Global investment banks have exported moral hazard through the work of investment analysts
IN THE DARK DAYS of 1998, Asia used to hear a lot about 'moral hazard'. The phrase describes a state of affairs in which economic players are not forced to bear the full consequences of their actions, and it was supposedly one of the principal causes of the region's financial crisis.
A businessman who knows he will be bailed out by his cronies in government if things go awry will be tempted to invest in more risky projects than otherwise might be the case. 'Heads I win, tails you lose,' encapsulates the dynamics at work. Over-investment and a consequent mis-allocation of capital are the predictable results.
Of course, Asia never had a monopoly on moral hazard, before or after the crisis. The United States has been grappling with a little moral-hazard problem of its own recently, one it has exported to the rest of the world through the global franchise of its powerful investment banks. The controversy over sell-side analyst research has not generally been painted in these terms, but it fits the argument comfortably.
There is much hand-wringing going on over why sell-side analysts - those that produce research targeted at individual or institutional investors - produce so few 'sell' recommendations.
This really should be no puzzle. One has only to ask: what does an analyst (or his company) have to gain from being bearish on a stock? The answer is: not much, or not nearly as much as he or she has to gain from being positive.
A sell recommendation does not make anybody any money. At best it will save them from a loss, unless they are in the business of short-selling. And it certainly does not win any lucrative corporate finance business; it is more likely to alienate potential clients.
In many ways, the sell-side analyst's career is a one-way bet. Being consistently positive may not guarantee a rich pay-day, but being bullish and correct at the right time - as Internet analyst Henry Blodget was when he said Amazon.com's stock would rise from US$240 to US$400 - certainly carries that possibility.
This call catapulted Mr Blodget from the relative obscurity of CIBC Oppenheimer into the hot seat at Merrill Lynch, where he replaced Jonathan Cohen, an unfortunate pessimist who had predicted Amazon's stock could fall back to US$50. Three years on, Amazon trades at just over US$9 but, as in sport and comedy, timing is everything in investment analysis.
Mr Blodget said this month he was giving up being a stock analyst. He will walk away with a severance package estimated at US$2 million, after making an estimated US$7 million last year. He has felt no need to apologise for the part he played in inflating the dotcom bubble, saying he always warned investors that Internet stocks were high risk.
The lesson should not be lost on investors. Sell-side research is aimed at getting other people to trade, usually to buy. But the pied pipers who led investors to the technology table were not risking their own money.
Analysts received fat bonuses when their cheerleading helped to land their firms investment-banking mandates to take Internet firms public. They did not have to pay back those bonuses when the inevitable collapse came, causing massive wealth destruction to those who had followed their tune. Is it any wonder there was an excess of optimism before the crash?
The position of the sell-side analyst is not that different to that of the proprietary trader, although the forces at work are more subtle and complex. If proprietary traders are paid according to the profits they earn, that may encourage them to take excessive risks, since they are playing with the bank's money and will not have to refund any losses. Banks seem to have cottoned on to this one, given the absence of Nick Leeson-type scandals in recent years.
Of course, sensible people in the investment business have always known that sell-side research is subject to a potential conflict of interest, but that misses the point.
The 1990s' boom popularised investing, bringing more novices into contact with sell-side equity research than ever before, often through new media outlets that sprang up to feed the booming demand for business information. The scale and spread of the subsequent losses have turned this into a political process with consequently unpredictable results. In the public mind, the credibility of sell-side research has been irredeemably tarnished.
Some of the dirtier secrets of the profession are being aired in public and the results are not pretty. It appears unlikely the equity research business will be left to go on as before.
The process extends to Hong Kong, where the conflicts are the same but regulation generally is weaker.
The Securities and Futures Commission signalled its intention to tighten the rules, hosting a conference on 'The Future of Equity Research' at the end of last month.
The sensitivity of the current climate was underlined when one of the speakers, Peter Churchouse of Morgan Stanley, disclosed his speech had been vetted by corporate headquarters in New York, before going on to stress that it reflected his personal views, not necessarily those of the firm.
Mr Churchouse, remembered for predicting five years ago that the Hang Seng Index would reach 28,000 by mid-1999, put up a cogent defence of his profession, but one that was sometimes hard to square with reality.
He bemoaned the more demanding and complex environment analysts now face.
'Analysts are required not just to analyse companies but play a very big role in corporate business for their firms in marketing [initial public offerings] and other deals - something that was not high on the agenda in the earlier [days],' he said.
Independence and integrity of research figured strongly in his speech.
'The first allegiance for our research analysts is the firm's investor clients,' he said.
Can this really be the same company that employs Mary Meeker, so-called 'Queen of the Net'? A highly critical Fortune magazine cover story in May described Ms Meeker as 'the single most powerful symbol of how Wall Street can lead investors astray'.
Defending her refusal to downgrade stocks that had declined by up to 97 per cent, Ms Meeker was quoted by the magazine as saying: 'If you take a company public and you are really aggressive on the downside, it can be devastating.'
As Fortune pointed out, if you are not aggressive on the downside, it can be devastating for investors.
Mr Churchouse said sell-side research was valuable because a strong corporate banking franchise could help give analysts deeper insights into strategic thinking and industry trends.
'But at the heart of this is analyst credibility. Those who compromise their judgment stand to lose their credibility, and, if so, they quickly become ineffective.'
Some might say that is the point we have reached.