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Commentary: Research Should Pay Its Own Way


Everything was on the table when New York Attorney General Eliot Spitzer began his crusade to clean up Merrill Lynch & Co. (MER) in April. Criminal charges. A restitution fund for investors. Even partial reinstatement of Depression-era laws walling off investment banking from research. But Spitzer let Merrill off the hook with a $100 million slap on the wrist after it promised that its investment-banking business will no longer influence how much its analysts get paid.

The New York AG dropped an earlier demand that the stock-picking be spun off somehow into an independent entity. In doing so, he essentially bought into the Wall Street wisdom that says research can survive only as a subsidized function of a full-service firm.

Unfortunately, the pact signed by Merrill Chairman and CEO David H. Komansky merely papers over the basic conflict at the heart of Spitzer's case. Fostering a competitive research market is the best way to keep stockpicking honest and unbiased. But to do that, you need independent brokers who can make a business out of selling their research.

As Wall Street wisdom goes: You get what you pay for. The Street should know. It has practically been giving its research away since 1975. Says Patrick McGurn, vice-president of proxy advisers Institutional Shareholder Services: "We've taken analyst research with a whole shaker of salt for some time now."

Wall Street needs to stop using analysts as marketing tools and start charging for research. Even with the settlement, Merrill's analysts can go on road shows with investment-banking clients. That sends analysts a clear message that downgrading a company hurts their employer's profits.

Wall Street's argument that full-fledged research is a money-losing proposition rings hollow. True, the costs of running a research department are tremendous. The reason: The Street is paying bloated, investment-banking wages--something no independent research outfit need do. Prudential Financial Inc. estimates that the five largest firms spend $1 billion annually to maintain equity research departments with hundreds of analysts.

If Wall Street firms forced research departments to pay their own way, they would foster a healthy market for quality research. Even competing against subsidized research, independent firms make money. Prudential, which eliminated its investment-banking division, reported first-quarter net income of $263 million from research, brokerage, and related operations. Value Line has survived for 70 years.

Moreover, investment banks might be able to cut costs by paying analysts less--and still get the same quality of research. Many independent firms' lower-paid analysts already seem to be making better stock calls than analysts at the larger brokerages, where average annual pay hit a peak of $1 million in 2000 (table).

Indeed, the crisis of confidence in Wall Street is spawning a new breed of analyst. San Francisco-based StarMine Corp. has been rating investment-bank analysts for money managers for three years. Now, investment banks such as W.R. Hambrecht & Co. and U.S. Bancorp Piper Jaffray are hiring StarMine to keep score of their own analysts' recommendations. "Our business plan is to more than double our revenues this year," says David Lichtblau, a StarMine vice-president.

Some financial-services leaders, such as Charles R. "Chuck" Schwab, say the way to eliminate conflicts of interest is to keep two sets of analysts: one to advise investment bankers and another for retail investors. For that to work, retail investors would still have to pay for research.

They'll have to do that anyway to get disciplined, trustworthy research, but it's a price eminently worth paying. By Emily Thornton

With Heather Timmons in New York


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