Why Wall St. fights to keep research
Giants fear small firms will benefit
By Stephen Gandel
Crain's NY
Wall Street's biggest firms are stubbornly resisting efforts to make them separate their research operations from investment banking, because they fear such a move will favor smaller competitors and cost them hundreds of millions of dollars in deals annually.
Without the lure of research, investment banking units at securities firms like Merrill Lynch & Co. would have fewer advantages over small rivals, which once commanded a far larger share of deal work than they do today. The huge cost of research would no longer be paid for by investment banking, and commissions on the retail and institutional stock business are not large enough to subsidize the expense.
"Having to separate their research departments would definitely hurt all of the large firms," says Raphael Soifer, a Ridgewood, N.J.-based Wall Street consultant. "It would make investment banking far more difficult."
Pressure to take just such an action is growing. New York Attorney General Eliot Spitzer continues to push Merrill Lynch to make its research units independent. He says his office has uncovered evidence that shows how research analysts whose compensation and promotion are tied to investment banking baldly and illegally misled investors for the sake of investment banking profits.
"We have demonstrated that the tension between investment banking and analysts' objective analysis led to reports that didn't reflect what the analysts actually believed," says Mr. Spitzer.
While Mr. Spitzer tries to negotiate a deal with Merrill Lynch, his investigators continue to scrutinize other large firms, such as Morgan Stanley, Credit Suisse First Boston and Salomon Smith Barney. He seems certain to turn his attention to those brokerages when he is done with Merrill.
Investors are clearly nervous about the probes and the implications of any settlement. Since Mr. Spitzer revealed in early April that he was investigating Merrill Lynch, the shares of that firm and the six other firms said to be under investigation have lost nearly $25 billion in combined market value. Last year, Citigroup, Goldman Sachs, Morgan Stanley and Merrill Lynch collectively generated over $8 billion in fees from underwriting stocks and bonds.
"If someone passed a law that research couldn't be conducted inside a brokerage, the effect would be to hurt the markets and the investor," says Stuart Kaswell, general counsel of the Securities Industry Association, Wall Street's largest trade group. "The current system works well."
Key role of research
While many would dispute that assessment, there is general agreement that large stock-picking departments help the major Wall Street firms maintain their dominance in the highly lucrative world of investment banking.
For a long time, there was little connection between Wall Street research and underwriting. Analysts' salaries were paid by the fat commissions securities firms got for executing trades. But in the 1970s, commissions were deregulated and began to drop. As a result, securities firms needed to find another way to subsidize their costly research departments. By one estimate, research costs Wall Street as much as $13 billion annually.
When stocks began to take off in the 1980s, large securities firms realized they could win more investment banking work by promising that their research departments would cover the companies. The research turned out to be overwhelmingly positive; analysts hardly ever told clients to sell a stock.
"Research became an instrumental aspect in luring in new clients," says Michael Madden, a partner at Questor Management Co. who ran investment banking at Lehman Brothers and Kidder Peabody in the 1980s and 1990s.
Later in the 1990s, as analysts started getting featured on stock-picking television shows and in investment magazines, an analyst's following and his or her ability to sway investors became the top reasons corporate executives selected an investment bank. At that point, the quid pro quo research structure of Wall Street was solidified.
Wall Street firms built research teams with hundreds of stock pickers-paying small fortunes to retain top talent. The rising cost of research made it a large barrier to entry into the investment banking business. Small investment banks suffered. Last year, the top five underwriters issued 73% of all U.S. stock offerings. In 1994, the figure was only 45%.
"Research is one of the reasons the small firms lost out to the big firms," says A. Robert Towbin, who heads the New York office of investment bank Stephens Inc. Other factors include mergers, expansion of sales forces and a growing demand from stock issuers for capital.
But Mr. Towbin believes research reforms will benefit small firms.
"If research is really removed from investment banking, then you would be back in the good old days, when the most talented bankers got the business," says Mr. Towbin. "It would be OK to be a boutique investment bank again."
Mr. Spitzer suggests that separate research divisions would be advantageous. He says investors would flock to firms that touted their independent stock pickers. In an era of cut-rate commissions on stock transactions, though, that model hasn't been enough of a draw to sustain money-losing research. Prudential Securities Inc., which dumped its investment banking division at the end of 2000 and began advertising its objective advice, has yet to turn a profit since restructuring.
Analyst pay cuts loom
Indeed, the biggest losers from changes that Mr. Spitzer and other regulators propose could be the analysts themselves. Prohibited from paying analysts from their hefty investment banking profits, securities firms will cut back their research departments and reduce pay dramatically, Wall Street observers predict.
"I think there will be a systematic reduction in analyst pay," says Reilly Tierney, a securities industry analyst at Fox-Pitt Kelton. "That might not be bad for the market, though it won't be great for me." |
