Cockroach Theory

Loading the player...

DEFINITION of 'Cockroach Theory'

Cockroach theory is a market theory; it suggests when a company reveals bad news to the public, there may be many more related negative events that have yet to be revealed. The term comes from the common belief that seeing one cockroach is usually evidence that there are many more that remain hidden.

BREAKING DOWN 'Cockroach Theory'

Cockroach theory is predicated on the idea that a company's fortunes do not exist in a vacuum. The forces that put a company in peril are as likely to be external as internal. When a company is affected in a negative way by external forces, it is unlikely that its peers in the industry are impervious to the effects of those forces. Therefore, when one company's misfortunes are revealed to the public, chances are that similar misfortunes are percolating beneath the surface at other companies.

Cockroach Theory at Work

In October 2001, reports emerged that energy company Enron, which had been held up as a model of success for American corporations, had for years been engaging in deceptive accounting practices that misled investors and the public as to the company's financial health. By August 2002, Enron was in bankruptcy, and the accounting firm responsible for its audits, Arthur Andersen, had surrendered its CPA license.

The Enron scandal opened the eyes of regulators and the investing public to the idea that shady accounting practices may be more widespread than originally believed. Sure enough, over the next year and a half, similar accounting scandals brought down a host of companies, including WorldCom, Tyco and Adelphia.

In February 2007, subprime lender New Century Financial Corporation faced liquidity concerns as losses arising from bad loans to defaulting subprime borrowers started to emerge. This company was the first of many other subprime lenders that faced financial problems, contributing to the subprime mortgage meltdown. In other words, the fact that one subprime lender (one cockroach) faced financial problems indicated that many other similar businesses were likely to face the same issues.

The Effects of Cockroach Theory

Cockroach theory can have pernicious effects on the market. Faced with bad news about one company in an industry, investors often take a look at their holdings in other companies in the same industry. Sometimes, the news is bad enough to convince investors to unload industry stock, sending prices across the entire industry tumbling. Moreover, news of impropriety at one company can pique the interest of government regulators, which then train a closer eye on its industry competitors.

RELATED TERMS
  1. Subprime Market

    The market for lenders and borrowers of subprime credit, a credit ...
  2. Subprime Rates

    Interest rates charged to subprime borrowers, such as on loans ...
  3. Subprime Credit

    General term for borrowings of subprime debt, or loans made to ...
  4. Subprime Lender

    A type of lender that specializes in lending to borrowers with ...
  5. Subprime Loan

    A type of loan that is offered at a rate above prime to individuals ...
  6. Subprime Borrower

    A person who is considered a higher-than-normal credit risk. ...
Related Articles
  1. Investing

    What's Cockroach Theory?

    A cockroach theory suggests that one piece of bad news indicates more bad news will follow.
  2. Trading

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  3. Markets

    What is a Subprime Mortgage?

    Subprime mortgages are offered to borrowers with low credit ratings, usually 600 or below.
  4. Investing

    Enron: The Fall Of A Wall Street Darling

    Enron is a classic example of greed gone wrong and how investors were led astray.
  5. Markets

    The 2007-08 Financial Crisis In Review

    Subprime lenders began filing for bankruptcy in 2007 -- more than 25 during February and March, alone.
  6. Financial Advisor

    The 10 Strangest Phrases In Banking Explained

    Just about every industry has its own special language, the world of banking and finance is full of jargon to communicate with their own kind.
  7. Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
  8. Investing

    Why Enron Collapsed

    Enron’s collapse is a classic example of greed gone wrong.
  9. Investing

    When To Short A Stock

    Learn how to make money off failing shares.
  10. Trading

    Dow Theory: Current Relevance

    By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.comThere is little doubt that Dow theory is of major importance in the history of technical analysis. Many of its tenets and ...
RELATED FAQS
  1. What is a subprime mortgage?

    A subprime mortgage is a type of loan granted to individuals with poor credit histories (often below 600), who, as a result ... Read Answer >>
  2. How much risk is associated with subprime mortgages?

    Discover the risks associated with subprime mortgages. Find out whether taking out a subprime mortgage on your home is really ... Read Answer >>
  3. Are subprime mortgages still available for homeowners?

    Buying homes became increasingly difficult after the housing bubble burst. Since then, subprime mortgages have been making ... Read Answer >>
  4. What role did securitization play in the U.S. subprime mortgage crisis?

    Learn how the securitization of sub-prime mortgages into asset-backed securities fueled the real estate market crash in 2 ... Read Answer >>
  5. When is a bond's coupon rate and yield to maturity the same?

    Read about some of the major business risks assumed by Enron and Arthur Andersen, its accounting partner, before its infamous ... Read Answer >>
  6. Do negative externalities affect financial markets?

    Learn how negative externalities affect financial markets where parties to financial transactions do not pay full costs for ... Read Answer >>
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center