cfr - mark twain wall st

8/14/2019 CFR - Mark Twain Wall St

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2. Firms will notify customers of the availability of independent research on customeraccount statements and on the first page of research reports.

So what will independent research sent by your broker look like? Well, given that yourbroker is likely to be ticked off that hes paying for it, picture the crap that comes withyour monthly cable bill. You know, those little ads for online Viagra and debt

consolidation that never leave the envelope.

3. An independent consultant for each firm will have final authority to procure independentresearch, and will report annually to regulators concerning the research procured.

Who will be the independent consultants chosen to reconstruct Wall Street? Again,silence. But if recent reconstructions are anything to go by, expect them to besubsidiaries of Halliburton.

4. Payments for independent research will total $432.5 million.Why $432.5 million? Well, Spitzer may have run a sophisticated econometrics model -

assuming nominal interest rates ofx, per capita income growth ofy, etc - to determine

precisely how much independent research we as Americans need to consume. Or maybeits his lucky number. I dunno.

The bottom line is that its all about independent research. The more independent, the better.

But what is an independent research firm anyway? Spitzer explained to USA Today that it wasa brokerage firm that generates all of its revenue from the sale of its stock research and/or fromcommissions for stock trading. These firms, he continued, do not provide investment-bankingservices for the companies they cover, so they avoid conflicts of interest for its stock analysis.Wall Street firms, he concluded, would [therefore] be required to purchase independent

research for five years and thus subsidize the independent research firms.

And so making Wall Street firms buy independent research will make Americans moreprosperous and secure. At least if you buy into a series of simple myths on the workings of thesecurities industry.

Myth 1. Good research is independent research

There are certain sweet-smelling sugar-coated lies current in the world which allpolitic men have apparently tacitly conspired together to support and perpetuate.One of these is that there is such a thing in the world as independence:independence of thought, independence of opinion, independence of action.

Another is that the world loves to see independence admires it, applauds it. Mark Twain

Twain was clearly on to something here. Independence in the Spitzer settlement whoprovides it, who contracts it, who benefits from it would appear to be nothing more than anelaborate, and very expensive, kabuki pla y.

There are three fundamental problems with the notion that good research is independentresearch. The first is that, empirically, there is no evidence that what the settlement defines asindependent research is actually better than non-independent research. For example, in the


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Institutional Investorranking of top equity research teams in 2002, virtually all of them werefrom Wall Street firms. In fact, Salomon and Merrill, two of the chief villains in Spitzers tale,were ranked numbers one and three. So-called independents barely register.

The second is that the very definition of independence was crafted solely to punishinvestment banks. That is , after all, what Spitzer had set out to do not to weed out conflicts ofinterest. Think of how many prominent independent research houses also manage money orbroker trades both of which give them a clear incentive to urge investors buy stocks.

The third has to do with conflating honesty with research contracted, rather than produced,by investment banks.

Mark Twain understood what it took to get honesty out of Wall Street research. Honestyis the best policy, he said, when there is money in it. There will clearly be money in honesty ifinvestors are the ones paying for research. If, on the other hand, banks are forced to pay forinvestors research, then its a given that factors at odds with honesty may pay. Like businessrelationships they may have with the independent research houses. Or between theindependent consultant and the independent research houses.

The reason honesty may not pay is simple: lack of accountability. The research providerswill not be accountable to investors, as investors will not be footing the bill. Despite the fact that

Spitzer concluded that investment banking taints research, the settlement has mandated thatresearch will be paid for and distributed by who else, investment banks. The research providerswill be accountable to the banks, or their consultants, who do pay them, and to the governmentofficials who decide notwhether they produce useful research, but whether they fit a politicallycrafted definition of independent.

There are people who think that honesty is always the best policy, Twain said. This is asuperstition. There are times when the appearance of it is worth six of it. Like when thegovernment puts itself in charge of designating it, rather than the citizens whose well-being willactually be determined by its presence or absence.

That's the difference between governments and individuals, Twain said. Governmentsdon't care, individuals do.

Myth 2. Stock research is a form of public good, sort of like street lamps, and should

therefore be subsidized

Reading the financial press these days, there seems to be a palpable terror out there ofdisappearing stock analysts. Apparently there will be huge swathes of the American economy,thousands of small- and mid-cap companies, that investors will be dying to know about but whichno one will study. All because of the tragedy that investment banking profits will no longer beavailable to directly fund the production of buy recommendations excuse me, research.

Spitzer agrees. Thus the bad banks will be required to fund a $432.5 million kibbutz tochurn out independent research on companies that investors apparently need to know about, butallegedly wont pay to know about.

Mark Twain, once again: In order to make a man or a boy covet a thing, it is onlynecessary to make the thing difficult to obtain.

Difficult, not easy. Costly, not free. If research is to be coveted, the coveters must pay.

Why the assumption that research is covetable, but that coveters wont pay? Consultantshave exclusive research and advisory contracts with corporate clients. Top independent researchhouses likewise have lucrative exclusive contracts with institutional clients. Mass distributionindependent research financed by banks as part of their parole agreement can only serve tofurther discredit and devalue research.


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Myth 3. It is sound public policy to encourage citizens to believe that wise investmentconsists in reading research reports on company stock prospects

This has been about one thing. It has been about ensuring that retail investors get a fair

shake. - Eliot Spitzer

There are two times in a mans life when he should not speculate: when he cant afford it,and when he can. - Mark Twain

If there is one thing that is now accepted as a virtual Truism among financial economists andhonest money managers it is that prudent investors should buy and hold a diversified portfolio ofsecurities. Individual investors, those who are intended to be the primary beneficiaries ofsubsidized research, are the least likely to be able to benefit from speculation on individualcompany shares. The notion that the financial security of the American public can be improvedby bombarding it with free opinions on stock prospects is both unfounded and irresponsible.

But what about institutional investors? Dont they also rely on investment banks forresearch?

Myth 4. Institutions buy research from investment banksThis notion is so widespread beyond the cozy confines of the securities industry that it is rarelyparsed or challenged, but it is doubly false. And since most Americans hold most of their stocksthrough institutions, this cant be ignored.

First, institutions only buy research from banks using trading commissions, which comefrom their clients assets rather than their own. This is at the heart of the biggest and mostunderreported scandal in the fund management industry: the use of soft dollar trading toinvisibly transfer fund management operating costs from fund managers to their clients. Thefunds dont buy, the client does. The client just doesnt know it.

Second, institutions were never stupid enough to believe that marketing propagandapublished by banks was research. That game could only be played on the retail level. The

institutions pay to speak to specific analysts privately, often to get the insider scoop on what technonsense the public would be fed in short order. But they also use trading commissions fromtheir client assets to buy items wholly unrelated to research. They just dont dare to admit this,lest they fall afoul of the SECs so-called 28(e) safe harbor for research purchased with tradingcommissions.

As Mark Twain observed, Almost all lies are acts and speech has no part in them.

According the SECs web site, institutions pay soft-dollar trading commissions toinvestment banks to buy newspapers, magazines, online services, conference registrations,accounting services, proxy services, performance measurement services, computers, monitors,printers, modems, cables, software, network support and maintenance agreements. And this isonly the legal stuff the stuff that the SEC, shamelessly, allows institutions to classify asresearch.

Take investment banks out of the trading process, and this massive, industry-widekickback scheme is brought to a screeching halt. A cynic might suggest that this has somethingto do with why the settlement left investment banks in charge of distributing research. Trulyangry investment banks might hurt a gubernatorial campaign.

Dont you hate cynics?


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Benn Steil is the Andr Meyer Senior Fellow and Director of International Economics at theCouncil on Foreign Relations

cfr - mark twain wall st

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