Wall Street gets an F

Two new books on the economy blast investment bankers for bias and warn that the financial system is out of anyone's control.

By Damien Cave

Jul 19, 2001 | In the summer of 1998, eager to discuss a potential public offering, the Internet start-up Priceline contacted Morgan Stanley Dean Witter. But executives from the discount travel agency didn't ask to speak to an investment banker, or one of the brokerage house's partners. Instead, they called Mary Meeker. As the firm's hotshot Internet analyst, she had the power that Priceline wanted, the power to boost a stock's price by simply giving it a "buy" rating.

The call broke from financial tradition: Analysts are theoretically supposed to focus on research, not the actual underwriting of would-be public companies. But Priceline's executives didn't seem to care. After choosing Morgan, Priceline CEO Richard Braddock emphasized Meeker's role. Neither the bank's reputation nor the nuts and bolts of the IPO's proposed terms swayed Braddock, according to Benjamin Cole's enlightening new book, "The Pied Pipers of Wall Street: How Analysts Sell You Down the River." Meeker's coverage was the product that mattered most to Priceline.

"We just think Mary is the best," Braddock said. "That was the distinguishing reason we chose Morgan."

Braddock was hardly alone in his enthusiasm. Wall Street analysts spent much of the late '90s basking in the media spotlight's full glare and enjoying the trust of investors and, consequently, investment banking clients. But in the wake of the dot-com implosion, analyst reputations have also suffered. Stockholders are suing by the dozens, arguing that conflicts of interest led to bogus, biased "buy" recommendations. According to Cole, analysts and their optimistic predictions played a key role in duping the public by forging a system that allowed institutional and inside investors to profit on IPOs while average investors lost out.

Congress and the Securities and Exchange Commission are now investigating whether Wall Street and its analysts illegally stoked the once-hot IPO market. In June, the SEC issued an alert warning investors not to rely solely on analysts' recommendations because of "the potential conflicts of interest analysts might face." In response, the Securities Industry Association, a trade group, drafted a code of conduct recommending that firms keep analyst compensation packages separate from investment banking revenue, forbid analysts from trading against their stock recommendations and require them to disclose their own stake and their firm's stake in the stocks they cover. So far, 14 investment firms have endorsed the code. Merrill Lynch has gone even further, announcing that its 600 analysts would soon be barred from buying shares of the companies they cover.

The logic of the proposed reforms is clear: Remove the financial incentives that lead to analysts' bias and the public will once again trust in Wall Street research and the firms that produce it. The "free" market will then do the rest. With confidence restored, the argument goes, investors will stop kvetching, new regulations will be unnecessary and all will once again be well.

But extinguishing doubts about Wall Street's integrity and preventing the rise of new regulations may not be that easy. Cole's analysis is complemented by Martin Mayer's "The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets." Mayer suggests that the analyst crisis could be only the first sign of a major financial meltdown. Even if the industry goes along with the SIA code of conduct, which contains no enforcement mechanism or form of punishment for disobedience, taken together, these books suggest that the American financial system is poised for destabilization. Decades of deregulation, lax enforcement and the increasing dominance of the world's interconnected stock markets have dramatically changed the landscape. Never mind whether analysts can get their act together and behave more responsibly; not even the mighty Fed, argues Mayer, has the ability to control today's economic excesses.

Next Page: How analysts went from research to stoking bubble-mania

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