Henry M. Paulson, Jr., chairman and CEO of Goldman Sachs Group, believes that the late 1990s had all the marks of a classic speculative bubble – inflated asset values, a public fascination with Wall Street and investing, and an optimism bordering on euphoria. And now that the bubble has burst, the country is facing “a crisis of confidence in American corporate culture and financial markets.”


Who’s to blame? Everybody, Paulson said in his keynote speech at Wharton’s 2002 Global Business Forum on November 15. Sure, a few crooked CEOs and dishonest stock analysts besmirched the image of corporate America. “But the euphoria was hardly confined to investment banks,” he said. “It struck the media, academia, the best consulting firms, sophisticated institutional investors and small individual investors alike.”


Regulators, accountants and business reporters weren’t vigilant enough. And the public ignored one of the basic rules of investing – and life: “If something seems too good to be true, it probably is.”


From his perch atop what is one of Wall Street’s most prominent investment banks, Paulson, who has been Goldman’s boss since 1999, is well situated to assess the bubble bacchanal and the subsequent hangover. His company was one of the leading underwriters of the stock offerings of technology and Internet companies during the late ‘90s. Among its clients were such successes as eBay and Expedia and such failures as Webvan and eToys.


But this involvement has also brought Goldman and other investment banks to the attention of securities regulators in New York and elsewhere who are digging into whether Wall Street analysts touted stocks publicly while privately disparaging them and whether investment banks seduced CEOs with promises of stock from sought-after public offerings.


Paulson’s comments at the Global Forum came just five months after a  well-publicized speech he made in June at the National Press Club in Washington, D.C. There, he declared that Wall Street needed to take part of the responsibility for the public’s loss of confidence in corporate America in the wake of a raft of scandals at companies such as Enron, Tyco and Adelphia. His firm, too, had gotten swept up in the giddiness, he admitted. “We have not done as good a job as we might have in preserving and protecting the appearance of independence of our research analysts,” he said then.


The editorial page of The New York Times called his speech “unusual and compelling.” But at the Forum, Paulson’s message had a somewhat different thrust. While conceding that his bank, like others, had made mistakes – “We certainly could have done a better job as the gatekeeper for the capital markets, particularly with telecom and dot-com IPOs and other financings” – he devoted far more time to cataloging the excesses of the era and pointing out what others had done wrong. “The bottom line is this: When the bubble burst, lots of people lost lots of money, and under such circumstances, it’s only natural to find someone to blame. But the bubble was not the result of a conspiracy of greedy bankers and corporate officers.”


What, then, was the real cause? “Simple human psychology,” he said. Conditions in the economy and changes in technology flowed together, like streams gathering to form a roaring river, to dupe people into believing that the rules of investing had changed. “By 1995, we were in the last third of an 18-year bull market characterized by unusual economic growth and productivity gains.” Inflation was low. Employment was rising. Recollections of the last protracted recession were dim, as were memories of the last bear market. “Genuinely revolutionary technology in the Internet and broadband” had arrived. “This led to an overconfidence and inflated expectations.”


In addition, more Americans than ever were investing, with the number of mutual funds rising from 1,500 funds in 1980 to more than 8,000 in 2000. “The result was like a huge national echo chamber. The most popular television show in America was Who Wants to be a Millionaire. Time magazine had just anointed Jeff Bezos of Amazon.com its Man of the Year.”


The few voices of caution – Federal Reserve Chairman Alan Greenspan, who warned of “irrational exuberance” and economist Robert Shiller, who published a book by the same title – were drowned out by the revelry. Even many bears eventually left their dens and turned bullish. Said Paulson: “In the words of Charles Kindleberger, author of the classic Manias, Panics and Crashes, ‘There’s nothing so disturbing to one’s well-being and judgment as to see a friend get rich.’”


Only after recounting all this did Paulson get to the misdeeds of corporate chieftains – he called it the “erosion of business practices” – which had been the main subject of his June speech. Investors’ expectations that companies would increase their earnings every quarter “put immense pressure on management to push accounting practices to the legal limit and in some cases beyond.” And this pressure “was reinforced by many investment analysts and business journalists themselves caught up in the euphoria.”


Before its collapse, Enron, for example, was lauded as a model for other energy companies. Then came the big bang as the bubble burst. A bear market – and recrimination – have followed. Enron, of course, filed for the largest bankruptcy in American history, and Arthur Andersen, once a model of rectitude, has been effectively dissolved. Meanwhile, investment analysts have been accused of shilling for companies that they knew were built on shaky foundations. Even Jack Welch, once lionized as America’s best CEO, has been criticized for enriching himself at the expense of General Electric shareholders.


The bursting of the bubble, Paulson pointed out, is tied with the bear market of 1937 through 1938 as the second worst in modern American history, after the one accompanying the Great Depression. “The combined losses of the U.S. stock exchanges in 2000 through 2002 represent approximately $8 trillion in market capitalization.”


Everybody – Wall Street, regulators, the media, investors – should step back and assess the mistakes they made, he said. “At Goldman Sachs, we were actually quite disturbed because we saw things [at other investment banks] that we knew weren’t right. We knew we didn’t do them, and we took comfort in that.” Competitors, for example, were paying their analysts for bringing in investment-banking clients and letting analysts invest in the initial public offerings of companies that they covered.


“But that turned out to have been a distinction without a difference because we didn’t adequately insulate our analysts. I got to tell you that if we had to do it over again we would do it differently.”


Paulson added that his company is “now committed to a major effort to improve practices in areas such as investment research and IPO allocation. Equally important, a whole generation of [investment] professionals has been given a healthy dose of skepticism.”


As for regulators, they sometimes didn’t grasp problems until it was too late. They now need to act forcefully where they uncover misdeeds. But they also should “avoid the temptation of overreacting. In my judgment, it would be a mistake to blame our capital raising processes for the bubble,” he said.


The media needs to be more skeptical. “Surely, elements of the business press were powerful advocates for the new technologies and helped to foster the bubble psychology.” And everybody needs to pay closer attention to ethics, which got little attention during the boom. “If there’s one thing that the scandals of the last year have taught us, it’s that ethics must be a core element of how we do business.”