Mark Twain on the Wall Street Research Settlement

Securities Industry News August 25, 2003 Benn Steil Council on Foreign Relations

Over the past year, our government has made great efforts to ensure the safety and prosperity of American citizens through the elimination of WMD. Weapons of Mass Delusion, disguised in the form of “research,” were apparently employed by investment banks in an effort to persuade Americans to buy ever more stock of companies with infinite P/E ratios. Although most of these ratios are still infinite, the Ps are now a lot closer to the Es. The chief weapons inspector in this effort was Mr. Eliot Spitzer, New York’s Attorney General and Acting Chairman of the Securities and Exchange Commission. Down in Washington, Bill Donaldson, who apparently works for Mr. Spitzer, could only admire from afar as Spitzer revealed email after email proving Wall Street’s nefarious efforts, and crafted an ambitious settlement with the confessed shysters. Although the settlement is more bull than the market whose collapse precipitated it, this is not to denigrate Spitzer’s ambition in fashioning it. It is, in fact, a most noble ambition to wish to become governor of New York. But since the settlement has become a sort of sacred cow, we subject it to the respectful handling of one of America’s most revered social commentators. Mark Twain once observed that “sacred cows make the best hamburger.” So let us toss this one on the grill and flip it around a bit. According to the SEC’s web site, this cow has four parts. 1. “For a five-year period, each of the firms will be required to contract with no fewer than three independent research firms and will make available the independent research to the firm's customers.” What do customers get after five years? No guidance here, so best to assume the Marie Antoinette principle applies. Let them read cake.

2 2. “Firms will notify customers of the availability of independent research on customer account statements and on the first page of research reports.” So what will “independent research” sent by your broker look like? Well, given that your broker is likely to be ticked off that he’s paying for it, picture the crap that comes with your monthly cable bill. You know, those little ads for online Viagra and debt consolidation that never leave the envelope. 3. “An independent consultant for each firm will have final authority to procure independent research, and will report annually to regulators concerning the research procured.” Who will be the “independent consultants” chosen to reconstruct Wall Street? Again, silence. But if recent reconstructions are anything to go by, expect them to be subsidiaries of Halliburton. 4. “Payments for independent research will total $432.5 million.” Why $432.5 million? Well, Spitzer may have run a sophisticated econometrics model assuming nominal interest rates of x, per capita income growth of y, etc - to determine precisely how much independent research we as Americans need to consume. Or maybe it’s his lucky number. I dunno.

The bottom line is that it’s all about “independent” research. The more independent, the better. But what is an “independent” research firm anyway? Spitzer explained to USA Today that it was “a brokerage firm that generates all of its revenue from the sale of its stock research and/or from commissions for stock trading. These firms,” he continued, “do not provide investment-banking services for the companies they cover, so they avoid conflicts of interest for its stock analysis. Wall Street firms,” he concluded, “would [therefore] be required to purchase independent research for five years and thus subsidize the independent research firms.” And so making Wall Street firms buy “independent” research will make Americans more prosperous and secure. At least if you buy into a series of simple myths on the workings of the securities industry. Myth 1. “Good research is ‘independent’ research” There are certain sweet-smelling sugar-coated lies current in the world which all politic men have apparently tacitly conspired together to support and perpetuate. One of these is that there is such a thing in the world as independence: independence of thought, independence of opinion, independence of action. Another is that the world loves to see independence – admires it, applauds it. – Mark Twain Twain was clearly on to something here. “Independence” in the Spitzer settlement – who provides it, who contracts it, who benefits from it – would appear to be nothing more than an elaborate, and very expensive, kabuki pla y. There are three fundamental problems with the notion that good research is “independent” research. The first is that, empirically, there is no evidence that what the settlement defines as independent research is actually better than non-independent research. For example, in the

3 Institutional Investor ranking of top equity research teams in 2002, virtually all of them were from Wall Street firms. In fact, Salomon and Merrill, two of the chief villains in Spitzer’s tale, were ranked numbers one and three. So-called “independents” barely register. The second is that the very definition of independence was crafted solely to punish investment banks. That is , after all, what Spitzer had set out to do – not to weed out conflicts of interest. Think of how many prominent “independent” research houses also manage money or broker trades – both of which give them a clear incentive to urge investors buy stocks. The third has to do with conflating honesty with research contracted, rather than produced, by investment banks. Mark Twain understood what it took to get honesty out of Wall Street research. “Honesty is the best policy,” he said, “when there is money in it.” There will clearly be money in honesty if investors are the ones paying for research. If, on the other hand, banks are forced to pay for investors’ research, then it’s a given that factors at odds with honesty may pay. Like business relationships they may have with the “independent” research houses. Or between the “independent” consultant and the “independent” research houses. The reason honesty may not pay is simple: lack of accountability. The research providers will not be accountable to investors, as investors will not be footing the bill. Despite the fact that Spitzer concluded that investment banking taints research, the settlement has mandated that research will be paid for and distributed by – who else, investment banks. The research providers will be accountable to the banks, or their consultants, who do pay them, and to the government officials who decide not whether they produce useful research, but whether they fit a politically crafted definition of “independent.” “There are people who think that honesty is always the best policy,” Twain said. “This is a superstition. There are times when the appearance of it is worth six of it.” Like when the government puts itself in charge of designating it, rather than the citizens whose well-being will actually be determined by its presence or absence. “That's the difference between governments and individuals,” Twain said. “Governments don't care, individuals do.” Myth 2. “Stock research is a form of public good, sort of like street lamps, and should therefore be subsidized” Reading the financial press these days, there seems to be a palpable terror out there of disappearing stock analysts. Apparently there will be huge swathes of the American economy, thousands of small- and mid-cap companies, that investors will be dying to know about but which no one will study. All because of the tragedy that investment banking profits will no longer be available to directly fund the production of buy recommendations – excuse me, “research.” Spitzer agrees. Thus the bad banks will be required to fund a $432.5 million kibbutz to churn out “independent” research on companies that investors apparently need to know about, but allegedly won’t pay to know about. Mark Twain, once again: “In order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to obtain.” Difficult, not easy. Costly, not free. If research is to be coveted, the coveters must pay. Why the assumption that research is covetable, but that coveters won’t pay? Consultants have exclusive research and advisory contracts with corporate clients. Top independent research houses likewise have lucrative exclusive contracts with institutional clients. Mass distribution “independent” research financed by banks as part of their parole agreement can only serve to further discredit and devalue research.

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Myth 3. “It is sound public policy to encourage citizens to believe that wise investment consists in reading research reports on company stock prospects”
This has been about one thing. It has been about ensuring that retail investors get a fair shake. - Eliot Spitzer There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can. - Mark Twain

If there is one thing that is now accepted as a virtual Truism among financial economists and honest money managers it is that prudent investors should buy and hold a diversified portfolio of securities. Individual investors, those who are intended to be the primary beneficiaries of subsidized research, are the least likely to be able to benefit from speculation on individual company shares. The notion that the financial security of the American public can be improved by bombarding it with “free” opinions on stock prospects is both unfounded and irresponsible. But what about institutional investors? Don’t they also rely on investment banks for research? Myth 4. “Institutions buy ‘research’ from investment banks” This notion is so widespread beyond the cozy confines of the securities industry that it is rarely parsed or challenged, but it is doubly false. And since most Americans hold most of their stocks through institutions, this can’t be ignored. First, institutions only buy “research” from banks using trading commissions, which come from their clients’ assets rather than their own. This is at the heart of the biggest and most underreported scandal in the fund management industry: the use of “soft dollar” trading to invisibly transfer fund management operating costs from fund managers to their clients. The funds don’t buy, the client does. The client just doesn’t know it. Second, institutions were never stupid enough to believe that marketing propaganda published by banks was “research.” That game could only be played on the retail level. The institutions pay to speak to specific analysts privately, often to get the insider scoop on what tech nonsense the public would be fed in short order. But they also use trading commissions from their client assets to buy items wholly unrelated to research. They just don’t dare to admit this, lest they fall afoul of the SEC’s so-called 28(e) safe harbor for “research” purchased with trading commissions. As Mark Twain observed, “Almost all lies are acts and speech has no part in them.” According the SEC’s web site, institutions pay soft-dollar trading commissions to investment banks to buy newspapers, magazines, online services, conference registrations, accounting services, proxy services, performance measurement services, computers, monitors, printers, modems, cables, software, network support and maintenance agreements. And this is only the legal stuff – the stuff that the SEC, shamelessly, allows institutions to classify as “research.” Take investment banks out of the trading process, and this massive, industry-wide kickback scheme is brought to a screeching halt. A cynic might suggest that this has something to do with why the settlement left investment banks in charge of distributing research. Truly angry investment banks might hurt a gubernatorial campaign. Don’t you hate cynics?

5 Myth 5: “OK, so maybe investment banks make lousy researchers, b they make great ut brokers” Mark Twain begs to differ. “If you pick up a starving dog and make him prosperous,” Twain noted, “he will not bite you. This is the principal difference between a dog and an institutional broker.” Ok, he didn’t really say “institutional broker.” But he surely had one in mind. You make an institutional broker prosperous by giving him information about your order flow. He then bites you either by trading on it or, if he’s an agency broker, by passing it on to another client in return for his order flow. I wish I had a penny for every time one of these “unconflicted” agency brokers helpfully hinted to one client that another client is “a big buyer in Boston” or “a big seller in Kansas City.” Information leakage in the brokerage p rocess is probably the single largest source of market impact and opportunity costs. Yet despite the recent mass migration to anonymous, nonintermediated electronic trading around the globe, Bill Donaldson seems to see prosperous brokers and marketmakers as the source of liquidity in our marketplace, rather than the beneficiaries of it, as they clearly were in the days of ¼ spreads and hidden limit orders. In comments on CNBC in May, he questioned whether penny spreads themselves had cut liquidity and raised trading costs, thereby perfectly illustrating H. L. Mencken’s dictum that “For every problem, there is a solution that is simple, neat and wrong.” If penny spreads lead to penny-jumping, the solution is not to eliminate the pennies but to eliminate the jumping. If limit orders had strict price-time priority at the New York Stock Exchange - as they do on the ECNs and every single European exchange system - then investors would have the strongest possible incentive to compete for executions by posting more aggressive limit orders, thereby narrowing spreads and increasing market depth. The fact that the inside spread may be shallow in a penny market is irrelevant in an anonymous electronic marketplace, where a market order trader can instantaneously access limit order liquidity multiple levels deep. So what needs to be done? As with the problem of tainted research, the key is simple: get the incentive structure right. If institutions had to pay their own trading commissions, as recommended by the UK Myners report, then prosperous brokers would no longer be needed in the marketplace. Their role in a modern electronic trading environment is not actually as brokers – look at how sophisticated trading desks are these days on the buy-side – but as cogs in the soft-dollar wheel, made possible by the 28(e) regulatory loophole. As to penny-jumping, the NYSE’s Special Committee on Governance should back demutualization of the exchange, to be followed by a public listing. An NYSE not owned and controlled by banks and brokers would immediately shutter the floor to cut operating costs and to end the penny jumping that discourages investors from sending more and larger orders to the exchange. As The Economist recently noted in discussing the contrast between the commercial success of the demutualized European exchanges and the declining profits of their members, “these changes are down to an increase in automated equity trading, which attracts less brokerage commission but pumps up turnover on exchanges.” Tainted research is merely wallpaper on a stock trading structure built on corrosive conflicts of interest. If Mr. Spitzer were serious about protecting investors, he wouldn’t be telling banks to put up new wallpaper. But criticizing the settlement on this basis is knowingly to confuse good policy with good politics. As Mark Twain said, “Yes, you are right - I am a moralist in disguise; it gets me into heaps of trouble when I go thrashing around in political questions.”

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Benn Steil is the André Meyer Senior Fellow and Director of International Economics at the Council on Foreign Relations