So Long, Stock Ratings?

Regulators are probing many Wall Street firms for the conflicts of interest facing stock analysts. To avoid what may be costly settlements, many firms have indicated a willingness to drop the ratings game altogether.

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By Rex Moore (TMF Orangeblood)
October 16, 2002

I read the headline, but I couldn't believe it: "Wall Street Ready to Scrap Ratings for an End to Probes."

The article says many major investment firms -- giants such as Merrill Lynch (NYSE: MER), Citigroup's (NYSE: C) Salomon Smith Barney, Credit Suisse First Boston (NYSE: CSR), Morgan Stanley (NYSE: MWD), Goldman Sachs (NYSE: GS), and J.P. Morgan Chase (NYSE: JPM) -- have given some indication that they're willing to scuttle the heretofore ludicrous rating systems for stocks. What do they want in return? An end to the numerous investigations into the companies' conflicts of interest.

This is pretty drastic stuff. After all, can you imagine Wall Street without "buy," "sell," and "hold" ratings? Or moderate buy, strong buy, market outperform, semi-recommend, two thumbs up, hot item, accumulate, dabble, dribble, gulp, tweak, and twist? What will we poor, small investors do without a long-term accumulate/short-term sell rating on a stock we're interested in?

Of course, the better question is what will the big, rich analysts do if they don't rate stocks anymore. I can just imagine the phone call from the manager to the analyst:

Manager: Hello, Sam?
Analyst: Yes?
M: We're going to be making some changes in your department.
A: [Momentary pause] But, I'm the only one in my department!
M: Yes, well. Let me put this in terms you might understand. If you were a stock, I'd warn our big clients to stay away from you, although I'd continue to maintain a "buy" rating for the general public.
A: [Gasps] You don't mean... you can't mean...
M: Yes, you're being delisted. Please get your margaritas out of the fridge and clear your desk by the end of the day.

At this point, I guess we should back up a bit and explain just what's going on here. Many of us regularly scoffed at analyst ratings, especially considering the paucity of "sell" recommendations. We knew that Wall Street firms did not want to overly agitate companies and risk losing lucrative investment-banking business.

You see, the firms make far more money from arranging securities transactions, lending money, and underwriting IPOs than any business they generate from analysts. Therefore, if the CEO of a big company takes exception to negative research produced by a firm's analyst, he can make sure to direct his I-banking business elsewhere. Understandably, the Merrills and CSFBs were hesitant to tell the truth about some less-than-appealing stocks.

In short, the system, as it currently stands, is nothing but one big ol' messy Conflict Of Interest. And this situation has produced some memorable quotes. During his investigation of Merrill Lynch, New York Attorney General Eliot Spitzer obtained internal emails in which Merrill analysts complained about not being able to speak the truth. "I don't think it is the right thing to do," said one. "John and Mary Smith are losing their retirement because we don't want a client's CEO to be mad at us."

Another good one was the so-called "Agilent Two-Step," coined by a CSFB analyst who kept a favorable rating on the company while painting a more realistic picture for big clients. "That's when in writing, you have a 'buy' rating, but verbally, everyone knows your position," said one analyst.

The lust for lucrative fees went beyond fraudulent ratings. Both Salomon Smith Barney and Goldman Sachs have been accused of giving important executives -- such as eBay (Nasdaq: EBAY) CEO Meg Whitman and former Enron Chairman Kenneth Lay -- chances to nab hot IPO shares in exchange for their I-banking business.

So, with Bulldog Spitzer, the SEC, and lawmakers on Capitol Hill on their tails, Wall Street firms are crying "uncle." According to The Washington Post, there's talk of a "global settlement" drifting about. But rather than finally achieving every beauty pageant contestant's dream of world peace, this settlement would mean all the big firms would give up the stock-picking business and concentrate on investment banking.

No more ratings. No more price targets. No more actual news stories that say, "But today, he cut his short-term rating on Amazon (Nasdaq: AMZN) from 'buy' to 'accumulate.' He maintained his long-term rating as a 'buy.'" If all this fun goes away, it would mean one of the biggest sea changes on Wall Street since Maria Bartiromo switched hairstyles.

But what would the big firms do with their analysts? Why would they need the research teams if they were to stop issuing ratings? It's hard to imagine, but you might see such stars as Henry "Amazon at $400" Blodget, Holly Becker, Daniel Niles, Mary Meeker, and Abby Joseph Cohen working in the food court at your local mall. "How's that pizza coming along, Henry?" "Well, the pepperoni smells like it's been in my jogging shoes for three days, but I'm rating it a 'strong eat.'"

OK, so maybe it won't come to that. Perhaps the big firms will spin off their research divisions into independent companies. No longer under pressure to generate I-banking business, analysts would be free to produce unbiased, honest ratings... something that could actually benefit investors.

We can hope, but we won't hold our breath.

Rex Moore reminds you that the white zone is for loading and unloading only. There is no parking in the white zone. At time of publication, he owned shares of eBay. You can view his holdings, as well as the Fool's disclosure policy, on odd-numbered Wednesdays.