Wall Street gets an F

Two new books on the economy blast investment bankers for bias and warn that the financial system is out of anyone's control.

Published July 19, 2001 7:32PM (EDT)

In the summer of 1998, eager to discuss a potential public offering, the Internet start-up Priceline contacted Morgan Stanley Dean Witter. But executives from the discount travel agency didn't ask to speak to an investment banker, or one of the brokerage house's partners. Instead, they called Mary Meeker. As the firm's hotshot Internet analyst, she had the power that Priceline wanted, the power to boost a stock's price by simply giving it a "buy" rating.

The call broke from financial tradition: Analysts are theoretically supposed to focus on research, not the actual underwriting of would-be public companies. But Priceline's executives didn't seem to care. After choosing Morgan, Priceline CEO Richard Braddock emphasized Meeker's role. Neither the bank's reputation nor the nuts and bolts of the IPO's proposed terms swayed Braddock, according to Benjamin Cole's enlightening new book, "The Pied Pipers of Wall Street: How Analysts Sell You Down the River." Meeker's coverage was the product that mattered most to Priceline.

"We just think Mary is the best," Braddock said. "That was the distinguishing reason we chose Morgan."

Braddock was hardly alone in his enthusiasm. Wall Street analysts spent much of the late '90s basking in the media spotlight's full glare and enjoying the trust of investors and, consequently, investment banking clients. But in the wake of the dot-com implosion, analyst reputations have also suffered. Stockholders are suing by the dozens, arguing that conflicts of interest led to bogus, biased "buy" recommendations. According to Cole, analysts and their optimistic predictions played a key role in duping the public by forging a system that allowed institutional and inside investors to profit on IPOs while average investors lost out.

Congress and the Securities and Exchange Commission are now investigating whether Wall Street and its analysts illegally stoked the once-hot IPO market. In June, the SEC issued an alert warning investors not to rely solely on analysts' recommendations because of "the potential conflicts of interest analysts might face." In response, the Securities Industry Association, a trade group, drafted a code of conduct recommending that firms keep analyst compensation packages separate from investment banking revenue, forbid analysts from trading against their stock recommendations and require them to disclose their own stake and their firm's stake in the stocks they cover. So far, 14 investment firms have endorsed the code. Merrill Lynch has gone even further, announcing that its 600 analysts would soon be barred from buying shares of the companies they cover.

The logic of the proposed reforms is clear: Remove the financial incentives that lead to analysts' bias and the public will once again trust in Wall Street research and the firms that produce it. The "free" market will then do the rest. With confidence restored, the argument goes, investors will stop kvetching, new regulations will be unnecessary and all will once again be well.

But extinguishing doubts about Wall Street's integrity and preventing the rise of new regulations may not be that easy. Cole's analysis is complemented by Martin Mayer's "The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets." Mayer suggests that the analyst crisis could be only the first sign of a major financial meltdown. Even if the industry goes along with the SIA code of conduct, which contains no enforcement mechanism or form of punishment for disobedience, taken together, these books suggest that the American financial system is poised for destabilization. Decades of deregulation, lax enforcement and the increasing dominance of the world's interconnected stock markets have dramatically changed the landscape. Never mind whether analysts can get their act together and behave more responsibly; not even the mighty Fed, argues Mayer, has the ability to control today's economic excesses.

The modern securities industry came of age with the Glass-Steagall Act of 1933. Glass-Steagall barred banks and other financial institutions from trading and underwriting stocks, bonds and other securities. Congress aimed to eliminate conflicts of interest -- to keep banks from "floating a new issue of corporate stocks or bonds, then hyping the sales by pushing dubious securities off on their own deposit customers and trust accounts," as William Greider put it in 1987's "Secrets of the Temple: How the Federal Reserve Runs the Country."

The division also mandated stability. Congress aimed to create a system that would reduce the risk of panic, so Glass-Steagall and later laws protected both banks and brokerages from failure. Deposit insurance became common; fixed commission rates became the anti-failure, anti-competitive tool given to brokerages.

The strategy worked by keeping the industry fat and happy, Cole reports. Ordinary trades cost clients anywhere from $100 to several hundred dollars (as of the late 1960s), and large trades could often generate five- or six-figure commissions. There was plenty of money to go around. In a typical year, such as 1967, only one of the New York Stock Exchange's (NYSE) 330 member firms was reported to have sustained a net loss. That same year, Merrill Lynch earned 57 percent of its total revenue from retail commissions.

"All a brokerage had to do to make big money was to keep its stockbrokers -- and their retail clients -- happy," Cole writes.

Analysts helped meet these goals. They played an important but hidden role in the system, researching companies and feeding their knowledge to brokers who sold their recommended stocks to clients.

"We put out 2-inch-thick black binders on different industries, which we would work months and months to produce," says Stephen Koffler, an analyst who started researching the aerospace industry in 1968, and whom Cole quotes in his book. "People who bought our reports paid us, so to speak, by trading through us."

Ultimately, "it was a sweet deal," Cole writes.

But the deal didn't last. On "May Day," May 1, 1975, a new law took effect that prevented the NYSE from regulating rates. The industry would never be the same. What was once perhaps the most sheltered industry in the nation turned ferociously competitive.

Trading volume started climbing. In the '60s, a typical day on the NYSE might see a total of 10 million shares change hands. In 1982, the market witnessed its first 100 million-share day, and by 2001, the market crossed a new threshold: 2.1 billion shares were traded in a single day.

But even with the increased volume, it became harder and harder to make money through commissions. Between 1975 and 1998 (taking inflation into account), full-service brokerages slashed their rates by fully 95 percent. As a result, consolidation roared through the industry. Of the 30 largest securities firms in 1971, only two have remained intact -- Merrill Lynch and Bear Stearns.

Brokerage houses looking for new revenue sources also started doing more underwriting. (This is essentially the market-related services that an investment bank performs for new ventures: collecting the vital figures, writing a prospectus that explains why the stock or bond is worth buying and then conducting a "road show" to the offices of institutional investors.) Underwriting can be very lucrative, particularly during a go-go speculative bubble like the dot-com boom. Fees generally range from 7 to 9 percent of the underwriting dollar volume. Then there are the paper profits. A firm that agrees to underwrite an investment usually receives a discounted stake in the new venture, which it can then sell (or "flip") when share prices climb above the initial asking price.

The underwriting mania peaked in the 1990s. As the stock market rose steadily, the securities industry turned aggressively toward initial public offerings, secondary or follow-up stock offerings and doing mergers-and-acquisitions work.

The shift toward corporate finance proved fruitful for the firms. But the bounteous revenue stream also poisoned the integrity of research, Cole argues. The so-called Chinese wall between research and investment banking collapsed under the weight of cold, hard cash.

Consider the Global Crossing IPO. When the investment bank CIBC Oppenheimer took the telecom firm public in March 1998, it earned several million in fees and bought $30 million in stock. By March 1999, the firm's stake was worth $4.6 billion. When a few investment bankers can bring in so much cash so quickly, "Is it any wonder," Cole asks, "brokerages now look to investment bankers to make money and to analysts and stockbrokers to assist?"

Cole's retelling of the late '90s bubble is harsh -- some of his examples make Wall Street analysts look like they belonged not on the Street, but on infomercials.

Take Hemant K. Shah, an independent high-profile pharmaceutical analyst who used his pulpit to sell, then slam, Biovail, a Toronto company that manufactured time-release versions of popular drugs. Shah's gripe had little to do with fundamentals; he praised the company when it got a new CEO in 1989, and even helped the small company raise money. He touted the company's shares to his money manager clients even as he tried to manage a deal for Biovail -- an obvious conflict of interest that he didn't disclose at the time.

Then the company did a deal of its own, cutting Shah out. He turned nasty. According to court documents that Cole collected, Shah planted false negative news about the company in the press, told his clients not to buy and even claimed (falsely) that George Soros was following his advice. Biovail stock rose in value anyway, but the company sued. Executives now estimate that Shah's 1996 and 1997 campaign forced Biovail's stock to trade at a third below the proper level.

Shah's case is hardly unique. Cole has collected quotes from several analysts and former analysts who readily admit that their research was biased toward their firm's investment banking interests. Sean Ryan, a Bear Stearns analyst, told Bloomberg Markets Magazine that in 1999 he recommended the online bank NetBank even though he thought it was a crummy company. "I put a buy on it because they paid for it," he said. Though he told institutional investors what he really thought of the company, Ryan maintained his stance of public praise.

Another analyst, who regularly put "buys" on stocks she covered, said she couldn't remember the last time she read a 10-Q quarterly report -- a key set of documents that a public company must file with the SEC. Still another, eyeing the close relationship between investment banking and analysts, told Cole that "research is supposed to be independent, but it is hard to see how it can be." Corporate pressure and the incentive to earn cash by brining in new clients, he said, damned the system.

Even Benjamin Edwards III, scion of the A.G. Edwards investment banking empire, admits that "an analyst has a hard time being objective if the client is important. They [the investment bankers] always want us to be optimistic and bullish."

A few of the analysts that Cole quotes counter his claim that Wall Street research has become a form of "customer service" rather than a tool for accuracy. They admit that during the boom their ratings didn't tie in to fundamentals but they argue that fundamentals weren't driving the market. "Stocks don't go up and down because they have a specific 'value,'" says superstar analyst Henry Blodget, in a quote that Cole pulls from a May 1999 Fortune magazine article. "They go up and down because investors decide to buy or sell."

Or, as Meeker put it: "A stock can go up and down based on money flows at a much more rapid clip than it can on the fundamentals." In other words, "buy" ratings were justified because people kept buying.

Cole points out, however, that analysts maintained buy ratings even after people started selling. In the spring of 2000, with Amazon.com down 70 percent from its high, Blodget still called the stock a "buy." The other Internet stocks he covered -- eToys, Pets.com and others -- also suffered a bloodbath but until July, Blodget maintained his recommendations. And even then, he only downgraded the companies to "holds."

The numbers confirm that Blodget's upside bias was hardly unique. Cole cites three independent studies, which show that analyst picks have become increasingly less accurate since the 1970s, underperforming the market and tending to be overly optimistic by a 3-to-1 margin. Of 33,169 buy, sell and hold recommendations in 1999, for example, only 125 -- or 0.3 percent -- were pure sells, according to Zacks Investment Research.

But is there an actual danger to such overwhelming optimism? Cole concludes that unsophisticated investors lost out. But the greatest weakness of "The Pied Pipers of Wall Street" is that Cole never quantifies the damage. He never even bothers to quote from investors who supposedly lost money by relying on analysts. Indeed, because of this oversight -- along with its scattered, collagelike structure and insider focus -- "Pied Pipers" will probably not become the definitive work on the shifting role of Wall Street analysts.

Still, Cole's overall argument is hard to disagree with. When analysts treat retail clients differently from institutional investors, the playing field becomes unequal. The team with the most money wins, while smaller investors suffer.

And when correct information is absorbed by only part of the market -- when the general public trusts biased advice from supposed experts -- the market works inefficiently. The exact conflict-of-interest pitfalls that Congress tried to avoid with the Glass-Steagall Act become more common. Bubbles and busts become more extreme. The entire economy -- as evidenced by the present economic slump -- becomes more fragile.

Enter the Fed, the single most important institution entrusted with the job of easing the pain of downturns and catalyzing upticks in the market. But can the Fed work its magic again?

Not necessarily, argues Martin Mayer. The veteran financial journalist picks up where Cole leaves off. Although written in impenetrable prose, "The Fed" makes a strong case for skepticism -- providing a welcome antidote to previous paeans to Alan Greenspan's leadership of the economy.

Mayer starts by showing that the Fed has steadily grown more powerful over the past century, relentlessly claiming ever more jurisdiction, independence and political clout. Although the Treasury and the Office of the Comptroller of the Currency (OCC) formerly competed for primacy on several occasions, today, says Mayer, the Fed is the undisputed "cock of the walk in American financial regulation." The 1999 Gramm-Leach-Bliley bill, which made the Fed an "umbrella advisor" to the banking securities and insurance industries, simply legitimized the institution's rise to prominence.

But the central bank suffers from at least two dangerous weaknesses. First, the Fed's expertise lies with traditional banking. And since banks are on the decline (they once controlled 60 percent of the country's commercial and industrial financing, but now manage only about 20 percent), the Fed's influence has also dipped.

Monetary policy, adding or subtracting from the money supply, garners its power from the demand for bank loans. When interest rates are low, the theory goes, more people will borrow; adding cash to the economy. When they're high, people will trim their spending. But now, when people can get cash from credit cards, home equity loans, stock and other financial instruments, the Fed's power over liquidity "will not necessarily go where you want it to go when you need it to go there," Mayer writes.

"Now the 'new economy' is financed by 'venture capitalists' and underwriters who push initial public offerings, and the movement of a few basis points in short-term interest rates matters nothing to them unless the result is a noticeable change in the valuation of -- one hesitates to say it -- stocks."

In order to affect the economy, the Fed must influence the markets. But this is getting harder and harder.

"Do we really understand the long-term consequences of the technologically driven disintermediation of payment flows away from credit-sensitive financial institutions [or traditional banks]?" asks E. Gerald Corrigan, former president of the New York Fed.

"No," Mayer answers, "we don't."

The Fed in particular "knows relatively little about securities, and even less about insurance," Mayer argues. And the institution may not be ready to learn either.

In fact, the Fed's second weakness lies with its penchant for secrecy and aversion to change. Unlike the SEC, which has a reputation for encouraging openness, according to Mayer the Fed tends to be managed with a closed, top-down form of efficiency. Bank examiners aren't allowed to publish their findings, even if a bank is about to fail, and all staffers report to the chairman. Even Federal Reserve bank governors are rarely allowed to voice opinions that differ from the official stance.

"The Fed has never believed in sunshine as a disinfectant," Mayer writes. And yet, now more than ever, disclosure matters. The Asian crisis might have been avoided if banks in Thailand and Malaysia had publicly revealed their risky investments before collapse was imminent. Damage from the real estate fallout of the '80s and the savings and loan scandal could have been minimized, Mayer argues, if the institutions were forced to regularly divulge their finances. Greenspan has opened up the Fed more than other chairmen, but in Mayer's view, the Fed needs to go much further if it wants to ensure stability.

Mayer, who once acted as an advisor to President Reagan, stops just short of asking for legislation that would actually mandate openness. Like Cole, he seems to believe that the onus is on investors, who must learn for themselves that the markets and the economy are far more fragile than they may believe. But the dangers that these books identify offer hints into what could become a changing cultural mood. Through the '90s, when the markets and the Fed could do no wrong, regulation resembled an unnecessary burden. But if the economy continues its downward spiral, government may look less like a villain -- and more like a white knight.

By Damien Cave

Damien Cave is an associate editor at Rolling Stone and a contributing writer at Salon.

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