From a historical perspective, today's conflict-of-interest crisis on Wall Street can be viewed as an unplanned consequence of deregulation.
Until about 25 years ago, balance was maintained between a securities company's investment bank and its brokerage side though fixed commissions for stock trading. Artificially high trading fees kept the retail side disproportionately profitable and to a large degree preserved the autonomy of analysts who worked for brokerage clients.
"Rates were very high so the research department could stand up to investment banking and carry its own weight," said Henry Hu, professor of corporate and securities law at the University of Texas.
When a federal law unfixed commissions in 1975, the stage was set for the situation as it exists now, where research is sometimes held hostage to corporate finance and analysts are often more shill than stock picker. The tension threatens every major Wall Street firm but one:
, whose timing in neutering its investment bank by lopping most of the segment off looks more prescient by the week and ironically could spare it the burden of re-regulation, when and if that arrives for its peers.
"Intuitively, the fact that
Prudential doesn't have investment banking, means that they'll be adversely affected in the near-term," said Michael Paisan, an analyst at Williams Capital Group. "But the elimination of the so-called conflicts of interests has allowed them to retain and gain additional credibility."
Instead of being tarred with the conflicts brush,
securities unit has in fact drawn considerable attention for the no-nonsense stock ratings its research division offers.
Prudential's move to unshackle its analysts from the conflicts of interests that exist elsewhere has so far proven to be a "smart move," according to Hu. "It's getting a lot of free advertising because people refer to Prudential as the one big exception. There is a market for independent research."
No Bottom Line
Analysts say it will be hard to determine how the change in strategy impacts business because Prudential Financial does not break out the results of its Prudential Securities unit, instead these numbers are embedded in the private client segment.
In its first quarter earnings report Tuesday, Prudential Financial said it lost $19 million in its private client business compared with a loss of $6 million last year, as a result of weak equity markets. But that was much better than analysts had expected. Morgan Stanley analyst Nigel Dally, for example, was looking for a loss of $33 million.
In a research note issued earlier in the year, Lehman Brothers' analysts Eric Berg and Stewart Johnson said that the emphasis on arms-length research eliminates "even the slightest feeling by investors that the interests of corporate issuers of securities might take priority over investors' interest."
"Individual investors view hard-hitting reports by researchers such as outspoken
Prudential bank analyst Michael Mayo as unambiguously independent," they wrote.
All in the Timing
Still, it is investment banking that reaps the huge payouts, as brokers orchestrate stock offerings and provide advice on deals. Research is offered as an incentive for preferred customers at other companies and it does not usually generate lucrative fees. Although the capital markets are lifeless at the moment, that could change over the next couple of years.
Whatever the business merits of the move, Prudential's timing couldn't have been better. Evidence from a New York state attorney general investigation suggests that at least one firm,
, has used its research department to help generate revenue for the division that underwrites securities offerings. (In a related note, Merrill and the New York attorney general are reportedly near a settlement that would allow the firm to avoid any criminal or civil charges.)
Prudential isn't the only research firm that shuns underwriting, but the company broke ranks with the big names on Wall Street when it dramatically curtailed its banking unit last year and changed the analysts' rating system to a simple buy, hold and sell formula. Notably, the company has increased the number of sell ratings that it issues.
Prudential Financial on Tuesday reported a 35% drop in earnings in its first quarter, mainly due to a loss on investments. The company, which went public in December, posted net income of $263 million, or 46 cents a share compared to $403 million, or 69 cents a share, a year ago.
Excluding a $96 million loss realized on its investments, a tax gain and other factors, first-quarter adjusted operating income was $332 million, or 58 cents per share. Thomson Financial/First Call had projected a 47-cent profit.
Revenue rose 15%, to $5.06 billion from $4.41 billion a year ago, fueled by a 41% jump in insurance premiums.
The ultimate success of Prudential Securities, then, will depend on the accuracy of its stock recommendations. "Even though they're more independent, do they really add value?" Hu said.
In a recent poll by Investars, Prudential ranked No. 12 out of 26 major brokerages for the accuracy of its picks, with a negative return of 0.75% for the year. Of the major brokerages with large investment banking units, only
and Merrill Lynch ranked higher.