Spitzer and the Myth of Independent Analysis
"This has been about one thing," New York politician Eliot Spitzer said before a flock of television cameras at the New York Stock Exchange. "It has been about ensuring that retail investors get a fair shake."
So went the crowd-pleasing explanation for why the state’s just re-elected Attorney General, along with federal regulators, reached an industry-wide settlement with ten major Wall Street investment banks. The settlement brought to a close Spitzer’s investigation of conflicts of interest charges on Wall Street.
A less publicized motivation for the deal was buried deep in a New York Times story, which recounted the investigation’s origins. New York Stock Exchange chairman and power broker Richard Grasso told Spitzer that he would never achieve his ambition of becoming governor of New York with Wall Street as an enemy. So Grasso advised him not to bring Wall Street firms into court. Instead, he urged Spitzer to negotiate a deal to restructure Wall Street business practices and impose attention-grabbing fines. Spitzer agreed.
Neither proponents nor opponents of regulatory intervention in financial markets can be pleased with the outcome, an exercise in the worst form of corporate cronyism. Regulators will oversee a 5 year, $450 million corporate welfare program to support so-called "independent research" on stocks, plus an additional $85 million for "investor education." Investment banks will fund the program and distribute to retail investors research that is supposedly unaffected by conflicts of interest.
The Spitzer settlement stands no chance of ameliorating the perceived conflicts of interest within the securities industry. Boutique stock research firms that receive subsidies under the Spitzer settlement will still have a vested interest in generating retail purchases of stock. Their funding will be indirectly dependent on fees generated from IPOs and other stock offerings by investment banks. Equity analysts at investment banks will still face pressure from companies not to appear overly bearish. Financial executives will continue to cut off communication with analysts who do not publish favorable opinions on their stock, whether those analysts are from independent firms or full service investment banks. All of the incentives that led "independent" researchers to be bullish during the 1990s stock market bubble will still exist under a politically-managed system of stock research.
Spitzer seems to have deluded himself into thinking that independence equates to quality. Virtually all of the top equity research teams in 2002, as ranked by Institutional Investor magazine, came from Wall Street as opposed to research-only firms. Spitzer’s top Wall Street targets, Salomon Smith Barney and Merrill Lynch, placed first and third in the annual survey. Research-only firms barely register in the survey.
The overall quality of stock research will not improve simply because more money is spent on "independent" analysis. In fact, the opposite is likely to happen, for four reasons:
1) Lower analyst pay. Because investment banks must now subsidize and distribute research by their competition, resources will be diverted from their own research budgets. The likely impact is that analysts’ pay will decline, discouraging talented individuals from working as Wall Street research analysts. Independent research firms are not able to compensate their analysts as well as investment banks precisely because of the lack of investment banking revenue.
2) Reduced research coverage. Faced with higher research costs, investment banks may have to focus their research efforts on a few larger companies. This would result in more limited service to investors, as small cap companies would not receive the same attention as large cap companies.
3) Government picks winners and losers. Under the Spitzer settlement, nominally "independent" research will be distributed for free by government mandate. Government bureaucrats will decide which research firms get to participate in the free distribution system. Obviously, since it is shielded from the burden of having to please customers or compete in a real marketplace, its quality will be inferior to paid research. The job performance of each "independent" analyst will be judged not by paying customers, but by regulatory officials who are indifferent to the interests of real investors.
4) Less demand for paid research. A truly independent and high-quality stock research report costs thousands of dollars to purchase. To the extent that some investors will receive free research reports via the Spitzer program, they will choose not to pay for top dollar research. Some truly independent stock research firms outside of the state-run program will suffer from having to compete with subsidized competition.
At best, the regulatory mandate to provide subsidized stock research is redundant for small investors. They already have the option of using independent research by buying mutual funds run by professional portfolio managers. Mutual funds and pension funds already purchase independent research or perform their own proprietary research. Mutual fund managers also have the best relationships with Wall Street analysts, and are able to evaluate the quality of research reports provided to them by investment banks.
The Spitzer settlement actually harms small investors, misleading them into thinking they should manage their own money rather than obtaining assistance from professional money managers. He is creating moral hazard by making investors think that investment risks are minimized simply by skimming an independent stock research report. This is dangerous, encouraging excessive risk taking by people who are not qualified to evaluate individual stocks or stock research.
Spitzer thinks that if investors are simply given access to more information, they will be able to beat the market. The government’s efforts to help investors in this fashion have always failed. It has mandated that companies produce quarterly audited financial statements. It has demanded SEC oversight of company disclosures and regulatory filings. It has enacted Regulation Fair Disclosure to foster wider dissemination of corporate releases to individuals and day traders.
The information was not used by small investors to make better investments. Instead, it caused them to become fixated on quarterly performance, which in turn forced companies to manage their earnings numbers in creative, sometimes desperate ways.
Worst of all, Spitzer is encouraging investors to think that they are decent investors who lost money in the stock market because some overly optimistic Wall Street analysts tricked them. The truth is simpler but unpleasant: most small investors are not good at investing at all. They followed trends and hype seen on television. They took on investment risks voluntarily, but in no way were they assured that positive returns were guaranteed. The fact that they would invest based solely on a Wall Street analyst’s enthusiasm is proof enough that they are gamblers, not serious investors.
That they falsely measure their losses from the March 2000 top of the NASDAQ is further evidence of self-delusion. Spitzer the pol is happy to capitalize on their childish view of the world. He offers intervention by the therapeutic state to soothe their bruised egos, while catapulting himself to prominence—in 60 Minutes profiles and in adoring New York Times editorials—as the savior who "cleaned up Wall Street."
Spitzer’s settlement fails to achieve its stated objectives, but will collect tons of money for the government without any proof that fraud was committed. After early on imposing a $100 million fine on Merrill Lynch, Spitzer imposed steeper fines on Citigroup ($300 million) and Credit Suisse First Boston ($150 million). Smaller fines of $50 million were imposed on other broker-dealers such as Lehman Brothers, Goldman Sachs, and Morgan Stanley. The fine structure and legal restructuring violate all norms of fairness and justice, both for Wall Street and for investors.
The varying fines were reportedly related to the severity of e-mail "evidence" assembled by Spitzer allegedly showing conflict of interest. Yet this evidence mainly consisted of uninformed innuendo, press leaks, and smears of Wall Street analysts via unnamed sources inside Spitzer’s office. In some cases, e-mails had to be carefully stripped of context and made to look incriminating. In other cases, the e-mails were distorted to say the opposite of what the authors actually wrote.
The fine structure failed to distinguish between securities firms that have retail asset management subsidiaries versus those that sell exclusively to institutional investors. Nor did he differentiate firms based on market share in the sectors most impacted by the telecom and Internet bubbles. Thus, he took a view that equity analysts were equally culpable whether they distributed research recommendations to small investors via retail brokerage arms, or simply touted stocks on television, where viewers learned of their recommendations free of charge.
In Spitzer’s case, which the prosecutor presented entirely to the news media, no evidence demonstrated that a single individual investor relied on a specific investment bank’s stock research report in making a bad investment. Only in hindsight, after the stocks declined in value, do the research reports even appear deficient.
Spitzer surely found it virtually impossible to find an aggrieved investor who had even read a research report before buying an Internet stock. The contents of a typical equity research report do not support the theory that equity analysts intended to perpetrate fraud. Such reports contain caveats, warnings, and stipulations to explain risks to the overall investment thesis. They do not lead any reasonable reader to the conclusion that positive investment returns are guaranteed.
Thus Spitzer avoided bringing criminal charges against the investment banks, which require proof of intent to defraud. Instead, he sued them under vague civil laws, and proceeded to trash their reputations via the news media in order to strong arm them at the negotiating table.
To ascertain whether any fraud was really committed, it is important to understand how the financial markets work in practice. The primary audience for a Wall Street research report is not the retail investor but the institutional investor—the mutual fund manager, pension fund manager, or life insurance company. These customers have long understood that the investment rating is the least important part of a research report. The detailed rationale, industry knowledge and financial model underpinning the report are far more useful to a buyer. The institutional clients knew that there were valid reasons for Wall Street analysts to avoid "sell" ratings on stocks:
1) Company management may cut off the lines of communication with analysts who recommend selling their stock. A Wall Street analyst is useless to institutional investors if he spoils a good working relationship with company management, and allows competing analysts to dominate the information flow.
2) The institutional investors themselves hate it when a stock they own is downgraded to a "sell" rating, causing the stock price to fall. They complain vehemently when it happens. They would prefer more subtle methods of signaling unhappiness with a stock. Wall Street analysts risk spoiling relationships with their clients by issuing "sell" ratings.
Many analysts also kept positive to neutral ratings on companies that provided underwriting or merger advisory business, in order to maintain good relations with these companies. Institutional investors knew about this problem for years, but it did not prevent them from getting the information they needed to make buy and sell decisions. They could usually read an analyst’s conviction level or balance his opinion with competing research. They could also get an unvarnished opinion directly from the analyst, regardless of what he wrote in a published report seen by the company management. In fact, one of Spitzer’s celebrated "smoking guns" was an e-mail from a Merrill Lynch analyst to an institutional client expressing skepticism about one of his own buy-rated stocks. If anyone was being deceived, it was the company.
Despite lacking a real case, the powerful Spitzer threatened and intimidated the investment banks. With the news media supporting him and gleefully reporting on leaked e-mails and other information about the investigation, there was no effective check on his abuse of power. The investment banks lacked any means to defend their reputations. The prosecutor became furious when confronted about the leaks, becoming more belligerent during negotiations.
According to press reports, several investment banks were hesitant to accept the financial penalties assessed by Spitzer, which implied an admission of wrongdoing. In the end, they capitulated to his strong-arm tactics, and accepted the industry-wide restructuring.
The banks also settled out of raw self-interest. They thought they could secure certain benefits for themselves, such as appearing pro-active, ending bad publicity, and getting people to buy stocks again. Some figured they could influence the regulators to create various loopholes and exceptions to benefit themselves at someone else’s expense—at least until the other parties persuade regulators to reverse the favorable treatment. The compromise is a shaky and open-ended one, given its 5 year duration. At the end of that period of time, regulators may decide that even more intervention in the industry is necessary.
By far the biggest concern of the investment banks was the potential for investor class action suits. Many entered into negotiations with Spitzer thinking that he would generously keep their emails from falling into the hands of his political allies, the trial lawyers. After the deal, he announced that he would make all of this information public. Trial lawyers will try to misuse it the same way Spitzer did, this time in front of gullible juries. The class action suits are potentially open-ended, a morass like asbestos.
The Spitzer settlement is a travesty of justice. If it is true that certain individuals in the securities industry perpetrated fraud in order to garner investment banking fees, they should be criminally prosecuted and punished. Only a corrupt politician would ignore possible crimes in return for an industry’s support in future political campaigns. The liberal New York democrat helped himself, not investors.