From IDD
New Concern: Could Merrill Woes Spread?
Christopher O'Leary (christopher.oleary@tfn.com)
May 13, 2002
The growing crisis at Merrill Lynch & Co., whose research group has been charged by the New York attorney general as having severe conflicts of interest and could possibly face criminal charges, is fueling concerns among bankers and investors that the situation could spill over into the capital markets.
There were settlement rumors being floated last week at press time, but such rumors had surfaced before and proved false. In any event, the immediate effect of a criminal charge might well be major downgrades of the banks nabbed for wrongdoing. Moody's Investors Service said last week that, should Merrill or other banks face criminal indictments due to the research scandals, the banks' credit ratings would likely be downgraded, perhaps severely. "If the course of the investigations turns very negative for a particular firm, then multiple notch downgrades are possible," Moody's analysts said in a May 5 statement. Merrill is currently rated Aa3 by Moody's, AA-minus by S&P and AA by Fitch Inc.
Merrill isn't the only firm in danger of getting pulled into a criminal investigation-others such as Morgan Stanley and Citigroup have also been rumored to be probe targets. Yet Merrill has been foremost in the spotlight, as New York State Attorney General Eliot Spitzer released copies of e-mails last month written by Merrill researchers, including former top Web analyst Henry Blodget, that featured researchers mocking the value of companies they were still strongly recommending to clients.
The crisis provoked Merrill's top management, Chief Executive David Komansky and President Stanley O'Neal, to promise to reinforce firewalls between investment banking and research. Komansky reportedly told employees last Thursday that Merrill had been "tarnished" by the Spitzer investigation, but argued that any wrongdoing was on the part of a handful of researchers, and was not a mass phenomenon. Merrill did not return calls for comment.
The stakes for Merrill could be enormous. Spitzer has said one outcome of his investigation might be an order requiring Merrill to split off its research from its investment banking unit-a possibility that could be an economic disaster for Merrill, many Street observers believe, and has sparked acquisition rumors (see sidebar). Merrill has strongly been resisting such a move, arguing that such a hiving off would place it at a competitive disadvantage.
Merrill's perch in the debt underwriter rankings might also be affected-far more so in the event of a criminal charge. The kingpin of almost all debt categories in the 1990s, Merrill ranked ninth in long-term U.S. debt in first-quarter 2002 with $39.4 billion total underwritten, down from $53.9 billion in the same period last year, when it was ranked third.
Streetwide implications
Yet no matter what happens to Merrill, the broader implications for the Street could be far more severe. Several bankers at institutions that do not have ties between lending and underwriting (usually because their shops do not have a banking component) said that there has been a growing revulsion on the buy side over the conflict-of-interest mess the Street has created in recent years.
"Our industry is seeing some investors sitting on the sidelines-many people are hesitant right now. Much of the industry has lost credibility," said James McKinney, head of debt capital markets and member of the executive committee at William Blair & Co. "We count ourselves among the fortunate because, by consciously staying out of the direct lending business, we have avoided its inherent conflicts of interest."
Stand-alone shops that have not been embroiled in the research/banking scandals and pay-to-play strategies that are hitting a number of major banks these days have been gaining a growing amount of new business in the last year, bankers said.
At the end of the day, though, much now hinges on the Spitzer investigation. Should criminal charges be leveled against Merrill or any other Street player, the game would change drastically, one top bond investor said. "It's a whole new issue then-that would be trouble," he said.
"A criminal indictment would be a serious thing," added Tom Foley, a director at Standard & Poor's, which so far has not issued any official warnings about possible downgrades. "If that occurred, we would seriously look at the rating for the firm and might take a rating action." Fitch, which also has been publicly silent about the Merrill situation, could not be reached for comment.
Glass-Steagall redux?
To some players, however, the current research-related scandal is just one example of how the Street, by discarding old firewalls between investment and commercial banking, has been emboldened to take on all sorts of activities that are blatant conflicts of interest.
The conflicts between investment banking and research date to 1975 and the deregulation of brokerage commissions, and are not tied to the Glass-Steagall Act, the Depression-era regulation that separated investment and commercial banking and which was repealed in 1999. Still the potential for a revival of Glass-Steagall increases with each new scandal. One fixed-income head met with congressmen last week and asked about just that possibility. So far, there is nothing in the works, he said he was told, but added that if the scandals continue, it's likely some legislator will attempt to raise the issue.
There is growing frustration in some quarters that the death of Glass-Steagall has created a pay-to-play monster in the capital markets. Issuers are complaining privately to some bankers that they can no longer get the best deal execution because the issuers are forced to use underwriters that are major lenders to their companies.
"I can't tell you how many of my clients tell me, I love you guys, and we're not going to get as good an execution, but if we don't put this bank in the deal we won't get our loans,'" said one banker at a regional firm. "It's hurting some of us."
The chummy ties between research and investment banking are just further reasons for investors to grind their teeth in frustration. "Of course corporations will favor bankers that favor their stocks," the banker said. "Of course people are going to reach across the Chinese wall because the greed factor is too strong."
If volatility is coming, however, it is not yet visible in the daily trades of the debt markets. "From a trading standpoint, it has not been an issue yet," said Chris Mahony, who manages fixed-income investments for J&W Seligman & Co. |
