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How Analysts Missed the Clues

Following a report on the day's Enron hearings, Margaret Warner and guests discuss the ways Wall Street investment firms can influence stock markets.

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    During the ongoing congressional probe of the collapse of energy giant Enron, the same question has been put to company executives, members of corporate boards, and outside auditors: Were their actions clouded by a conflict of interest?

    Today, the Senate Governmental Affairs Committee raised that issue with representatives of another sector: Wall Street stock markets analysts, whose job it is to recommend the best stocks for investors to buy.


    The question we ask today is, have the Wall Street analysts kept their part of the bargain?

    I regret to say that based on the investigation our committee has done, my answer is no, they have not.

    Ten out of fifteen analysts who follow Enron were still rating the stock as a "buy" or a "strong buy" as late as Nov. 8.


    You now have a problem of appearances. Before this you didn't. It's the issue of appearance of conflict of interest.

    And what we're trying to do as quickly as possible is to restore people's faith in the financial markets in this country so we can get back to business.


    Before the committee were officers of four major firms that were among the last to downgrade Enron as an investment opportunity.

    Each promoted Enron's stock as late as last fall, not long before the company went bankrupt.

    Ray Niles analyzes stocks for Salomon Smith Barney.

  • RAY NILES, Salomon Smith Barney:

    Given everything that has happened since late October, I think it is appropriate to ask why the analyst community, at least the vast majority of its members, missed the mark on Enron.

    The short answer, Mr. Chairman, is that we now know that we were not provided with accurate, complete information.

    It is now common knowledge that Enron's financial statements, which had been certified by its independent auditor, did not represent the company's true financial condition.

  • RICHARD GROSS, Lehman Brothers:

    The basic business model we believed was very strong, was growing rapidly, was portable into other commodities and that this was the strength of Enron.


    Since Enron declared bankruptcy in December, criticism of Wall Street analysts has intensified. Some observers say much of the industry failed to report Enron's problems, and may have been influenced by a conflict of interest.

    Many investment firms occupy two roles. In one part of the firm, an analyst recommends to investors whether to buy stock in a company, while another part of the firm, the investment bankers, may work with that same company to help complete a merger or other transaction.

    As the stock market surged in recent years, so have the role and influence of stock analysts. The biggest stars tout their favorite stocks on television, often moving markets.

    In recent years, about 90 percent of the stock analyst opinions made public have been favorable, so- called "buy" recommendations. Most of the rest were "holds." Only about 1 percent were negative, or "sells."

    Several New York investment firms recently separated their stock analysis from their investment banking function. And yesterday, Morgan Stanley Dean Witter changed its stock rating system, eliminating "buy" recommendations.


    Does the Enron case show something needs to change with the way Wall Street analysts operate?

    To explore that, we turn to John Coffee, a professor at Columbia Law School and a member of advisory committees to both the SEC and the National Association of Securities Dealers. Peter Siris, managing director of Guerilla Capital Management, a New York investment firm, and columnist for The New York Daily News.

    Previously, he worked as a Wall Street analyst. And Stuart Kaswell, general counsel for the Securities Industry Association, which represents the nation's large brokerage houses. Welcome, gentlemen.

    Professor Coffee, beginning with you. First of all fill out the picture a little more for us about the role these analysts play. Who do they actually work for? How do they operate? And who relies on their advice?



    Basically securities analysts evaluate corporate securities by interviewing management and by examining financial statements and try to project future earnings and the overall strength of the company.

    Ideally, when things are working well, they are the kind of watchdog who tests the company's statements and tells the market whether they're credible.

    The Supreme Court has suggested that they're the principal force that keeps the stock market efficient. But there are also issues about conflict of interest, and that's what we're seeing the current debate focus on.


    So Peter Siris, do you think that the Enron case shows there's a problem here with the way Wall Street analysts operate?


    Oh, of course there's a problem. There's no question that there's a problem.

    The first thing is if… you have to look at the economics. The economics on Wall Street is very simple. You get paid 3 cents or 4 cents a share for trading stock. You're paid $3 a share for doing an IPO or a secondary, and multiples of that for helping in mergers and acquisitions, so that all the money is in investment banking.

    All the money is in mergers and acquisitions. And corporations don't want to do investment banking with somebody who says you're an idiot.

    Corporate… corporations want to do investment banking with people who say you people are geniuses and your stock should quadruple or keep going up forever.

    And so if I'm an analyst, as I was, and somebody gives me a very simple value proposition, which is, you can sit there pounding on some stock that you don't like or you can go out there and shill like crazy for some stock you like and get a couple extra million dollars of bonus and have a nice house on the beach in East Hampton and a big fancy co-op on Fifth Avenue; this isn't a very tough choice.


    You're saying, Peter Siris, despite the fact that the analysts today all said there's a Chinese Wall between these two sides of the company….


    No, no, no please. This Chinese Wall. I hear this Chinese Wall is nonsense. Let me tell you why it's nonsense.

    First, they can erect any kind of wall they want. If I'm a corporation, and I've been a senior executive in industry and hired bankers, I am going to go with the brokerage firm whose analyst is the most bullish on my stock.

    So I don't care, investment bankers are suits. You know, investment bankers travel in packs. They wear nice suits. And between them, ten investment bankers have an IQ of maybe 50 or 60.

    What you want is the analyst who's out there pushing the price of your stock up so there can't be a Chinese Wall by definition.


    Stuart Kaswell do the analysts — in that situation do they feel free to in fact say this stock is no good?


    The analysts have nothing at stake except their own credibility and their firm's credibility.

    The public is not going to give money to brokerage firms to invest unless they have faith in the brokerage firm's ability to make good recommendations.

    I just disagree with the idea that you're going to go out and do whatever you can in order to hurt your customers that you've sought so hard to accumulate, to collect.


    But is it the case that even if you're on the analysts' side often your compensation is tied to activity on the investment banking side?


    The SIA, the Securities Industry Association, has adopted best practices. And that severs the link between any particular transaction and a… and compensation for the analysts. Now, also the NASD…..


    And when that did start?


    That started last summer. We wouldn't say that there was a problem, but there was an appearance of a problem as someone said in the tape you showed before.

    So we felt that the appropriate thing to do was to develop best practices, not have the investment bankers overseeing the research department but create a separate unit within firms, the major bulk bracket firms, the largest underwriters in the country agreed to that.

    Now the NASD, and the New York Stock Exchange rules will codify that into rules. Now we agree that the rules that are going to be put forth are helpful even though we don't agree with every aspect of it.

    But I just disagree with the whole notion that the system is corrupt and nothing can be done. That's just nonsense.


    Professor Coffee, where do you come in on this?


    I think probably in between. There's been a lot of empirical research, and it tends to show that analysts who are affiliated with an underwriter behave very differently than analysts who are affiliated with an independent brokerage firm.

    The underwriter-analyst tends to be much more favorable about his firm's stocks, makes higher earnings recommendations, makes more buy recommendations, and is much slower to downgrade a stock.

    I think the truth is that even though there are many objective, honest analysts, the compensation comes from the deal side. And as long as compensation comes from investment banking, the analyst knows how to maximize his income, which is by being very friendly to the investment banker and his clients.


    If I might just….


    Go right ahead.


    If I might just say.. last year there were 99 buys for every sell.




    "Buy recommendations" or "strong buy recommendations" for every "sell." I'm a little slow, but I figure when I buy a stock, I have to sell something else to replace it with.

    So theoretically, you should find more than one percent of all recommendations as sells.


    How do you explain… let me just get Mr. Kaswell to explain that. How do you explain that?


    There are two things going on. One if you look at the statistics over the last, say, 20 years, the analysts have added value. If you had followed their advice, you would have outperformed the market.

    The other thing is analysts tend to follow the stocks they like. There is a selection bias. So that to say they follow stocks that they like it's because they pick the ones they like. They don't follow the ones that they consider to be losers.

    The other thing and to get back to the Enron situation for a minute, nobody got Enron right. The rating agencies, which don't have this alleged conflict, they got it wrong too. So it isn't that the Wall Street analysts are the only ones who made a mistake.

    The market just made a mistake on Enron because the information reaching the analysts was bad.


    Peter Siris, what about that point?


    Can I just say that I got Enron right. And I came out in print a long time ago saying that I thought Enron was a house of cards. And I don't think people read the information.

    When I was in industry and I… the analysts called me, there were ten analysts following one company that I was involved with. And not one of them had read the financial statements.

    If you go back and read Enron's detailed financial statements, you would have seen most of these problems.

    But I will venture to say that all the analysts who showed up on Capitol Hill today and all the analysts that were pushing that stock, they never went to the trouble of reading all of the documents that Enron filed. And that's it.

    If you won't read the documents, you know, how are you going to be a watchdog?


    Professor Coffee, your view on that about whether these analysts become dependent on the companies for the information rather than doing it independently.


    Well, I think there clearly is a conflict. The real issue we have to get to is what do you do about this conflict? You can try a radical divorce much like the Glass-Steagall Act did separating commercial banking from investment banking 50 years ago but that's a very costly remedy.


    And the real problem is that securities analysis is not a self-supporting profession. If you tried the radical reform that some have proposed of totally separating securities analysts from anyone near investment banking, I think we'd probably be able to support only about one half or less of the analysts we now have.

    The real problem is how you police this kind of conflict. Here I think we need a lot more than the kinds of codes of ethics and best practice norms that Stuart Kaswell is talking about.

    I think we need specific remedies such as an anti-retaliation rule, just about every analyst you interview has had some experience with pressure or a threat of job termination or retaliation if you put out a negative research report.

    That's the kind of thing that should be changed. I think also– and this is what the NASD, the National Association of Securities Dealers, has just proposed– we should try to make sure that all analysts report only to the investment research side of the firm and are never subject to discipline from the investment banking side of the firm.

    The problem is, that threat is always there because the money comes from the investment banking side. The compensation is over on the deal side. The profession of securities analysis is not self-supporting.

    You need specific rules that police these conflicts, and I think that's what the NASD and Congress should be looking at.


    Briefly Professor, are you talking about government imposed by Congress or the SEC or are you talking about private, voluntary rules by some of these associations?


    We've had these voluntary rules in various fashions for some time and they don't change the basic data, which shows that the few analysts that are independent perform more accurately and are much more willing to put out sell recommendations than those analysts who are attached to investment banking firms.


    All Right. Stuart Kaswell…


    Given that kind of conflict I think you really do need precise rules.


    We agree that the self-regulatory organizations rules which have the force of law should be in place.


    I think that's not what he's saying. He's saying he doesn't think that enough. Do you think it is enough?


    Then we would disagree. We think indeed they probably go a little too far. We agree with the idea that there should be a separation between investment banks and the research department and making that a requirement as opposed to a best practice is a good thing.


    Peter Siris, your remedy.


    Actually, I think the NASD could do this.


    Peter Siris, your remedy.


    My remedy is actually very simple, which is I think investors have to take the time to look through the information.

    Investors have to patronize people who come out with "sell" recommendations. I think a lot of this becomes self-policing.

    If people will scream and yell about the kind of stuff that went on with Enron, I don't think you'll see it again. I'm actually very… I feel very strongly that there will be a big house cleaning.

    The kind of accounting that's gone on at Enron and many other companies– and we will see a lot of nonsense in the next year or so with companies with aggressive accounting– if people will stop just looking for earnings momentum and start asking harder questions, I think you'll find that this issue resolves itself without a lot of regulation.


    Gentlemen, we have to leave it there. Thank you.

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