
$100 million
a year. Other bankers weren't far behind. Wall Street firms made tens of billions of dollars in the late 1990s, and paid roughly half of their revenues to employees. Hedge-fund managers who bought shares in technology IPOs could make even more money, as share prices increased by hundreds of percent. Looking back, Andy Krieger's $3 million bonus in 1988 seemed like peanuts. In response to a claim that $6 million was an impressive bonus in the late 1990s, one industry veteran said, “What he thinks of as a lot of money isn't a lot of money. He thinks that people who are worth $50 million are rich guys. In this world, lots of people have that kind of money. Nobody's impressed when they hear you have guys in the firm making $6 million.”
¹³

Investors didn't do nearly as well. Unfortunately, the mania in technology stocks ended badly: by 2002, 99 percent of all IPOs of Internet companies were trading below their first-day closing price, and more than half of such companies were worth less than $1 per share.
¹⁴
In addition to the hundreds of billions of dollars lost on Internet companies, roughly a trillion dollars of money invested in telecommunications companies was squandered during the late 1990s, and nearly half a million people working in the telecommunications industry lost their jobs.

Although most investors now know these facts all too well, what is not widely understood is how intimately this technology boom and bust was connected to earlier changes in financial markets. It is tempting to blame the bubble on investor greed or banker venality. But the story is not that simple. Human
nature
didn't change; human
behavior
did, as a natural response to the changes in the structure of financial markets and legal rules during the previous decade.

Three groups of people—investors, bankers, and corporate executives—formed the key connections. Investors succumbed to incentives for increasingly risky behavior and, given the complexity of financial reporting, decided it no longer mattered whether companies made money; they rushed to buy stocks without earnings, anyway. Bankers substituted for accountants as the primary facilitators, responding to investor demand, deregulation, and the limited prosecution of financial fraud by pumping stocks in return for fees. Frank Quattrone and his ilk were not evildoers; they were simply the most skilled in responding to new circumstances, like the strongest lions of the pride after a kill. Young corporate executives engaged in deceitful practices, just as their elder counterparts at Cendant and other companies had a few years earlier; but, in a new milieu—technology—where it was even more difficult to distinguish fraud from mere puffery. Their behavior, too, made perfect sense, given the upside associated with “free” stock-option grants and the low probability of punishment.

In short, the “
dot.com
” era was not some bizarre anomaly in which investors briefly went insane. Nor was the bubble created solely by the nefarious “pump-and-dump” schemes of a few greedy bankers and corporate executives. Instead, the era followed, inexorably and seamlessly, from the earlier changes in markets and law. Investors, Wall Street, and corporate executives were all participants; but, given the incentives facing each group, their behavior—if not excusable—should not have been surprising, either.

 

 

F
irst, as markets became more complex, individuals became intoxicated by what economist John Maynard Keynes called the “animal spirits” of markets.
¹⁵
The various international bailouts were only the most recent incentive for investors to take on more risk. During the two decades before 1990, individuals actually had taken money out of the market. But then, in 1991, the stock market went up 30 percent, and individual investors began buying stocks, fueled a few years later by the media—especially television network CNBC—which expanded coverage of financial markets. Individuals began trading based on anything from a whim to a trend to a tip from a relative, coworker, or Internet chat room.
Day trading—
making numerous stock trades throughout the day—became a popular pastime, even though nearly all day traders lost money. As investors focused less on detailed financial statements, they
became open to investing more speculatively—in, say, shares of an Internet bookseller or a provider of wireless telephone products.

Year after year, more people became investing experts, and devoted innumerable hours to comparing stock prices and financial ratios. Everyone knew about the Netscape IPO, even though most investors had not heard of either Netscape or IPOs a few years earlier. Even teenage tennis-star Anna Kournikova and N.F.L. football tight-end Shannon Sharpe were discussing P/E ratios in television advertisements for Charles Schwab. And who could forget on-line broker E*TRADE's commercial about the emergency-room patient with “money coming out the wazoo”?

Almost anyone who invested in stocks during the 1990s made money. It was the longest bull market since World War II, and the numerous financial debacles of the decade seemed far removed from most investors' lives. So what if Orange County declared bankruptcy, or Procter & Gamble lost a hundred million, or Barings failed? Why agonize over a few bad apples at Cendant and Waste Management? And why worry at all about international crises? The various crises of the 1990s led to bailouts, which encouraged investors to take on excessive risk. Economists from Morgan Stanley wrote an essay entitled “It Started in Mexico,” in which they reported, “Our analysis of correlation between markets and investment styles points to the Mexican bailout as a factor that set the stage for increasing investor confidence worldwide and helped to ignite the growth market of the late 1990s, along with a strong U.S. economic expansion.”
¹⁶

A few disasters might occur here and there, but in the long run, you couldn't afford
not
to be in stocks.
¹⁷
The numbers spoke for themselves: as Jeremy Siegel argued in his 1994 book,
Stocks for the Long Run,
stocks had been chronically undervalued throughout history. The trend continued through 1999: an investment in the Standard & Poor's 500—the index of the largest U.S. stocks—returned an average of more than 16 percent per year. If you had put just $75,000 into stocks in 1984, you would have over a million dollars by the end of 1999.

Were investors behaving rationally during this period, or not? One view was that higher stock prices were justified because of a technology revolution of the scale of the industrial revolution, in which new Internet and telecommunications tools would—at some future date—lead to record corporate profits, just as the railroads had revolutionized business a hundred years earlier. The other view was that investors were simply manic, or “irrationally exuberant.” There was evidence supporting
both views. It was undeniable that consumers were using new technologies, especially wireless telephones and the Internet. But hundreds of telecommunications companies were competing in markets that, like the railroad industry, would support only a handful of leading firms. And it was difficult to imagine, paradigm shift or not, that very many of the hundreds of on-line consumer websites would ever make any money.

As investors were rushing to buy stocks in a rising market, several experts were demonstrating how the second view—of investor mania—was the correct one. Experiments by Daniel Kahneman, Richard Thaler, and Amos Tversky—which showed that people overestimated their own skills, overvalued items they owned, were shortsighted, greedy, and occasionally even altruistic—were an assault on the citadel of efficient-market theory that well-regarded economists such as Paul Samuelson and Eugene Fama had been putting forward since the 1960s. More than a generation of business and government leaders had been taught that markets were efficient and that stocks were “rationally” priced; based on these teachings, they had implemented a deregulatory approach to financial markets since the 1980s.
¹⁸
But as the markets continued to soar, these new studies were evidence that the prior assumptions about markets had been wrong.

At first, finance theorists dismissed the new studies as mere anecdotes—just evidence looking for a theory—because they did not have the mathematical rigor of previous rationality-based efficiency theories. Moreover, in a market with “arbitrage,” where sophisticated investors could buy and sell mispriced securities, stocks arguably would be “rationally” priced even if some investors were irrational. It might be true, as some new experiments showed, that 80 percent of car drivers thought they were of above-average skill, or that most gamblers took greater risks when playing with
house money
(money they already had won). But, the argument went, the same irrational behaviors didn't matter in financial markets, because sophisticated, rational investors could make money trading with irrational investors until arbitrage opportunities were gone, and stocks were no longer mispriced.