Misgivings Over Wall St. Reform
When global markets closed Nov. 1, a Friday, research analysts at Goldman, Sachs & Co. rated 55% of the stocks they covered as “buys” and only 6% as “sells.”
But when markets reopened the following Monday, the same analysts rated the same 1,900 stocks worldwide as just 26% buys and a full 22% sells.
What went wrong that weekend to cause these industry experts to suddenly downgrade nearly half their companies in one swipe? Was it news of impending war, perhaps, or a coming landslide for the Democrats?
Neither. All that happened was that Goldman -- like other big Wall Street firms before it and others since -- chose that date to unveil its new, small-investor-friendly stock-rating system and to tug many of its more optimistic ratings closer to earth.
The new ratings guide is one of a fistful of reforms that has grown out of the yearlong federal and state investigation into conflicts of interest in Wall Street research, a probe that is expected to be capped as early as today by formal approval of a $1.4-billion settlement outlined in December between the government and 10 of the biggest securities firms, including Goldman.
More evidence of questionable conduct by analysts or their supervisors, perhaps some additional embarrassing e-mails, may come to light in the final settlement documents. However, the main reform elements already are known and, in some cases, already in practice. The simplified ratings guide is one.
The reforms also include well-publicized efforts to rebuild -- or at least heighten -- the so-called Chinese wall separating analysts from investment bankers, to require brokerages to purchase and supply customers with “independent” research by outside companies and to establish a fund for investor education programs nationwide.
Most experts doubt the reforms will fundamentally change how Wall Street works, but they should at least provide the public with more information about what analyst opinions really mean and about the relationships and incentives that underlie them. Thus armed, small investors may bring more healthy skepticism to their own stock-picking efforts, reformers say.
Congressional criticism about firms issuing almost nothing but “buy” recommendations has turned that situation around sharply.
According to Mitch Zacks of Zacks Investment Research in Chicago, the proportion of Wall Street “sells” has risen above 10%, from a low of less than 2% in early 2000. That may not sound like a lot, but it’s the highest percentage since Zacks began compiling records in the mid-1980s, he said.
The reforms may have some unexpected side effects as well, such as making it tougher for mid-size and small companies to attract research coverage from mainstream Wall Street analysts.
An equally unforeseen result, some say, could be a boomlet of fly-by-night research firms, attracted by the millions of dollars to be set aside for independent research.
As the length and difficulty of the settlement negotiations implies, the securities industry hasn’t embraced the coming changes without misgivings. But the Street knows it has plenty at stake in winning back public confidence.
Many small investors, feeling burned, have simply tuned out. That describes Keith Shavers of Los Angeles, a pricing manager for a freight-logistics firm.
“I’m thoroughly disgusted by the stock market,” said Shavers, 33, who used to trade actively but hasn’t so much as looked at an account statement in six months.
“With all the corruption, there’s no way you can win. What are you supposed to do, the opposite of everything they say?”
Breakdown in Trust
The crux of the analyst scandal concerned the breakdown in the independence of the stock-research function, which is supposed to provide investors with unbiased information and advice.
The probe uncovered e-mails from celebrity analysts such as Merrill Lynch & Co.’s Internet whiz Henry Blodget that seemed to confirm the hardened cynic’s view that analysts were mere shills, publicly touting stocks they privately disdained in order to help their firms win lucrative investment banking business.
The problem long predated the Internet bubble.
Conflicts of interest have always existed, but market historians trace the recent decline of analyst independence to the end of fixed broker commissions in 1975. Once cut-rate commissions on stock transactions became the norm, the brokerage business no longer could support a large and expensive research operation by itself. The money had to come from somewhere else, and that somewhere was investment banking.
Yet in most research departments, there was a powerful culture of independence that took years to erode, Wall Street veterans say. Research jobs were intellectual and high prestige; analysts, with more than a whiff of arrogance, tended to regard investment banking as mere commerce.
Chuck Hill, research director at analyst-tracking firm Thomson First Call, recalls that even as a young technology analyst at Kidder, Peabody & Co., he had the stripes to put a “sell” on an investment banking client if he didn’t like the stock.
At some firms, according to Hill and others, if the front-line analyst was known to be cool on a client, the report would be assigned to an analyst who actually worked in the investment banking department and could be relied upon to say something upbeat.
Such reports, of course, didn’t carry as much weight with sophisticated investors because the analysts were considered tainted. The client wasn’t fully satisfied, either, preferring coverage by a “real” -- meaning independent -- analyst.
It wasn’t until the merger mania of the late 1980s, with its astronomical investment banking fees, that the bankers suddenly had the clout to start demanding favorable coverage for their clients.
The arrogance in the research department dissipated pretty quickly, said one longtime pro, who asked not to be named.
“If the boss said, ‘We need you to recommend this stock,’ you could still decline,” he said. “But you do it too often and you get fired.”
A still-active analyst who also spoke on condition of anonymity -- he didn’t even want his industry coverage area mentioned -- said some of the reforms might make life easier for certain analysts.
For example, new regulations compel analysts to attest in writing that their opinions are their own and have not been coerced by management. It’s intimidating to sign under penalty of perjury, this analyst said, but on the other hand, the seriousness of the oath might make a boss hesitate to apply undue pressure.
“Clearly, you have more protection,” the analyst said.
Rebuilding the Wall
To Edward Wedbush, chief executive of Los Angeles-based Wedbush Morgan Securities, the most significant reforms involve efforts to rebuild the Chinese wall -- that is, sealing off investment banking from the part of the company that does research for public customers. Some firms are even considering spinning off their research departments into separate companies to heighten the independence.
But once the merger-and-acquisition arena recovers from its current torpor and investment banking fees start climbing again, “the better analysts will want to go where the money is,” Wedbush said.
Thomson First Call’s Hill, less diplomatically, calls the Chinese-wall reforms “baloney.” As long as investment banking profits drive the train, he said, analysts will feel pressure to support banking clients.
Hill was similarly skeptical of the new rule that Wall Street firms provide their customers with independent research to supplement their in-house reports. High-quality boutique research firms won’t participate, he said, because their big institutional clients -- pension funds, insurance companies and the like -- won’t want the reports shared with the public.
Thus, the quality of the independent research will be suspect.
“When you put a pot of money out there, I’m sure you’re going to have a lot of fly-by-night outfits chasing it,” Hill said.
Another unintended consequence of reform, experts say, may be a rise in the number of “orphan” companies that can’t attract Wall Street coverage.
The number of firms receiving coverage from at least one analyst has shrunken 26% it’s to 4,499 from a 1999 peak of 6,072, according to Zacks Investment Research.
The biggest factor in the decline is the weak stock market and the resulting layoffs of thousands of securities professionals, including analysts. But the pressure to grade more harshly is causing many analysts to simply drop coverage of marginal stocks rather than issue “sell” recommendations.
Louis M. Thompson Jr., president of the National Investor Relations Institute, said the loss of coverage makes it more expensive for smaller companies to raise money. They have to work much harder to get their “story” across to big investors, he said.
From the investor’s perspective, that’s not necessarily a bad thing. Money manager Jeffrey Bronchick of Reed Conner & Birdwell in Los Angeles said the best opportunities generally are the lesser-known ones.
Investors who can ferret out good stocks overlooked by Wall Street can make real money, he said.
But that means doing real homework rather than slavishly following Wall Street “buys” and “sells,” Bronchick said.
“People who lost money in the bubble deserve most of what they got,” Bronchick added. “To suggest that Wall Street since the 1600s has ever been anything but a promotional machine is the height of naivete.”
Small investor Judi McDonald of Hanson, Mass., wouldn’t disagree. Certainly, there were companies that fraudulently boosted their profits or hid their debts, she said, but at the same time many investors “fed into that corporate greed with their own greed.”
McDonald, who belongs to a local investment club and heads her state chapter of the National Assn. of Investment Clubs, said no amount of regulatory reform can alter the fact that securities firms exist to sell stock. Any opinions they offer the public need to be viewed in that light.
“The basic interest of a broker or an analyst really doesn’t match the basic interest of an investor at all,” she said.
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Times staff writer Josh Friedman in Los Angeles contributed to this report.
