Merrill revelations point to industry-wide malaise

PUBLISHED : Thursday, 18 April, 2002, 12:00am
UPDATED : Thursday, 18 April, 2002, 12:00am

The investigation by New York attorney-general Eliot Spitzer provides a wealth of graphic detail about how Merrill Lynch's Internet analysts were compromising their research to assist investment-banking colleagues' deal-making efforts.

That close-up look behind the scenes is unique but belongs in the wider context of how the securities business has evolved.

Merrill's Internet research team, led by Henry Blodget, became privately cynical about having to soft-pedal on their recommendations and even financial models so potential clients for investment banking services were kept sweet.

In private e-mails Mr Blodget was famously calling some of the companies he was covering 'crap' or a 'dog'.

He even threatened, horror of horrors, to 'start calling the stocks . . . like we see them, no matter what the ancillary business consequences are'.

The team's publicly released research stayed positive, however, and they never issued a sell rating between the spring of 1999 and the autumn of last year. Neutral was as negative as it got.

Mr Spitzer has said the inquiry would be widened to other big-name investment banks and held out the possibility of pursuing criminal action. That is a scary prospect for the investment banks as it was the criminal case brought against Arthur Andersen over the Enron Corp scandal which caused the accounting firm's clients to flee and the business to unravel.

Merrill did produce a blustering reply that it was 'outraged' at not being given the opportunity to contest the Spitzer evidence in court. It also said the damaging e-mails had been 'taken out of context'.

While it is hard to imagine what context could mitigate against such clear evidence, there is a wider context to be considered - the changing dynamics of the securities industry in which Mr Blodget and his team were just small cogs. Liberalisation of brokerage commissions has brought intense price competition in many markets around the world.

As a business proposition, broking securities now pales before investment banking. It is simple economics which is causing the analyst's pure research function to be muddied by conflicting claims to support investment banking initiatives.

Fund management has also played a part. The big houses have long recognised the pitfalls in relying on brokerage research and have hired their own analysts to provide unbiased research. While they also still read brokerage research, fund managers have long learned to disregard the headline recommendation and even take some of the forecast numbers with a pinch of salt.

To some degree they have not rocked the boat with the big investment banks about the quality of research because they have been more interested in obtaining generous quotas of hot new offerings which the banks are bringing to market.

The patsy in all this has been the retail client, who does not have the sophistication to read between the research lines.

The reports from Mr Blodget and his former analyst colleagues not only go to street-smart fund managers but are the basic sales materials when brokers talk to mom-and-pop clients.

Critics might say small investors who insisted on lower and lower commissions to switch brokers were getting what they paid for.

It would be nice to think that left alone, markets rather than the blunt instrument of legislation, could do the correctional work.

With investment banking and broking clearly unable to live under the same roof without conflicts arising from serving clients with diametrically opposed interests, there is a niche for leading firms which concentrate on broking alone.

This would mean clients having to pay higher commissions to ensure the research they received was independent and of good quality.

Charles Merrill built his firm on the concept of bringing Wall Street to Main Street.

Decades later, it is ironic that Merrill is now highlighting the dangers for Main Street clients of bringing Wall Street into their homes.