Subsidies for Stock Pickers
An impending power grab by Eliot Spitzer, the Democrat attorney general for New York, threatens to disrupt Wall Street and the entire system of capital allocation. What used to be one of the freest financial markets in the world is about to go further down the path of political interventionism and corporatism. In the name of helping the small investor, meddling politicians and bureaucrats are about to impose strict controls on Wall Street research that will make investing more expensive as it undermines competition in the financial services industry.
Spitzer, a liberal Democrat, has launched investigations charging Wall Street securities firms with misleading investors by publishing overly optimistic stock research on their banking clients. The investigation started with a $100 million fine on Merrill Lynch, and is culminating in an industry wide settlement involving the Securities and Exchange Commission and a dozen investment banks.
The bureaucrats have designed a broad plan to tax the investment banks and transfer the money to smaller stock research firms with no investment banking business. While the plan for a government board to choose the recipients of this revenue is meant to guarantee research free of conflicts of interest, it can do no such thing. In fact, the plan will create a stock research cartel more prone to conflicts and corruption than the system it replaces.
It does not seem to strike the news media as odd that a dozen of Wall Street's top investment banks quickly signed off on the broad outlines of the Spitzer plan. Citigroup, for example, already restructured its research department before the regulators even had a chance to finalize the details of their plan. Various business news outlets have explained it away as Wall Street being "pro-active" and "getting out in front" of inevitable changes that are estimated to cost the industry $1 billion to $2 billion over five years.
Paradoxically, the higher costs the new regulatory structure will impose on equity research are a boon to the current industry leaders. It already takes about $500 million per year to fund an adequate research effort on Wall Street. As that number moves higher because of government dictates, no bank currently outside of the Street will ever dare to venture in.
The full-service investment banks that offer debt and equity financing, merger advisory, and corporate lending will be guaranteed a dominant position in the financial services industry. With their superior resources and scale, they already have the teams of lawyers, DC lobbyists, and compliance officials necessary to operate in an over-regulated environment. It is no coincidence that Citigroup, already the largest most integrated bank on the Street, was the first to endorse the Spitzer plan.
Spitzer's idea to subsidize smaller research firms was a bureaucrats' way of addressing the problem of conflict of interest. Investment banks not only provide research on companies, they also provide debt and equity financing to the companies. The research analysts are prone to bullishness on their own clients—companies that pay them to distribute I.P.O. and follow-on shares to the marketplace. Institutional investors such as mutual funds, hedge funds, and pension funds have known for decades that investment banks tend to be bullish, and discounted their stock advice accordingly. The Spitzer board would direct Wall Street banks and brokerage firms to subsidize the costs of so-called "independent" research, provided to smaller, less sophisticated investors.
Yet two of the supposed beneficiaries of politically directed stock research—Charles Schwab and the Precursor Group—have stepped forward to condemn Spitzer's plan. They know that investment banks will be able to dominate any political board that "oversees" stock research. The fact that the money to pay for research still comes ultimately from investment banking revenue means that its recipients will tend to be just as bullish as Wall Street analysts. If banking money corrupts research, funneling it through a government board will not remove the taint. Rather than eliminating conflict of interest, the Spitzer plan would solidify it with the blessing of the US government.
Spitzer has peddled the myth that small investors relied on Wall Street research reports to make their investing decisions during the stock market bubble. In fact, a miniscule portion of the investing public even saw the cover page of a Wall Street stock report. If they had bothered to read it at all, they would have been bewildered by voluminous stock charts, earnings forecast tables, and other mathematical gobbledygook.
In reality, the average investor heard about an internet company at a cocktail party, on CNBC, or in a barber shop. Many investors also received a phone call from their retail stock broker tempting them with the story that some hot shot Wall Street analyst has a "Strong Buy" rating on Amazon.com. The fantasy of getting rich quickly with no work was what misled small investors, not optimistic research.
Small investors thought that investing was so easy and risk-less that there was no need to pay for stock research. Even in the current bear market, consumers accustomed to cheap on-line trading commissions are unlikely to start opening their wallets to pay additional fees for research. Thus Spitzer's senseless plan is to force them to pay for a product they don't normally buy with their own money. The higher costs of conducting fundamental research for small investors who do not utilize such products will ultimately be passed on to the investors themselves. Like other make-work government programs, the Spitzer board will probably result in research products of inferior quality and usefulness.
It was the investing public, not investment banking business, that made Wall Street analysts overly optimistic in the late 1990s. During the stock market boom, Wall Street faced insatiable demand from fund managers, day traders, and individual investors for risky Internet start ups and telecom companies. Most of the start up ventures in this sector had flawed business models and shaky prospects.
Wall Street analysts felt enormous pressure to relax their normal research standards in order to recommend these companies. Those who dared to expose the weaknesses of "New Economy" stocks tended to lag their more exuberant competitors. The bubble was not simply a scam by Wall Street analysts, but rather a generalized speculative craze. The so-called independent research outfits were every bit as exuberant as their Wall Street counterparts. Most regrettably, Spitzer's scapegoating of Wall Street analysts is absolving investors of any responsibility for their own investment decisions.
A savvy politician, the liberal Democrat Spitzer has everything to gain from exploiting the discontent of investors who lost money after the bubble burst. His scapegoating of Wall Street research analysts is ironic considering that just a few years ago, federal regulators were assailing the same analysts for doing no original research and simply serving as mouthpieces for corporate executives.
The SEC, under media darling and Clinton appointee Arthur Levitt, imposed Regulation FD in 2000. The rule forbids company executives from disclosing material information exclusively to Wall Street analysts, as had been their habit. The aim was to create a "level playing field" by promoting broad dissemination of company information to individual investors, regardless of their level of expertise.
Instead of creating a level playing field, the rule immediately created volatility as information was dumped onto the market via press release, creating speculative fodder for hedge funds and day traders. Reg FD greatly reduced Wall Street's influence over stock valuations, but this did not stop the regulators from blaming the bear market on analysts.
Another inconsistency in the regulator's story: for months we heard a drumbeat of news that corporate executives were all dishonest. All the books had been cooked by crooked accountants and CEOs, causing the plunge in stock values. If corporations were furnishing the market with inaccurate financial statements, then how could falling stock prices be the Wall Street analysts' fault? They are given the same financial statements as everyone else.
Spitzer, a New York politician, understands how to campaign, fundraise, and even to shake down the private sector from his powerful political perch. He does not understand how financial markets work. Investment banks have always financed companies while also publishing research reports on the same companies. This is not proof that the research was tainted. An investment bank has every incentive to market the shares of quality companies in order to maintain its reputation with buyers.
Spitzer's original plan was so naïve that it sought a complete separation of research from investment banking. Thus, a research analyst could not even be paid to evaluate a new start up venture to determine whether it was worthy of financing. The initial public offering process would have been effectively paralyzed. Cooler heads at the SEC prevailed on Spitzer to drop this foolish demand.
The New York Democrat also apparently believes that Wall Street's lack of "sell" ratings on stocks proves conflict of interest. Yet most investors are interested in buying, not selling. A very small proportion of an investment bank's customers want to sell stocks. Naturally, it makes very little sense for an investment bank to have an equal number of "buy" and "sell" recommendations. Moreover, if a company is not deemed to be investable in the not-too-distant future, it makes little sense for a bank to have research coverage of that company.
At root, Spitzer is attempting to punish analysts for failing to anticipate the stock market collapse. It is an article of faith in the investing world that nobody can time the market. If research analysts knew the collapse was coming, they would have surely tempered their bullishness beforehand and prevented the bubble from expanding in the first place. Indeed, if they had the power to will the market to go up and down, they would simply publish more bullish reports right now to save their own jobs.
It seems as if the political class's response to every situation is to pass new laws. Like the Sarbanes-Oxley law, which restructured the accounting industry, the Spitzer restructuring of Wall Street will not achieve its stated objective of restoring confidence in the stock market. It will, however, create a government sanctioned stock research cartel. Because of its dependence on the political government for its very existence, its legacy will be higher costs, more inefficiency, and less competition.