Wall Street Conflicts Reach Beyond Banking

Everybody talks about potential conflicts of interest between research analysts and investment bankers at Wall Street firms. But what about conflicts between the analysts and the trading desk?

New York Attorney General Eliot Spitzer has cast the spotlight firmly on the sometimes too-cozy relationship between investment bankers and research analysts. Spitzer said a 10-month investigation of Merrill Lynch (MER Quote) revealed that its Internet group, led by former analyst Henry Blodget, often slagged stocks in internal emails that they professed to love in their published research. A spokesman says the attorney general's office hopes to be "a catalyst" for reforms that effectively separate investment banking interests from those of analysts.

Now, big Wall Street firms including Morgan Stanley (MWD Quote), Goldman Sachs (GS Quote), Lehman Brothers (LEH Quote), Bear Stearns (BSC Quote), Credit Suisse First Boston and Citigroup's (C Quote) Salomon Smith Barney are reportedly in Spitzer's cross hairs.

But even if you separate the investment-banking interests from research departments and shore up the Chinese walls, you're still going to have conflicts, observers say. While investment banking is a high-margin business on Wall Street, let's not forget another big source of income: the buying and selling of stocks. And the whole purpose of firms' equity research departments, the whole reason that they exist, is to facilitate the buying and selling of stocks. Stock research is something you get as an incentive to trade through a particular firm.

"A very important principle for anyone dealing with a financial adviser or firm is to ask who they get paid by," says Bill Sterling, chief investment officer at Trilogy Advisors. "Brokers are paid by commissions generated by transactions."

Large Numbers

One of the things that Spitzer complained of in his affidavit against Merrill was that "as a matter of undisclosed, internal policy, no 'reduce' or 'sell' recommendations were issued." This seeming policy arose, he said, to help smooth investment banking relationships. (Merrill, which didn't return calls seeking comment Thursday and Friday, has rejected Spitzer's claims, saying its reputation for integrity is very important to it.)

But if you think about it, Merrill's trading desk had just as much reason to hate sell ratings as its investment bankers did. For one thing, there are always more potential buyers of a stock than sellers. A sell recommendation on, say, Amazon.com is directed purely at investors who hold the stock. (Sell recommendations aren't shorting recommendations -- almost no broker will give one of those.) A buy recommendation, on the other hand, is something that all of a firm's clients can act on. If you already own Amazon, own some more; if you don't, buy some. Load up that truck!

Moreover, a trading desk's biggest customers are the ones with the most money under management. Knock down a stock they have a big position in with a negative piece of research and -- never mind if you're actually right -- they will be angry. And they'll kick more of their business your rivals' way. It's petty, but it happens.

Fixing It

One idea getting kicked around, according to Raymond James Chief Investment Strategist Jeffrey Saut, is that firms should mandate how many sell recommendations they have. So although historically only 1% or 2% of stocks have carried sell or sell-equivalent recommendations, perhaps a fifth of stocks would carry the lowest rating.

This is basically what Morgan Stanley did recently when it changed its rating system and put "underweight" recommendations on 22% of the stocks under coverage. Because stocks are rated relative to others the analyst has under coverage, an underweight in this system doesn't look like an albatross. Nor can investment bankers or big trading accounts complain, since a decent portion of stocks will be rated poorly as a matter of course.

But at this point, rule changes will do little to take the tarnish off Wall Street research departments. After seeing stocks collapse while analysts chanted "buy," investors don't care for sell-side research like they used to.

Moreover, with the passage of new disclosure rules, one of the big reasons to pay attention to Wall Street research has passed. It used to be that companies would selectively give important financial information to analysts (unless, in many cases, the analyst rated them poorly), and that had the effect of making Wall Street research required reading for many investors. With the Securities and Exchange Commission's implementation of fair disclosure rules, the practice of selectively giving out key information was banned -- and lots of research was suddenly irrelevant.

In that sense, going after Wall Street analysts now, says Sterling, is like bayonetting the wounded.