Origins of the Crash: The Great Bubble and Its Undoing (review)

What happened on Wall Street from 1997 to 2002 was a financial version of the perfect storm. Almost everything that could go wrong did go wrong simultaneously. The Securities and Exchange Commission reforms of the 1930s had closed many of the loopholes for chicanery, but new paths to questionable practices and debased principles eventually emerged. In his examination of the origins of the "dot.com bubble" and the circumstances of the balloon's bursting, Roger Lowenstein narrates clearly and convincingly the long series of events that contributed to the debacle. Like Ron Chernow, his journalistic colleague, Lowenstein produces solid history for the enlightenment of lay readers and academicians alike.

The author discusses a multitude of factors, but he tends to focus prominently on the destabilizing impact of the massive issuance of stock options both to the top executives of major corporations and to the optimistic founders of Internet startups. Once hailed as a crucial stimulus for the improvement of managerial performance, the options game soon went beyond the boundaries of prudence and propriety. Over time, option holders viewed these financial vehicles as the primary source of their exorbitant personal incomes. Consequently, they placed increased emphasis on driving the price of their firm's corporate common stock to higher and higher levels. In doing so, they threw caution to the wind and often, in collaboration with public accounting firms, drifted into borderline, if not criminal, financial reporting practices. The blessings of stock options as a motivating incentive within the business community were transformed into a systemic curse that hurt everyone, including millions of investors plus thousands of representatives of Wall Street firms, whether guilty or not.

At about the same time, the major public accounting firms were busy making significant encroachments on the market shares of the leading mainstream management-consulting firms. Their consulting divisions soon generated far more profits than flowed from the mundane work of auditing. Moreover, the same public accounting firm was allowed to offer financial advice and then to audit the outcome. Sticklers in the audit divisions, who earned lower salaries and had lower status, were overruled when they sent up cautionary red flags. The fear of possibly losing important consulting clients intimidated the auditors and their superiors at headquarters.

Meanwhile, there was spirited debate among participants in both the financial markets and the accounting profession about whether stock options should be counted as corporate expenses when granted or kept off the books.

The third force stirring up the water was the increased power and status of the investment banking departments of financial institutions. Decades ago, the leading investment banking houses and the leading brokerage firms had operated in complementary, but separate, market niches. The security analysts at the brokerage firms had the freedom "to call them as they saw them," which meant issuing recommendations to sell stocks as well as to buy and hold. Most of the remaining New Deal laws, which had dictated the institutional separation of various financial functions, were repealed in the 1990s. The new institutional arrangements brought together commercial banking, investment banking, and brokerage services under the same roof. Of the three functions, investment banking produced the highest net income over the short run, and the security analysts soon became their fawning servants. Sell recommendations on listed stocks became as rare as hen's teeth: the basic fundamentals of investing often were ignored.

A fourth element contributing to soaring stock prices was the expanded media coverage of the financial markets. Generally speaking, greater publicity allows investors to make sounder judgments based on more thorough information. In this case, however, the line between hard news and entertainment was frequently crossed. The cable network CNBC invited many promoters of tech stocks to appear as guests to share their overly enthusiastic opinions. Gurus like Abby Joseph Cohen at Goldman Sachs were treated like celebrities in the 1990s. The net result of these...