"Then felt I like some watcher of the skies/ When a new planet swims into his ken," Keats 'On First Looking into Chapman's Homer' (1817)
There are times when something happens, which you know means that life will never be the same again. As the planet known as Eliot Spitzer swims into our view, we can be sure that the world of equity research is forever changed.
The arrangement that Merrill Lynch has struck with Spitzer - the New York State Attorney General - is the first act in a process of reforming the world of equity research. Where this process will end is unclear at this early stage. But I am sure it will result in the wholesale transformation of research as we know it today. The effects will be most marked in New York and the US, but they will be felt throughout the world - Asia included.
The initial details of Merrill Lynch's agreement are as follows: the firm has agreed to disclose, first on a website and then on the front of its research, those companies from which it has received fees for announced equity underwriting and M&A deals over the previous 12 months. The firm will also ask the readers of its research to assume that the firm is going after investment banking business from the subject company of the research piece. Merrill will also reveal the proportions of the companies it covers which have strong buy, buy, neutral and reduce/sell ratings. This will apply to all of its equity research globally.
It seems that what is being foisted on Merrill is likely to be foisted on its peers as well. Spitzer's office is also investigating CSFB, Morgan Stanley, Goldman Sachs, Salomon Smith Barney, UBS and Bear Stearns among others. It would be unimaginably unfair if this agreement with Merrill did not set a precedent that all the other firms will have to follow.
Indeed, it is the first step in what is likely to be a long series of attempts to regulate the equity research business. There is no doubt that this has to happen. It is well known to be a grubby business in which flattery is rewarded with investment banking deals.
There is a lot to be said and investigated on this subject. The role of analysts, as well as the companies covered and the investors who supposedly read the research, perpetuate the whole tawdry charade.
But going back to Spitzer, it seems extraordinary that he will be the agent of change in something as wide ranging and complicated as the reform of research. He is a career lawyer-politician who uses law to further his public career. He is widely thought to be using his time as Attorney General of New York to boost his chances of going for the State Governorship.
Having got these concessions out of Merrill to change the way it handles the conflicts of interest inherent in its research function, he is now going after the bank's money. He is in the process of trying to extract fines out of Merrill and the rest of the street on the basis that he believes they defrauded the general public with overly optimistic research. He is seeking anywhere up to $100 million, which he will then be able to give back to the people of New York in nothing more than an electoral bribe.
This is cheap political grandstanding. Who has not lost money in the equity markets over the past few years? And who would not want a windfall now to repair their damaged portfolios? By gouging money out of the brokerages, Spitzer is demonstrating the worst aspects of Americana - cheap, litigious, blame mongering. To say that Merrill Lynch is the reason that the equity markets have declined is utter nonsense. But blaming the firm that took Wall Street to Main Street is an easy vote winner.
It will be interesting to see if Merrill and the rest do come up with some money. They definitely should not. It would set a dangerous precedent that would challenge the whole equity culture. Equity provides unlimited upside, but for that reward to be worth it, there must also be unlimited risk. Take away the risks and what you are buying is not equity. This is true regardless of what anyone else says about the equities that are being bought and sold.
Spitzer must know this and cannot expect the banks to acquiesce to his demands. Merrill's stock price declined 12% last week while the negotiating was underway. He knows and they know that it would decline a lot more if it were held that overly optimistic research was the cause of stock market crashes. The banks now have too much to lose - indeed their entire business model - if they agree that they should compensate investors. "He's a smart, ambitious guy," an acquaintance of Spitzer's told FinanceAsia.com. "I think the press conference was the primary objective, and that he'll back off when it's time to settle."
The whole nature of research function at banks is clearly flawed. And the whole system should and undoubtedly will change. But it is extremely dangerous for the protagonist to be an ill informed politican who obviously does not understand how it all works.
Just hitting the research analysts and not changing the whole process could cause more harm than good. The corporate executives who only give investment-banking mandates to sycophants are as much to blame as the investors who hand out brokerage based on how much a bank's research has puffed up their portfolio. The analysts are only one party in this messy mTnage a trois. Real reform will require tackling the whole issue, not just naming, blaming, shaming and fining the banks.
Sources report that the US SEC is rightly aghast at what Spitzer is doing. In his short-sighted approach to this issue he might sacrifice the one chance of effective reform on the altar of his political ambition. While we welcome the increasing honesty in research reports, Merrill and all the others must not be held to ransom in order to pay for Spitzer's political aspirations. He should back off now and let the process of reform be undertaken by the professionals. It is too important and complex an issue for it to be handled in this fashion.
