"Buy, Lie and Sell High"

Was there a kind of "Aha!" moment at which the rules of thumb and the knowledge that was built on years of experience was thrown out?

It happened about 1997, and it was a combination of things rather than a single moment. It was the success of Amazon.com in building their business fast and getting a very substantial valuation even though [Amazon] was not at all profitable. I think a lot of people [in the financial field] looked at that and said, "My god. If they can sell that kind of stock to the public, why can't we do it?" And as more people began to bring these kinds of companies public, the people within the industry who had held back -- the people who didn't think this was proper, or that it wasn't going to work in the long term, or that it wasn't legal, or whatever -- began to say, "Everybody else is doing it, so if we don't do it, we're not in business." So rather than a single moment, it was more of a steady buildup over a period of time.

When many people think of "dot-com IPO" they tend to think of sky-high valuations, but you actually contend that investment banks undervalued dot-com shares that were offered to the public. Could you explain this?

In the midst of the Internet bubble, you had two things going on. The sales forces of large brokerage houses and mutual funds, along with the business media -- and even the chairman of the Federal Reserve -- were hyping the idea, very strongly, that this was a new economy. New rules applied. There was a permanently higher level of valuation. Et cetera. So there was a willingness to pay substantially for shares in these companies.

Now you have an investment bank that brings a new company public. In that kind of an environment, with a major investment bank sponsoring that company and a major venture firm standing behind it, people would be willing to pay a great deal.

The investment banks were slow to understand, I think, how much the demand had increased for these things. There weren't a lot of shares available, if you look at the total demand, and so they were pricing them high by the standards of the investment banks -- and by the way, the investment banks actually knew a good bit more about these companies than the people they were selling [the companies] to, and they weren't telling them what they knew. The banks knew the companies were much weaker than they were representing them to be. So the banks were setting the initial offering prices somewhat more modestly than the circumstances provided.

The result of that was that there was a big rise in the value of the shares the minute they went public. So if you took it public at $10, the initial trades would be at $20 and $25. That created a huge amount of value that could be handed to friends of the investment banks.

Who were in turn "flipping" the stock?

Yes. If you got the stock at $18 and sold it immediately, you could double your money. That was an asset, if you will. And the investment banks began allocating those assets to their friends. And that's one of the practices that is being investigated today.

Why was that bad for the companies involved?

The companies got money in their IPO based on the [initial offering price of] $18. If the stock is immediately selling for $36, the companies could have gotten the difference, not friends of the investment banks. In a sense, the companies were being robbed. This wasn't discussed in the press, but it was a huge issue with the management of these companies. Because, in a sense, suppose they took 2 million shares out at $10 a share. They get $20 million back less what they pay to the bank. But if the stock is selling immediately at $20 a share, they would have gotten $40 million for the company to use and have paid essentially the same fees.

This is evidence of colossal wrongheadedness on the part of institutions that most Americans thought were pillars of our economy. Do you see any evidence that these institutions are chastened by what has happened?

Investment banks are chastened and some are downright frightened. They think they may have peripheral liability. On the other hand, all the incentives remain in place for institutions to continue to do what they did. I think its certain that this will happen again -- and maybe even on a bigger scale. I don't know exactly when and I don't know what form exactly it will take. It could be another Internet bubble. It could be another technology bubble, just not the Internet -- something in the biotech industry, maybe. On the other hand it could be something quite different. The incentives to make a great deal of money without the likelihood that you're going to have to give much of it back -- the reality is our laws have neither stopped this nor punished it.

How does Washington's reaction compare to its reaction to previous bubbles? I'm thinking about 1929, in particular, but there have been others as well.

Well, there was a huge difference in the government's reaction in '29. Back then we set up a whole new regulatory scheme and a whole new and substantial body of law. The difference now is that same body of law is still in effect and people have figured out how to get around it. People do that in 70 or 80 years. And the law was not effective in preventing this [Internet bubble] at all.

The changes to the law that are being debated now in Congress are useful, but they're very limited. They do not address the crazy-quilt pattern of regulations that we have, which has huge gaps in it that often protect the most sophisticated investors and leaves the least sophisticated to the whims of the market, which is exactly the opposite of what its supposed to do. [Congress] is not really trying to make any sense of that. They're proposing some additional regulations in some areas -- regulations that in many instances we're not even certain are going to be effective. So the response out of Washington this time thus far is much less than is merited and much less than happened [in the wake of previous crashes].

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