Confessions of a Wall Street Analyst (49 page)

Back to the Future: Some Policy Prescriptions

P
LENTY OF LAWS,
ethics policies, and regulations have been changed in hopes of cleaning up the Street. But will they make one whit of difference? Sadly, I think that few of them will have much impact in the long run. In part, that’s because many create their own set of unintended consequences. I also think that the role of the analyst on Wall Street is filled with inherent conflicts, none of which can be solved by these rule changes.

I didn’t realize this at first, however. Way back in 1989, when I started as an analyst at Morgan Stanley, I learned everything I needed to know about analyst independence, or so I thought, from Ed Greenberg. Ed was my mentor at Morgan Stanley, the consummate professional, and the guy who talked me into leaving MCI for the Street. His philosophy was simple, and I stuck with it for my entire career: think independently and don’t let yourself be influenced by the “noise,” as he called it. “Stay focused on analysis and valuation,” he said. “The stock picking will flow from that.”

It sounded pretty straightforward to me. But Ed warned that all the people around me, from the company executives to the traders, the bankers, and the buy-side clients, had different, and often competing, objectives. Paying
too much attention to any of them would only distract me from my job, which was to figure out the future direction of the stocks on my coverage list. There was another reason for staying independent, and it was the most essential one. If I altered my opinions to serve some objective other than giving investors the best possible advice, it would mislead anyone who read my research and acted upon it.

If I ever needed a reality check, I got one every time I spoke to my parents, Muriel and Jack. They were on my mailing list and received all of my reports throughout the years. My father was in many ways a typical individual investor. He watched CNBC constantly and listened to the talking heads as if they were speaking the gospel. He also read virtually every single word I wrote and constantly talked to his friends about my stock picks. Every time I came down to Florida for a visit, I’d be mobbed by my mom’s and dad’s friends, living on their modest retirement incomes, who would ask me again and again what they should do with various stocks.

“You know, Danny, I own a lot of AT&T,” a cheerful Aaron Beckwith would say, as I was still “Danny” with this crowd. “It’s my largest stock position. What should I do with it?”

These were real people with real life-savings taking the advice of the supposed pros quite literally. In these cases, my recommendation might make the difference between a comfortable retirement and a miserable one. It was a very big deal. I eventually crystallized my feelings about Aaron and my parents into what I called the “grandma” approach to research: I should never recommend a stock that I wasn’t comfortable recommending to my parents, my closest friends, or someone’s grandmother.

That didn’t mean that I shouldn’t consider startups or risky stocks, but rather that I always had to do my homework, seriously investigate all the issues surrounding a stock, and do my best to come up with the right ratings, including the risk level. I wouldn’t be right all the time, but I was obligated to do my best. Even though the clients I focused on were primarily large institutional investors, those institutions were often investing on the part of mutual and pension funds that perhaps managed my parents’ or Aaron Beckwith’s retirement savings.

Although the pressures from my larger, more powerful constituencies kept intensifying as the bull market picked up steam, I managed to stick to the Ed/Grandma approach pretty well over the course of my career. It was relatively easy at first, since very few people knew who I was and my calls
didn’t move stocks. Over time, as my work become more widely read, my rankings rose, and other analysts began to get cozier with the banking side of the business, it got increasingly more difficult, as I’ve described in this book.

But I had it easier than a lot of my counterparts. I was extremely lucky to have started on the Street at a time when there was very little investment banking activity in the telecom industry. The pressures didn’t really intensify until after I had built my reputation and had become ranked on the
Institutional Investor
magazine’s All-America Research Team. And by then, my job—or at least the pay—was guaranteed under multiyear contracts. So by the time the bankers went into heat, I had financial security from the contracts and a decent amount of job mobility from the high
I.I.
rankings. That gave me the leverage to resist any pressure to write or say something I didn’t believe.

D
ESPITE THE INHERENT
conflicts of Wall Street, there are a few simple but strong actions that would go a long way toward deterring future misbehavior. Start with the vigorous enforcement of insider-trading laws and regulations. If analysts and others knew they’d go to jail when caught, the laws would deter over-the-Wall analysts from disclosing not-yet-public information. Vigorous enforcement would also deter corporate executives from using misleading or fraudulent accounting to give them time to sell shares when they are aware—but the public is not—that their company’s fortunes are suffering. Aggressive enforcement actions could make a huge difference by deterring would-be criminals.

Second, I propose a new federal law requiring corporate insiders to pay back profits, if those profits have been earned by selling shares during a period of time when the company’s stock price is artificially boosted by fraudulent financial disclosures. Those profits would then be refunded to investors in that company’s stock.

Third, would be to lengthen “restricted” periods. Restricted periods are the period of time after a stock or bond offering or a merger or acquisition when analysts working for the involved banks have to be quiet. That means that they can’t write research reports or give an investment opinion about those companies paying their banks an investment banking fee. Lengthened restricted periods would keep analysts silent and thereby reduce the likelihood that a banker or company would pressure or tempt an analyst to give a
favorable rating to the stock of a company paying multimillion dollar fees to that analyst’s firm.

Last and most important, investors need to be aware that they’re playing a loser’s game. No matter what laws or rules are changed, the investment banking and brokerage businesses are fraught with inherent and inevitable conflicts, conflicts that can hurt even the biggest investors. Rather than trusting in the inherent fairness of the markets, individuals buying stocks should assume that they will never receive the same information as the professionals. It’s an insider’s world, and it always will be. Let me explain.

The Middleman’s Dilemma

Real estate agents do it. Insurance brokers do it. Headhunters do it. And Wall Street brokerages and investment banks do it. They act as middlemen, trying to match buyers and sellers as often as possible and make as many deals as possible. And they all have inherent conflicts of interest that are simply part of the job. Does the real estate agent always point out the leaky roof to a buyer? Does the insurance broker always direct the customer to the best-priced insurance policy, even if his agency doesn’t represent that company? Does the headhunter know or care whether the individual he has recommended will be a great performer or a Dilbert clone? The answer is no, and no one really expects them to do otherwise.

It’s a similar situation on Wall Street. Securities firms or investment banks are the quintessential middlemen. They match buyers and sellers of securities, and their goal is to get the largest number of bonds, stocks, or some mix of the two bought or sold through their firm. This at first seems to create a built-in conflict, but the market’s laws of supply and demand are supposed to neatly resolve this moral dilemma, since the price paid will be the price customers are willing to pay and sellers are willing to accept. However, if supply or demand is distorted by things like the unfair allocations of IPO shares or selectively disclosing nonpublic information, all of which you’ve read about in this book, it’s a different story.

There is, however, something quite unusual about the securities industry: the role of the analyst. Research analysts are expected—and obligated—to pick a side in this conflict and to change sides whenever circumstances change. If an analyst recommends a stock, he is siding with the corporate is
suer, suggesting that investors buy more of that stock and therefore allowing the corporate client to sell more shares at a higher price. But if an analyst advises investors to sell a particular stock, he is working against the corporate issuer because his advice could reduce demand for that stock, thereby lowering the price paid by investors and hurting the company’s ability to raise money.

When I started on Wall Street, I naïvely assumed everyone I dealt with accepted the independence standard. I never really thought about where it came from, why people expected it, or why Wall Street analysts were unique. Eventually, I started to see that the analyst’s obligation to be independent, while ethically imperative, wasn’t economically logical at all, given that he or she works for a firm whose primary purpose is to maximize fees. From the perspective of the cynic—or the economist—it makes sense that every employee of the firm, analyst or not, would work toward that goal.

In the 1990s, this “logical conclusion” became the norm for many analysts. Some of them changed their investment opinions to benefit companies that were paying fees that dwarfed any contribution that the other customers—the investors—were making. Ultimately, the banks and the analysts paid a price for this behavior, but that price was minuscule compared with the losses of the millions of people who trusted the advice they were given.

Can anything be done to restore the role of the analyst as an impartial adviser, or is it simply impossible given the inherent conflicts involved? And have the reforms put in place thus far done anything at all to bring the Ed/Grandma standard back to life? I will first address the simplest and most controversial proposal—the spinning off of research from investment banks altogether. Then I will critique the existing rule changes put in place by Eliot Spitzer and the National Association of Securities Dealers (NASD). Finally, I’ll give my own prescription for the things I think we can—and should—change.

Why Spinning Off Research Won’t Work

After discovering Henry Blodget’s “POS” (piece of shit) e-mails, Eliot Spitzer opened his negotiations with Merrill Lynch by demanding that Merrill disband, sell, or spin off its research department, thereby eliminating any opportunity for conflicted research.
¹
Though Merrill fought this aggressively and won, I imagine many Wall Street executives agreed with Spitzer. After all, research, once a valuable client service, seemed to have morphed into one huge conflict-of-interest machine with huge legal risks.

In my view, the proposal to spin off research makes no sense, because it’s based on a misunderstanding of how securities are distributed in our markets. The problem is that if an investment bank or brokerage lacks research analysts, it will simply create them anew: inevitably, someone will emerge to describe and evaluate any stock or bond that the firm is selling. It might be a salesperson, broker, banker, or trader, but someone will end up explaining the stock to the firms’ brokers, salespeople, and investor clients.

For example, say Verizon hires Citigroup to sell $1 billion of new stock. Someone has to explain Verizon’s financials, strategic position, competitive position, and a variety of other factors to Citigroup’s institutional salespeople and retail brokers. Normally, a research analyst would do so, as he or she would have the most knowledge of Verizon and the telecom industry. But with no research analysts, someone else would need to write up a “sales memo” and host a “teach-in” explaining the pros and cons of investing in Verizon. If a banker doesn’t do it, someone in the equity syndicate department might. Or a salesperson may volunteer or be assigned to provide some “comps” tables, showing how Verizon at $35 a share compares to the valuations of other stocks and the market overall. That would leave us with a larger problem than we had before: an inexperienced salesperson with no pretense at all of being objective or independent serving as Citigroup’s telecom “expert” even though he doesn’t understand the business in any depth.

Some may argue it’s better simply to call a spade a spade. Since it is sales on some level, why not call it sales and have it performed by a salesperson? Perhaps the fraud was in calling it independent research in the first place. I understand the argument, but in the end, jettisoning the research department simply shifts the burden of “explaining” a public offering to someone less qualified and possibly more conflicted.

The same principle holds if, instead of spinning off research, it is the banking side that is separated. Self-proclaimed “bankers” will emerge, and the same inherent conflicts of mixing banking and research will inevitably arise. The king is dead, long live the king.

A Critique of Actual and Proposed Reforms

In July 2002, roughly a year before Eliot Spitzer’s $1.4 billion settlement with the largest investment banks was finalized in April 2003, the NASD, the industry group governing Wall Street firms, introduced new standards of
conduct for research analysts, called Rule 2711.
²
The following section analyzes these reforms as well as some others.

1. Analyst Pay Can No Longer Be Tied to Specific Banking Deals

Firms can no longer pay analysts for specific investment banking deals they may have contributed to. Yet analysts can still be paid from the general profits of the firm, including investment banking profits, as long as the bonuses are not tied to any specific deal. Bonuses are determined based on a variety of factors, ranging from stock-picking and buy-side surveys like
Institutional Investor
magazine’s rankings to the quantity of reports, morning calls, and client contacts to feedback from colleagues.