Money and Ethics
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JIM LEHRER: Today it was Xerox and questions over its accounting. The scandals hitting corporate America continue to unravel, and our business correspondent Paul Solman of WGBH-Boston continues to shed some light on them for us. Here’s part three of his series on money and ethics. This one focuses on the behavior of investment stock analysts.
SPOKESMAN: I’m looking at your portfolio right now. You’ve got to buy.
PAUL SOLMAN: A new ad for discount broker Charles Schwab, playing off one of the year’s top business scandals.
SPOKESPERSON: I think you should buy.
SPOKESMAN: It’s a buy.
SPOKESMAN: Buy it.
SPOKESMAN: It’s a no-brainer. I’d sell. Did I say sell? No, no, I meant buy. Buy, yes.
PAUL SOLMAN: The ad mocks Wall Street firms touting stocks not because they liked the companies, but because they were getting paid to hype them, despite misgivings documented in their e-mails.
ELIOT SPITZER: This is only a sample of some of the communications revealed in our investigation.
PAUL SOLMAN: New York Attorney General Eliot Spitzer has made a name for himself by going after Wall Street, getting Merrill Lynch to pay a $100 million fine for having misled investors.
ELIOT SPITZER: The motive was investment banking fees and enormous personal compensation for the analysts. In the process, an untold number of people were left to rely on stock ratings the analysts themselves didn’t believe in, and there is no telling how much they lost as a result.
PAUL SOLMAN: Merrill has also promised reforms to prevent such abuses in the future. But several questions remain: Why did so many analysts become stock shills, and why did so few of us seem to notice until now? We start, in good old PBS fashion, with a bit of history and a good old PBS celebrity. The host of "Adam Smith’s Money World" started as a stock analyst in 1960, at a modest salary.
ADAM SMITH: It was barely $15,000 a year, and it was kind of like a treasure hunt. The field wasn’t very crowded, and you’d go out and you see the competitors of a company, you’d see the people that the company sold to, you’d see the company that — the people who supplied the company with its goods. Only at the very end would you go to see the company itself.
PAUL SOLMAN: Now the title "stock analyst" describes the job: Analyzing companies– their revenues, profits, their business– so that investors can decide whether or not to buy the stock.
ALAN BENASULI: It was basically a search for the truth.
PAUL SOLMAN: Money manager Alan Benasuli describes what he was looking for as an analyst in 1966, fresh from Harvard Business School.
ALAN BENASULI: Is it true that revenues are going to be rising as they tell us they will? If they are not, why will they not? And what will be the impact on the price of the stock, assuming we are right and they’re wrong?
PAUL SOLMAN: And Benasuli was right enough to be named "airline analyst of the year" six times by "Institutional Investor" Magazine. Its readers were the big money managers at banks, insurance companies, pension funds, and the like. The more helpful they found Benasuli’s analysis, the more stock trades they funneled through his firm, which charged hefty commissions fixed at a sizable percentage of the trade’s total value. The firm then paid the analyst from those commissions, since, after all, he’d helped bring them in.
PAUL SOLMAN: In other words the way you got paid was sort of indirectly in that the people who read your reports and trusted them would then buy or sell stocks through your firm.
ALAN BENASULI: That is correct. That was called soft dollars or commissions, general commissions. And then that disappeared.
PAUL SOLMAN: The disappearance began on May 1, 1975, known forever on Wall Street as "Mayday": The day the government forced Wall Street to compete on price instead of charging fixed stock commissions. And not surprisingly, commissions promptly plummeted.
ALAN BENASULI: The going rate went very quickly to 20 cents and ten cents and six cents per share, which is what it is today. And, therefore, the firms who were in the research business had to find ways to get paid.
PAUL SOLMAN: The way they found to get paid in the ’80s was "investment banking," the new profit center of the old brokerage houses. Investment bankers did mergers and acquisitions, took companies public by selling millions of dollars of their stock in IPO’s, initial public offerings. The commissions on these deals were enormous. Analysts were now valuable to the extent they could help the investment bankers. In the early ’90s, just as the system was changing, analyst Tom Brown switched brokerage firms and joined D.L.J.
TOM BROWN: Their compensation system was every quarter, you got a check for any investment banking transaction that you helped with.
PAUL SOLMAN: At the time, Brown was considered Wall Street’s top bank analyst, renowned for his research. But he was paid only a fourth as much as a hot new colleague, who was much more involved in investment banking deals. Brown’s epiphany, he says, came on the day his colleague addressed a D.L.J. analyst’s conference, in confessional mode.
TOM BROWN: And his line was to work well with selling deals. That you had to be able to say, "Father, forgive me, for I have sinned." And he went on to say that the way you sold deals was basically to lie and exaggerate about the company’s prospects.
PAUL SOLMAN: He said this to the entire group?
TOM BROWN: That’s what he said.
PAUL SOLMAN: Nearly everyone played this game, as an old college classmate of mine told me in January.
PETER SIRIS, Hedge Fund Manager: When I was in industry and I was a senior financial executive at two New York stock exchange companies, I used to say to the analysts, "you want to be in the deal? We’re going to earn $1.35 (million) next year. This is what each division is going to make. This is what the company is going to do. And if you write or say anything different from what I’m telling you, you won’t be in our next offer."
PAUL SOLMAN: You mean, your company, your bank will not get a piece of the action.
PETER SIRIS: Right. When I was in industry and then…
PAUL SOLMAN: You would actually say that to them?
PETER SIRIS: Absolutely. Why are you looking at me like it’s strange? I wanted one story out there. I wanted every analyst to have the same story, and if they weren’t willing to go along with exactly the way I wanted that story managed, I wouldn’t take their phone calls.
CORRESPONDENT: Looks like people were listening to you and buying on your list.
JEFFREY APPLEGATE: It had a pretty good day today, yeah.
PAUL SOLMAN: You can see how, within such a system, analysts helped inflate the stock bubble.
SCOTT SHEVICK: We’re forecasting 25 percent growth this year, 30 next, and 25 percent the following year.
PAUL SOLMAN: In the ’60s, says Alan Benasuli, he spent 90 percent of his time on research.
ALAN BENASULI: And I would say that of my recommendations, maybe 30 percent of my universe were buys.
PAUL SOLMAN: Benasuli says that by the ’90s, analysts were spending 10 percent of their time on research. Their buy recommendations? Up to 98 percent.
CORRESPONDENT: Star Internet analyst Mary Meeker on the wild tech sector.
PAUL SOLMAN: It would seem then, that the new pay system turned the analyst game and the Internet stock boom into something deeply cynical.
SPOKESPERSON: Give us your quick picks. What are the stocks to own?
MARY MEEKER: Yahoo, Amazon, and Ebay.
PAUL SOLMAN: But that ignores another important element: Boundless enthusiasm.
SPOKESMAN: The economy was in a recession.
PAUL SOLMAN: Jack Hidary was an Internet entrepreneur who took his company public in an I.P.O. in the ’90s. And though he auditioned many investment banks and their analysts, he says CEO’s like him were never thinking about the conflicts of interest.
JACK HIDARY, Entrepreneur: You’re not thinking that at all. No, you’re… what you’re really thinking is, "I’m excited, I want to take my company public, I want to raise capital for my company so that we can then expand our company." That’s what you’re thinking.
PAUL SOLMAN: And you think, "oh he understands me."
JACK HIDARY: Exactly. He knows the space, understands me, gets my company.
PAUL SOLMAN: It was only after Hidary’s company crashed that he began to realize how corrupted the system had become, how compromised analysts were.
JACK HIDARY: Traditional research goes to the CEO’s of companies and asks them, "how is your company doing?" Well, it turns out most often the answer is "pretty well."
PAUL SOLMAN: What a surprise.
JACK HIDARY: Yeah, what a surprise.
PAUL SOLMAN: And so he decided to open Vista Research, a new firm:
JACK HIDARY: That did not have any banking, any mergers and acquisition, advisory work, any trading, really just pure research. And we only get paid by one kind of company: The fund manager, the investor. We do not get paid by the companies that we talk about.
PAUL SOLMAN: So perhaps stock analysis post-bubble will return to the golden days of yesteryear, assuming, of course, that investors will actually pay enough to fund extensive unbiased research.
SPOKESPERSON: Upgrading the stock to a strong buy…
PAUL SOLMAN: But if they do, it will be a very different environment from the one stock analysts have grown into in the last decade or two.
TOM BROWN: The younger analysts, particularly, they didn’t know anything else, right? So they weren’t around when there were…analysts really did good, hard research. All they knew was promotion, and that’s what was so distressing to see is their lack of concern about the people who were buying these deals. They didn’t care about whether the company actually succeeded; they just wanted to do the transaction, because that’s how they got paid.
PAUL SOLMAN: Anybody ever take them aside and say, "hey, you know you’ve got these other constituents, that is to say the investors you’re giving advice to"?
TOM BROWN: No, nobody ever talked about that. I was the odd man out.
PAUL SOLMAN: Nobody on Wall Street ever talked about that, nor did they want tom brown to. Even after he was fired back in 1998 for refusing, he says, to tout questionable deals. His severance pay discussions, according to him, dragged on for months, because…
TOM BROWN: In the whole negotiation, what they wouldn’t give up on is that Tom Brown couldn’t speak to the media about his departure from D.L.J. and for that they were willing to pay me $500,000.
PAUL SOLMAN: $500,000 just for that one clause.
TOM BROWN: Just for that clause.
PAUL SOLMAN: D.L.J.’s response: Such clauses are common on Wall Street, and Brown was fired for other reasons. But the one certainty, Tom Brown refused the money. Let’s get back to our original question, however. Why did some analysts become virtual shills? Because the end of fixed high commissions meant their brokerage firms had to find another way to pay them, a way that proved so lucrative, new ethical norms took over. And why did so few of us squawk or even notice? Perhaps because the system was so lucrative for us as well. Or as Allan Sloan of Newsweek puts it…
ALLAN SLOAN: This has been going on for at least 18 years and for the first 17, nobody cared. It didn’t make any difference. The only reason we’re seeing any of this now is that the market has been in the dumps for 27 months and people are screaming.
PAUL SOLMAN: And, perhaps more worrisomely, they’re not investing.
JACK HIDARY: Two-thirds of investors say that the conflict of interest between research and banking is holding back the investment climate. So the confidence of the investor has been lost in the system. And the big picture here is that unless we restore that credibly, we’re not going to be able to get our financial markets going again.
PAUL SOLMAN: And if we don’t, that would give further impetus, perhaps, to the furor over who helped create the Wall Street bubble in the first place.