Remember the aftermath of the collapse of the Internet? Customers who bought once high-flying tech IPOs that had no fundamental merit and became worthless when the bubble burst filed lawsuits. So did the then New York Attorney General, Eliot Spitzer. The SEC investigated, as well.
The basis for the uproar was not so much that buyers were caught up in the frenzy and made crazy purchases (although I doubt anyone would have complained if they had made money). It was instead that the brokerage houses themselves had encouraged their customers by providing research reports from in-house analysts, who wrote that clients should buy the stocks–even though they firmly believed the securities had little value and that the proper course of action would be not to touch them with a ten-foot pole.
The poster child for duplicitous analysts was Henry Blodget, a relatively unseasoned researcher who became an overnight sensation in 1998 with a prediction that Amazon would double in price, which it promptly did. That report rocketed him into a job with Merrill Lynch and eventual recognition by Institutional Investor as the #1 expert on the Internet on Wall Street.
Mr. Blodget’s emails to colleagues, in which he derided companies he was touting in his official research, became a key feature of Mr. Spitzer’s case against the big brokerage houses. Blodget was charged with securities fraud by the SEC, and settled with the agency by agreeing to be banned for life from the securities industry and to pay $4 million in fines and return of investment gains.
The overall brokerage industry settled with Mr. Spitzer. Among other things, it agreed to provide customers, from late-2004 until mid-2009, not only with in-house research reports on stocks but also with research produced by independent third parties. According to the Financial Times, brokers paid independents $430 million for their efforts. (Incidentally, the FT article I cite strings together a number of aspects of the Wall Street research business that are individually correct but make up a picture that I don’t think is particularly accurate–maybe the topic of another post. But the factual information is interesting.)
Where to from here?
There are lots of cross currents, but my guess is that brokers will return to providing only in-house research as soon as the independents’ contracts run out. Why?
1. For one thing, the samples of independent research I looked at in 2004 and 2005 (after that I stopped looking) were pretty awful. The reports tended, for my tastes anyway, to be long on historical information, technical indicators and computer-driven, trend-following “recommendations”–and short on well-reasoned conclusions.
Why should this be? I don’t know. Maybe Mr. Spitzer only said the reports should be independent, not that they had to be good. Maybe these were the best services out there, so the brokers had to make do. On the other hand (what follows is just Wall Street humor on my part), you’d have to be crazy to point clients to outside research that’s better than your in-house product.
2. Wall Street believes that providing research is a money-losing proposition. The brokerage houses are run by traders, not researchers, so it’s natural that they would think this. But they’re probably correct.
Over the years, many investment managers–firms, incidentally, that are typically run by marketers, not researchers–have shaped their businesses to rely heavily on brokerage research instead of in-house efforts. The advantage to doing this? Research is paid for by clients’ trading commissions rather than taken out of the manager’s fee income. (Try to get that to change!!) The brokers argue that they would doubtless get those commissions anyway, even if they provided no services in return.
(An aside: Just before the financial meltdown, Fidelity, which has an extensive in-house research staff and which is also an industry benchmark for investment management firms trying to justify their research commission payments to brokers, was attempting to curtail such payments severely. This would have created a real dilemma for rivals that depend mostly on brokerage research for their investment ideas. Something to watch carefully.)
3. Many research boutiques are/were staffed by analysts laid off by brokers in their efforts to control costs. Rehiring them, even as consultants, might have been seen as awkward.
4. My guess is that brokers’ website monitoring systems show clients never access the independent reports. So the industry won’t upset anyone and will save $90 million a year by eliminating them.