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Wall Street's Research Conundrum


Haven't investors suffered enough already? After more than a year of foot-dragging, pressure from regulators has finally convinced Wall Street's chiefs that they must radically overhaul the way they conduct equity research. Chief executives Henry M. "Hank" Paulson Jr. of Goldman Sachs (GS), Philip J. Purcell of Morgan Stanley (MWD), and Citigroup's (C) Sanford I. "Sandy" Weill are pouring over various proposals to fix the problem. And on Oct. 8, Philip K. Ryan, chief financial officer of Credit Suisse Group, parent of investment bank Credit Suisse First Boston (CSR), became the first top exec to say in public that it could make sense for the bank to hive off its research department. "Research is exceptionally costly and does not have a business model of its own," he told a London banking conference.

Dumping research may sound like an obvious way to make a clean break with a discredited system in which the bankers' interests, not those of their brokerage customers, prevailed. But there's a risk that Main Street investors, the very people drastic reforms are designed to protect, could suffer--at least in the beginning. A wholesale revamp of the industry could cost thousands of analysts their jobs, leaving a small number of firms charging more for providing fewer research reports with less in them. It could also force some institutional investors to hire more analysts themselves, leading to higher prices for investors in mutual and pension funds. That prospect worries the pros, even though decisions on how the industry will operate in the future are still months away. "It's scaring me," says Shawn C.D. Johnson, research director at State Street Global Advisors, which oversees $770 billion in assets.

Truth is that, as yet, examples of flourishing independent firms that provide reports as detailed as Wall Street's are few and far between--limiting big banks' scope for outsourcing research. Services such as Morningstar, Standard & Poor's, and Value Line provide brief reports mainly aimed at retail investors. Some firms depend on backing from other businesses. For example, brokerage Sanford C. Bernstein & Co. is wholly owned by money manager Alliance Capital Management (AC). And the private client group of Prudential Financial Inc. which produces research still relies heavily on its parent's earnings, two years after ditching investment banking. The group has "been generating poor financial results to say the least," says Joanne Smith, insurance analyst at UBS Warburg.

There's a new risk if major firms follow the same road. Their most talented and experienced analysts are likely to metamorphose into bankers, who earn roughly twice what they do, leaving their less savvy colleagues to serve retail clients. Investment banks will keep the pick of the bunch because they will still need top analysts to help win deals from corporate clients and peddle them to investors. "They'll write marketing reports and position them as marketing reports, not as research," says David S. Pottruck, president and co-CEO of Charles Schwab Corp. "History suggests that's what they are anyway."

Of course, no research is better than the kind of bad research drudged up in damning e-mail trails at Merrill Lynch (MER), Salomon Smith Barney (C), and Credit Suisse First Boston. Shorter, honest recommendations are better than longer biased reports. And it might take jettisoning research departments to convince investors it is safe to return to the stock market. But even some veteran observers of the financial-services industry believe an absolute divorce goes too far. Samuel L. Hayes III, professor of investment banking at Harvard Business School, favors Citigroup's idea: the creation of impermeable firewalls by putting research into a completely separate subsidiary. "Research will cost more because there will not be a subsidy from the corporate finance side," he says. "But in the long term, investors will come out better because they will have something they can rely on rather than something being fed to them for other agendas."

Trouble is, investors could well suffer severe sticker shock. Research is hugely expensive. Big Wall Street firms, which do 95% of all equity research in the U.S., each shell out as much as $800 million a year for it. And when research from the likes of Merrill Lynch & Co. and Morgan Stanley is resold by services such as Multex.com Inc. (MLTX), there's a charge of between $10 for a page or two and $150 for a 60-page booklet. Substantial reports from truly independent research outfits have an even stiffer price-tag--roughly $750--so few individual investors ever buy them. "Individual investors have never been willing to pay a lot for research," says Multex chairman and CEO, Isaak Karaev.

Some bankers think the industry should again finance research out of trading commissions. That way, analysts' interests are aligned directly with those of investors. And it used to work. Institutional investors, such as pension and mutual funds, paid big bucks for research in the 1960s when brokerages charged a bundle on every trade. However, when the Securities & Exchange Commission ended fixed trading commissions in 1975 to promote competition, the equation changed drastically. Commissions are now as low as 4 cents per share, down from as much as 30 cents before 1975. At the same time, research has become a freebie given to clients in return for trades. "It's the old story," says Charles L. "Chuck" Hill, research director at Thomson Financial/First Call. "You get what you pay for."

In any case, asset managers have no yen to turn back the clock and pay higher commissions because they're under increasing pressure to cut costs themselves. "I'm not going to pay 10 times the current trading commission," says State Street's Johnson. Indeed, even behemoths like Fidelity Investments are facing intense cost pressure. The firm recently laid off 5.4% of its workforce, and it isn't eager to pay more for research. Asset managers' in-house analysts, who follow as many as 50 companies each vs. 12 at investment banks, use Wall Street research for insights into specific companies and industries.

Skeptical financial planners working with angry individual investors will be an even tougher sell. "You mean somebody actually pays for their research?" says John Osborn, a financial planner in the Houston office of MML Investor Services Inc. "P.T. Barnum lives!"

Such cynicism is likely to grow as investment banks try to cut corners and get by on less research. Firms are already reducing the number of stocks they're trading. On Oct. 8, Merrill Lynch announced that it will focus its NASDAQ sales and trading on 2,400 stocks, down from 10,000. And, instead of analyzing thousands of stocks, major firms may settle for a thousand--or less. "After all," reasons one securities industry expert in a major firm, "about 80% of U.S. investors' assets are tied up in 500 stocks."

Banks are also planning to put analysts' pay packages through the shredder, which may drive many of the brighter ones out of the business. Wall Street compensation consultant Alan Johnson estimates that senior analysts on average could receive $600,000, vs. $1 million this year, already a fraction of the $3 million they earned at the market peak in 2000.

While investment banks and regulators agree on what has to be achieved, they differ on the remedy. And that worries bankers. "I fear that investor confidence in research has been so shaken that it is difficult to see how to restore it," Goldman's Paulson told a group of pension fund managers on Oct. 8. "The danger is we will have a system which is unworkable for investment banks and inexplicable to the public." That would be the worst of all worlds for Wall Street, leaving Main Street investors as mistrustful as ever--and out of the market. By Emily Thornton in New York, with Geoffrey Smith in Boston, and Louise Lee in San Mateo, Calif.


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