The Scandal Learning Curve (or lack thereof)

The first decade of this century has really held the investors’ attention. Of course it started with the aftermath of the burst dot-com bubble, closely followed by the accounting scandals and now we have the next scandal: the credit crisis. However diverse these scandals appear to be, they have several characteristics in common. Can we learn any lessons from these patterns?

What they have in common is (1) an increase in share price over an extended period of time, mainly caused by growth in the world economy, (2) opportunism of decision-makers and (3) a lack of investor common sense.

When stock prices increase over an extended period of time it creates the idea that the sky is the limit, even though the basis for this (economic growth and efficiency) is non-existent. It creates a kind of pyramid scheme: people jump on the bandwagon hoping that the prices will have gone up even further when they sell. In times like these very few people look at the scope and especially the cost of the systemic risk. Initially, internet companies seemed to be able to avoid this economic pattern, but time has revealed a different story. It turns out that very few internet companies were really profitable. In cases such as Enron and Ahold, the option-style reward structures played a part. These structures made it very tempting for directors to manipulate prices. The credit crisis is a slightly more complicated event. Here, price developments in the housing market in the US and in the global merger and acquisition markets played a role. These price developments were not only supported by economic growth, but also by low interest rates worldwide. The low interest rates made borrowing or takeovers with borrowed money very attractive. Banks passed these deals on to special purpose vehicles that generated liquidity for these investments by placing short-term securities with institutional and other investors. Everything went well as long as interest rates stayed low and the securities of these vehicles kept their value. When the housing market in the US collapsed, mainly because the less prosperous house owners could not afford the recurring expenses any longer, the value of the securities decreased. The vehicles were no longer in a position to offer favourable refinancing and the first bankruptcies occurred.

It is hard to prevent these problems because there has been too much gain in the short term for the parties involved. In the end, the markets will clean themselves up, but only with financially painful consequences. Is there no other way? By now it should be clear that ongoing value appreciation stimulates the wrong behaviour in market parties, and this obscures the risks. However, it is human nature to extrapolate an existing trend and to suffer from the ‘keeping up with the Joneses’ syndrome: I should be able to have what he’s got. He has a bigger house, so I should have one too. All together this leads to a loss of sound judgement on the part of the investor and a pyramid style scheme on the markets. The above examples show that the pyramid schemes originate every time in different areas of the economy.

It is easy to identify this pattern with hindsight, but the real challenge is to anticipate it and to act accordingly.