Merrill Lynch may be $100m poorer having reached an agreement with New York Attorney General Eliot Spitzer but, in doing the deal, it has avoided the prospect of a forced separation of research and investment banking. Nevertheless, the scandal has run long enough to have a huge impact on the market: public trust of the integrity of Wall Street has been deeply shaken. Institutional investors have been affected too, including pension funds.
Seasoned investors have never relied on analysts’ ‘buy’ recommendations for designing their own strategies. One of the most famous and successful of all, Warren Buffett, the Oracle of Omaha, at Berkshire Hathaway’s last annual meeting declared: “Analysts’ reports mean nothing to me. If anybody who is sending me analysts’ reports would send me the money they spend on postage I would appreciate it”.
So, these investors were not surprised when Spitzer made public the content of e-mails exchanged among Merrill Lynch’s internet analysts led by Henry Blodget, in the middle of the internet-mania. The messages showed how dot.coms that were officially rated ‘buy’ or ‘strong buy’ were instead privately defined pieces of junk (or worse) and derided by the very same analysts. On these grounds, Spitzer accused Merrill Lynch of using its analysts to promote companies whose investment banking business the firm wanted to get or keep.
Merrill Lynch says the agreement represents neither evidence nor admission of wrongdoing or liability but chairman and CEO David Komansky concedes that Merrill’s reputation has been dented. Be that as it may, the settlement means investors have no recourse to seek damages against the bank.
However, they can choose to redirect their trading operations to other stockbrokers, as it is hinted by last Greenwich Associates’ survey among US portfolio managers. In fact the survey shows growing concerns about independence of operators: 48% of money managers said they should direct more business to brokers with little or no conflict of interest between their research and investment banking arms (below).
Actually, research is a “marketing machine” used by groups, not only to win new investment banking business from companies willing to issue stocks and bonds. It’s also one of the tools used by brokers to get new trading business from institutional investors, who, in turn, agree to play the game. For example, they agree to participate in the annual Institutional Investor ranking of analysts: a sort of beauty-contest poll on analysts among portfolio managers, which the magazine publishes every autumn. This ranking is hot stuff in Wall Street, because it can make investment banking deals migrate to firms whose analysts are atop the list – the higher the ranking, the more powerful is the analyst to attract investor attention to their stock or bond offering.
The California Public Employees’ Retirement System (CalPERS), which is the biggest US pension fund with $151bn (E164bn) in assets, is so concerned about the myriad of potential conflicts of interest that are tarnishing the financial markets, that it recently announced its intention to organise a special commission on this issue. “These conflicts can emanate from investment bankers, equity analysts, rating agencies, lending institutions, outside attorneys and other consultants,” explain CalPERS’ spokes-people. “The commission will examine ways in which conflicts of interest can be identified, disclosed and managed. In other words, it will focus on how to ensure that all the ‘spokes’ of the wheel involved in a company’s governance are working to ensure transparency and accountability.” The commission is part of a wider initiative promoted by CalPERS in favour of a financial market reform, in the aftermath of Enron’s collapse. “We want reforms to be put into place soon so that all investors may be insured of the integrity of our financial markets”, stressed Michael Flaherman, chair of CalPERS Investment Committee.
The independence of stockbrokers and research analysts is a sensitive topic anyway – more among medium-small pension funds than among the largest ones. Big pension funds usually have their in-house research facility and even if they outsource part of the analytical task, they would review the reports and put them in their own models before deciding any investment.
Take the example of TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund): the chairman John Biggs reassured participants’ concerns about Enron-related losses, praising internal analysts’ insights. “Our analysts gave us critical forewarnings of potential problems, thereby helping to further reduce our exposure to Enron-related securities,” wrote Biggs to TIAA-CREF’s members. “At CREF (the equity portfolio), our ‘hero’ was a veteran analyst named Kim Schnabel, who came to the conclusion that Enron’s accounting was impenetrable. On the TIAA (bond portfolio) side, we can thank the sceptical credit analysis of our senior managing director, Mike O’Kane, and a number of his fellow investment professionals. These two early-warning ‘alerts’ were indeed helpful (…) in the active portions of our investment programmes, where we select individual investments.”