New York State Attorney-General Eliot Spitzer, whose name rarely appears in print now without the adjective "crusading" appended like a glossy business card, gets full marks for showmanship. In just a few short months, he's transformed himself from anonymous state official into the giant killer of Wall Street. It's the political equivalent of turning lead into gold, and will no doubt yield big career benefits for him down the road. It's a shame that the AG's "reforms" of brokerage analyst research so far don't amount to a row of string beans, and that Washington clearly lacks the political will, or perhaps the muscle, to force substantive change.
Let's take a look at what Mr. Spitzer has done for investors so far. Last spring, he declared open war on some of the most cherished business practices of Wall and Bay streets -- most notably the use of equity research as bait for underwriting business. In May, Mr. Spitzer counted his first coup: A settlement with Merrill Lynch that required the brokerage to pay $100-million (U.S.) in fines and bulk up the "Chinese wall" between research and investment banking. Merrill expressed regret for a series of embarrassing e-mails in which its brokers trash-talked stocks on the firm's "buy" list, but admitted no formal wrongdoing. Analysts would no longer be paid based on their value to the banking side, except "to the extent that such participation is intended to benefit" the investor.
Presumably that meant it was still okay to flog companies whose stocks were being underwritten by the firm, as long as the analysts really hoped the stock would rise, as opposed to pretending they hoped it would rise. Tough to say, because that clause in the deal was never explained. But we digress.
In the wake of the Merrill settlement, it and other brokerages -- including Goldman Sachs, Morgan Stanley, Prudential Securities and Lehman Brothers -- simplified their rating systems. All the changes were variations on a theme: Rather than rating an obvious dog "neutral," or "underperform," or "hold," it would henceforth be termed "sell" or "reduce."
Investors, who'd figured out in 1996 or thereabouts that "hold" really meant "flush it ASAP," responded with a collective yawn.
Then at the beginning of this month, Mr. Spitzer, perhaps sensing from the continuing implosion of the stock market that confidence had not yet been restored, sued a rogues gallery of former telecom executives, implicating them in a kickback scheme on initial public offerings.
The plot has more twists than an Oliver Stone film, but it boils down to this: The executives in question were allegedly given sweetheart deals on hot IPOs underwritten by Salomon Smith Barney, while Salomon's former star telecom analyst, Jack Grubman, trumped up positive reports on these same firms. In exchange, Salomon allegedly received massive underwriting business. Mr. Grubman has denied altering reports to suit anyone, but presumably will have his day in court.
Lost in all this, or perhaps forgotten, is one simple question: How to prevent it from happening again? Everything Mr. Spitzer has done so far is nothing but a fresh coat of paint on an old, rotten plaster wall, because the brokerage business model has not changed. Equity research, produced in the enormous quantities that we now see on Wall and Bay streets, is fundamentally unprofitable. As Peter J. Solomon, a former vice-chairman of Lehman Brothers, told The New York Times: "Research is a loss leader."
That means there are two credible options for true reform. The first is to reimpose a new version of the Depression-era Glass-Steagall Act, splitting brokerages into separate investment banking and research arms. This would have two immediate effects: First, it would deprive investment banks of their ability to market their core product, which is stocks. Second, it would put thousands of analysts out of work.
Either way, it's not likely to happen. John Taylor, U.S. Treasury undersecretary and key financial policy maker for the Bush administration, was quoted recently as saying such a move would be an overreaction. "We don't want to overdo or make things too restrictive," he told The Times of London.
That leaves option two, which is to call a spade what it is. Pass regulation requiring banks and brokerages to clearly label equity research as marketing. Then remove all restrictions, other than those that apply to any advertising, and let investors judge for themselves. mdentandt@globeandmail.ca