The Crux of Reform: Autonomous Stock Rating

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The Crux of Reform: Autonomous Stock Rating

By PATRICK McGEEHAN

After the series of embarrassing revelations about conflicts of interest among stock analysts, critics say the time has arrived for Wall Street to do something it is loath to do: consider making some radical changes in the way it conducts its business.

The critics of major investment banks are calling for a clean break between those who underwrite new stocks and those who advise investors about buying them. Moving securities firms out of the stock-picking business was unthinkable just a few months ago. Though it still sounds like heresy to many, some current and former executives of big banks are discussing the idea as a solution in the extreme case to Wall Street's thorniest problem.

None of the changes proposed by the firms to insulate analysts from the influences of their banking colleagues is more than a cosmetic improvement, the critics say. At the very least, they say, the banks must take steps toward treating analysts as professionals whose first obligation is to help investors make objective decisions.

Citigroup, which has been urgently trying to end investigations into favors the firm's analysts and bankers may have done for corporate clients, has proposed putting its analysts into a separate division of the company. But that structural shift alone would not remove the inherent conflict of interest between the corporations that hire Citigroup to sell their stock and bonds, and the individual investors the firm advises to buy them. As long as the investment bankers would have to cover the costs of the analysts' research and of their bosses' bonuses, they would wield the power.

Because that power imbalance is intractable, Peter J. Solomon says, the big banks should, and probably will, leave the rating of most stocks to somebody else.

"An incremental approach will not work," said Mr. Solomon, a former vice chairman of Lehman Brothers who runs an independent advisory firm. "Incrementalism is what got these firms into trouble," he said, referring to the gradual adoption of analysts as support staff for investment bankers.

Between the Securities and Exchange Commission, state attorneys general and the stock exchanges, regulators are creating so many rules to govern the conduct of analysts that bank executives fear their employees will inevitably violate them, Mr. Solomon said. That risk, coupled with the huge costs of keeping a full complement of highly paid analysts to produce research with few buyers, is likely to move Citigroup's chairman, Sanford I. Weill, and other bank executives toward an overhaul of their research operations, he said.

"Sandy Weill is the guy who taught me in the mid-80's that research is a loss leader," Mr. Solomon said. He said Mr. Weill advised that research "has no value except, of course, to get banking fees."'

A Citigroup spokeswoman, Leah Johnson, declined to comment.

Investment banks could save billions of dollars annually by ceding much of the burden of putting buy or sell ratings on stocks to an independent company similar to Moody's Investors Service or Standard & Poor's. Those two companies are among several whose ratings of corporate bonds are considered authoritative. But they charge corporations for their ratings, and it is unlikely that thousands of public companies would start paying to have their stocks rated. Morningstar, the Chicago company that rates mutual funds and has begun publishing stock research, might be a better model.

The big securities firms would probably have to subsidize such a venture, at least for awhile, and they would supplement its research with economic and market analysis of their own, Mr. Solomon said.

Big banking companies like Citigroup should take the lead on such a move, he said, because stock research is less integral to their overall business than to smaller firms like Merrill Lynch that are more dependent on individual investors. Merrill officials adamantly refused to consider spinning off the firm's research department when they were negotiating a $100 million settlement with Eliot Spitzer, the attorney general of New York state, in the spring.

In April, Mr. Spitzer released dozens of e-mail messages written by Henry Blodget and other Merrill analysts that included bleak assessments of companies they were recommending to investors. To end Mr. Spitzer's investigation, Merrill agreed to make several changes to how it managed and paid its analysts. But like its main competitors, Merrill still expects its analysts to help the firm decide which companies to underwrite and to help sell their stock.

Research directors at other big investment banks insist that they must employ analysts to vet prospective clients because without the support of the analysts, their stock offerings would be doomed. Firms like Merrill, Morgan Stanley and Goldman, Sachs would never agree to any drastic change on their own, said Jack Rivkin, director of research at Neuberger Berman, a large money management company.

"None of the major firms can afford to separate their expertise from the capital-raising process unless the other big firms do it as well," said Mr. Rivkin, who is a former research director at Smith Barney. In addition, he said, firms that cater to individual investors need material to serve as the basis for their investment recommendations.

"I'm not an apologist for what has happened here," Mr. Rivkin said. He attributed much of the disintegration of research standards to a failure of management.

"Research has to operate as the conscience of the organization," he said. "They have individual investors making decisions based on what they say. With all of the excesses of the 90's, that discipline went by the wayside."

Reviving respect for honest, independent research is the best way out of the mess Wall Street has created, said Gary Vineberg, an independent analyst who is highly critical of how research has been co-opted at the big banks.

Still, Mr. Vineberg does not favor a full spinoff. Most investors are not accustomed to paying cash for investment ideas, and brokerage firms could not justify their high commissions or costs without proprietary recommendations, he said.

"If Merrill doesn't have research, it becomes Schwab with much higher prices," said Mr. Vineberg, who worked at Merrill for several years.

Even Schwab has spent a lot of money to provide its own stock ratings to customers, though it uses a set of quantitative measures and has no banking business to create conflicts.

"Before we talk about breaking research away from everything else, we should try a setup where research actually has independence," Mr. Vineberg said.

Wall Street needs to develop professional standards for analysts "like the legal profession has, like the medical profession has, where people are indoctrinated with a sense of responsibility," he said. "I haven't seen any real attempt to do that."

To get there, he said, would require a clean sweep of senior management of the firms. Even then, he said, it would involve such a stark change in the mind-set of investment bankers and their bosses that it might prove impractical.

"It's about a cultural change," Mr. Vineberg said. "They either have to make a really big effort to develop a professional research culture or break it away."