In Credibility, Wall Street Still Trails Vegas
October 22, 2002
by Irwin Stelzer
It is going to be more difficult than anyone thought to restore faith in financial markets. It seems that the business community just doesn’t seem to understand that investors, especially Americans, are willing to take risks, and to suffer losses if they guess wrong, but only so long as they are convinced the game is not rigged.
But as Sam Waksal made clear by pleading guilty to insider trading in ImClone Systems shares, and emails of several analysts made clear by revealing that stock recommendations were colored by a desire to help their firms win investment banking business, and several financial houses made clear when they admitted allocating shares in “hot” initial public offerings (IPOs) to favored customers, ordinary investors have good reason to believe that the game is rigged against them.
So now we know. And in response laws have been passed that attempt to regulate these practices, to clean up financial statements, and put the crooks in jail. Indeed, in some ways the reaction has been disproportionate to some of the alleged crimes: after all, not all of the losses investors have incurred since share prices started their descent to more realistic levels have been due to shenanigans by auditors, analysts, and corporate officers. Some are due to the bidding up of prices by overly exuberant investors eager to get rich quick.
But some of the $8 trillion wealth wipeout can be laid at the door of the operators of the share price casinos. The odd thing is that the shrewd operators on Wall Street are showing less sense than the dimmest casino operator in Las Vegas. Every Vegas casino owner knows that his customers will cheerfully play the wheels and bear their losses, so long as they know the game isn’t rigged.
We are now being treated to the spectacle of financial moguls desperately trying to accept just enough reform to quiet the media and to satisfy the politicians, but not anything so fundamental as to bring the integrity of their industry up to Las Vegas standards.
Citigroup’s Sandy Weill and his colleagues are suggesting that they can eliminate the tendency of their analysts to issue “buy” recommendations on shares that they know should carry a “sell” label—a practice known as “putting lipstick on a pig to make it look pretty”—by spinning them off into separate subsidiaries. In other words, they propose to rely on a new version of the Chinese Walls that were supposed to insulate analysts from pressure by investment bankers to say nice things about potential banking clients—walls that crumbled at the first sight of a big banking fee.
Every investment banker knows that he won’t land a client whose company has just been rubbished by one of his firm’s analysts, even one working in a separate subsidiary. And the size of banking fees being what they are, analysts don’t need explicit instructions to understand that their firms’ prosperity, and their futures, hinge in part on the extent of their kindness to potential banking clients of their firms.
Some idea of the magnitude of the problem is revealed by a recent study by Weiss Ratings, an independent analyst of financial service companies. It found that 34 of the 62 brokerage firms studied failed to issue a single “sell” recommendation on any company that filed for bankruptcy in the May 1-August 31 period covered by its study.
The solution, of course, is complete divestiture of the analyst groups. But, say the big banks, no one will pay for the services of analysts if they are forced to make a living by the quality and integrity of their advice. In which case, they should find other work, and let punters benefit from the lower, unbundled cost of transacting business with firms that don’t force them to pay for investment advice they now know to be shoddy.
The financial community’s obtuseness does not stop with its attempt to preserve the ties between analysts and bankers. When SEC chairman Harvey Pitt announced plans to name John Biggs, a really tough-minded regulator, to head the new board that will monitor the audit business, the business and accounting communities put pressure on the White House and on Republican friends in Congress to have the offer withdrawn, which it apparently has been. After all, Biggs has committed the apparently unpardonable crime of suggesting that options are indeed a business expense, and should be so recognized on company financial reports, and that auditors should get out of the consulting business.
Nor does the business community yet seem to understand that giving auditors lucrative consulting contracts is no way to increase their credibility. A recent study of 1,240 U.S. corporations by the Investor Responsibility Research Center in Washington shows that fees earned by auditors for consulting services continue to run two-and-a-half times audit fees.
American businessmen are not alone in failing to understand that they must take steps to restore confidence in the honesty of their casino. British executives whose firms are listed on U.S. exchanges are taking the rather strange position that it is unfair to subject them to the new legal rules of the game that apply to their American counterparts. Which raises an interesting question: just which requirements do the 1,300 foreign companies listed in the U.S. find unreasonable: that the CEO attest to the accuracy of his financial reports? that audit committees be truly independent? that officers and directors be prohibited from trading company shares during blackout periods?
One can be sympathetic to the British preference for general principles as opposed to U.S.-style rules. But the old days when good City chaps could be relied upon to discipline chaps who misbehave are long gone, and general principles may not be enough, in the current environment, to restore confidence in markets. Rules forcing audit committees to be truly independent, preventing auditors from being led into temptation by consulting fees, and requiring banks to divest their share-tipping operations may be necessary adjuncts to, although they cannot be a substitute for, a return to the days of J. P. Morgan, who lent on character, not on collateral.
This article appeared in London’s Sunday Times on October 20, 2002, and is reprinted with permission.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.