Wall Street gets an F

The modern securities industry came of age with the Glass-Steagall Act of 1933. Glass-Steagall barred banks and other financial institutions from trading and underwriting stocks, bonds and other securities. Congress aimed to eliminate conflicts of interest -- to keep banks from "floating a new issue of corporate stocks or bonds, then hyping the sales by pushing dubious securities off on their own deposit customers and trust accounts," as William Greider put it in 1987's "Secrets of the Temple: How the Federal Reserve Runs the Country."

The division also mandated stability. Congress aimed to create a system that would reduce the risk of panic, so Glass-Steagall and later laws protected both banks and brokerages from failure. Deposit insurance became common; fixed commission rates became the anti-failure, anti-competitive tool given to brokerages.

The strategy worked by keeping the industry fat and happy, Cole reports. Ordinary trades cost clients anywhere from $100 to several hundred dollars (as of the late 1960s), and large trades could often generate five- or six-figure commissions. There was plenty of money to go around. In a typical year, such as 1967, only one of the New York Stock Exchange's (NYSE) 330 member firms was reported to have sustained a net loss. That same year, Merrill Lynch earned 57 percent of its total revenue from retail commissions.

"All a brokerage had to do to make big money was to keep its stockbrokers -- and their retail clients -- happy," Cole writes.

Analysts helped meet these goals. They played an important but hidden role in the system, researching companies and feeding their knowledge to brokers who sold their recommended stocks to clients.

"We put out 2-inch-thick black binders on different industries, which we would work months and months to produce," says Stephen Koffler, an analyst who started researching the aerospace industry in 1968, and whom Cole quotes in his book. "People who bought our reports paid us, so to speak, by trading through us."

Ultimately, "it was a sweet deal," Cole writes.

But the deal didn't last. On "May Day," May 1, 1975, a new law took effect that prevented the NYSE from regulating rates. The industry would never be the same. What was once perhaps the most sheltered industry in the nation turned ferociously competitive.

Trading volume started climbing. In the '60s, a typical day on the NYSE might see a total of 10 million shares change hands. In 1982, the market witnessed its first 100 million-share day, and by 2001, the market crossed a new threshold: 2.1 billion shares were traded in a single day.

But even with the increased volume, it became harder and harder to make money through commissions. Between 1975 and 1998 (taking inflation into account), full-service brokerages slashed their rates by fully 95 percent. As a result, consolidation roared through the industry. Of the 30 largest securities firms in 1971, only two have remained intact -- Merrill Lynch and Bear Stearns.

Brokerage houses looking for new revenue sources also started doing more underwriting. (This is essentially the market-related services that an investment bank performs for new ventures: collecting the vital figures, writing a prospectus that explains why the stock or bond is worth buying and then conducting a "road show" to the offices of institutional investors.) Underwriting can be very lucrative, particularly during a go-go speculative bubble like the dot-com boom. Fees generally range from 7 to 9 percent of the underwriting dollar volume. Then there are the paper profits. A firm that agrees to underwrite an investment usually receives a discounted stake in the new venture, which it can then sell (or "flip") when share prices climb above the initial asking price.

The underwriting mania peaked in the 1990s. As the stock market rose steadily, the securities industry turned aggressively toward initial public offerings, secondary or follow-up stock offerings and doing mergers-and-acquisitions work.

The shift toward corporate finance proved fruitful for the firms. But the bounteous revenue stream also poisoned the integrity of research, Cole argues. The so-called Chinese wall between research and investment banking collapsed under the weight of cold, hard cash.

Consider the Global Crossing IPO. When the investment bank CIBC Oppenheimer took the telecom firm public in March 1998, it earned several million in fees and bought $30 million in stock. By March 1999, the firm's stake was worth $4.6 billion. When a few investment bankers can bring in so much cash so quickly, "Is it any wonder," Cole asks, "brokerages now look to investment bankers to make money and to analysts and stockbrokers to assist?"

Cole's retelling of the late '90s bubble is harsh -- some of his examples make Wall Street analysts look like they belonged not on the Street, but on infomercials.

Next Page: A sordid tale of spite and stock market revenge

• View blog reactions