Lehman's Fidelity Feast Gives Street Pangs

Its 'unbundling' agreement is said to be paying early dividends.
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The highly publicized decision to reduce the trading fees it charges Fidelity Investments is paying off for

Lehman Brothers

(LEH)

, and that's troubling news for its competitors.

Lehman, which last fall broke with Wall Street by separating the fees it charges Fidelity for stock trading and stock research, has seen an increase in trading volume from the world's biggest mutual fund family, an investment banking source told

TheStreet.com

.

The windfall illustrates the logic underlying Lehman's decision to "unbundle" research and stock trading, which traditionally have been sold as a package on Wall Street. It also shows how the move could force the hand of other securities industry firms to either unbundle their own research or find better ways to market and deliver it.

Representatives from both Lehman Brothers and Fidelity declined to comment.

In October, Lehman Brothers became the first Wall Street firm to publicly say it would unbundle its research and trading services when the company cut its deal with Fidelity. Since then, other brokerage houses have lost significant market share to Lehman in equity trading, a senior investment banker says.

Many bankers were shocked by the deal that Lehman struck with Fidelity, particularly because the $7 million flat fee that Fidelity is paying for Lehman research seems like such a bargain.

But for Lehman, whose research department isn't exactly a crown jewel, the motive was clear. By separating the cost of research from its trading fees, Lehman is able to remove a significant drag on its trading desk, which is one of Wall Street's finest. A big customer like Fidelity -- which previously bristled at having to pay for Lehman's research in order to trade through the brokerage -- is now free to trade as much as it wants for much less money.

The economics are simple. Prior to the agreement, research costs made up as much as 4 cents per trade when Fidelity bought or sold stock through Lehman. Now, the per-trade cost is 2 cents to 2.5 cents -- less than half of what it was before.

Lehman's move to unbundle trading and research was hailed as a watershed moment in the securities industry and sparked speculation that other mutual fund companies would seek similar arrangements. Less well-publicized has been the impact on brokerages, which had already seen the luster of their research departments fade in the wake of Eliot Spitzer's assault on the industry and the strictures of his 2003 global settlement.

While most firms have not said publicly what they will do with their research and trading services, some have put measures in place to help shield themselves from the effects of Lehman's unbundling move.

For example, some Wall Street firms now use their research divisions to educate their two main sales divisions -- retail, which sells to research and trading services to portfolio managers, and institutional, which sells the services to hedge and mutual funds -- separately.

Traditionally, Wall Street firms have a single morning call during which analysts discuss their long-term outlook for a stock with the firm's sales force. Analysts use the call to expand on the reasons they consider the stock a buy or sell and discuss why the stock makes sense as an intermediate- or long-term holding.

The traditional morning call, which mainly benefits retail salespeople at a firm, still exists. To it, however, some firms have added a new call for salespeople who advise institutional clients, such as hedge funds or mutual funds. These clients profit off short-term stock fluctuations and are also the clients who generate the most revenue for large trading desks.

On the new calls, analysts discuss daily stock recommendations based on short-term outlooks. Although all salespeople at the firm are allowed to access this call, the short-term advice benefits those that speak with the clients who trade based on daily movement of the stock.

The "two-call" concept sounds dangerously close to analysts giving different advice on the same stock -- one of the things that led to the broad overhauls codified in Spitzer's global settlement. Insiders claim, however, that analysts would never officially rate a stock differently for short- and long-term investors. Firms have strict compliance restrictions on just how far analysts can go when talking about daily recommendations, and all the advice given on both calls is said to be contained in the analyst reports.

Still, that such a structure is taking hold shows how Wall Street must scramble to find ways to keep their research departments competitive -- especially given Lehman's new edge. Separate education of the sales team gives analysts the opportunity to tailor the advice that goes out to a firm's biggest clients. The philosophy is that, if the trades go well and clients are happy, large volume traders like Fidelity won't mind paying the little extra bit for unique recommendations.

"For a portfolio manager, they want to be right on stocks, and that gets down to research," says Robert Hansen, equity analyst at Standard and Poor's. "Portfolio managers want to maintain access to research and research departments. Making money on trades is really a research-driven game."

According to the banker, bulge bracket firms continue to have heated discussions about unbundling. Typically, trading executives want the banks to unbundle, to allow them to compete with low-cost Lehman. Researchers want the trade economics to remain unchanged, knowing that unbundling can cause additional stress on their already struggling groups.

Additional problems come into the unbundling discussion, such as the salary structure of analysts after their services are no longer covered by trading fees. Most research analysts are currently paid based on the number of trades their stock recommendations bring to the firm. When research and trading fees are separated, it becomes difficult to determine how much business an analyst really brings into the firm. On the flip side, it's hard to motivate analysts to be creative in their ideas when they aren't getting paid for them.

The two research shops that have already unbundled -- Lehman and

Deutsche Bank

(DB) - Get Report

, which cut its own deal with Fidelity last month -- never really had the research reputation of a competitor like

Goldman Sachs

(GS) - Get Report

or

Morgan Stanley

(MWD)

. Perhaps that's why unbundling was less contentious at their firm.