How successful has Eliot Spitzer been at achieving his goal of greater transparency in capital formation?
Over Christmas, a lot of you had your doubts. You wondered how effective the reforms sought by the pugilist NY State Attorney General, who has been exposing the dot.com era corruption, could really be. With the next bubble just around the corner, it's a good time to be asking the question.
Well, on Monday Spitzer formally announced a settlement with the banks in question. And for good measure, he opened a goldmine of memos from the investigation. These will be being read long after The Starr Report has been forgotten.
Let's savor them briefly, before returning to the question we posed.
Spitzer's transparency crusade is founded on one principle: that the research analysts were working for the same investment banks that benefited from their advice. These benefits could be substantial: in 2000, investment banking earned Morgan Stanley $4.8 billion.
The analysts recommended stocks to the public and the institutional investors that were of dubious value, but what the hell - the banks got their business, the analysts got their bonuses, and the only people who were screwed where the small investors.
In fact that's oversimplifying it considerably: in the greatest loss of wealth in human history, we all got screwed, somehow, even if you only look at opportunity costs missed.
So Spitzer argues, if you improve the credibility of the information provided, wiser investment decisions can be made.
Yesterday we learned that not only were the banks' "research analysts" not independent - that we knew already - but the banks were paying each other off to ensure their recommendations marched in step. Five brokerages paid millions to "rival" analysts for favorable evaluations. Morgan Stanley paid out $2.7 million. On the receiving end, Bancorp Piper Jaffrays was $1.8 million richer from these payments.
These were called "research guarantees". By day, the banks were deadly rivals, competing under the invisible hand of market forces. By night, they were rewarding each other to ensure that one wouldn't break ranks, that the quality of information wouldn't improve - Solomon Smith Barney ignored warnings that its research was "basically worthless", and so ensure that the tech bubble wouldn't burst.
Eventually the quality of information became so synthetic, so divorced from reality, that it was unsustainable: the bubble collapsed and the shareholder suits followed.
Spitzer has recommended, and the banks have agreed to structural self-regulation. This is supposed to make the wall between analyst and investment banker in the same company stronger, and more transparent to the outside world.
But will that be the cure?
Both parties will continue to have the same boss. Because investment banking is the side of the business that brings in the cash, how will an honest analyst gain from giving honest advice to his organization? Is that a promising career move?
And equally, there's no economic benefit to the Investment Bank to hear honest advice. Put it this way: what is the benefit to you as a Bank to have a grouchy analyst who keeps insisting "Naaah, this looks like a piece of junk to me, I'm not going to say anything nice about it." Each employee must earn his keep. These superstars could be doing PR. The research analyst could be performing internal due diligence. But neither justifies the role and commensurate reward that an analyst commands.
No, let's make no mistake. Research analysts at banks are employed for one reason only: to keep the Investment side ticking.
As the "research guarantee" payments showed, even commercial rivals will collude to make sure that the bubble keeps going. So there's little to suggest that independent analysts will be any better. Not if they're looking for business from the investment banks.
Here the free market right employs its "leave us alone" argument, which boils down to trusting extreme vigilance of the information we are given, rather than structural reform. OK, that's evidently self-serving but that doesn't make it any less useful. Because it's true.
A heretical digression
What if, we suppose, we declare Spitzer's formulation to be false: what if he has made the parameters of his enquiry too narrow?
What if, we suppose, the Wall Street analysts are simply doing as they are bid, and responding, or acting on certain assumptions? Wouldn't that better explain their behaviour?
Well, wired into such assumptions are certain values. These values are our common currency. One 'value' that seems to be asked of us is to believe that the emerging Asian economies will manufacture faster and quicker than European or USA-based economies, so naturally, manufacturing jobs will travel East. Another seems to be that technological innovation can be commoditized into these supply chains, and therefore, anyone who invests in R&D is a loser.
These all might be true, if technological innovation had ceased yesterday, and there was nothing new left to invent.
But let's suppose that isn't the case. That systems companies, such as Nokia or Sony or Sun, have a unique knowledge of integration issues that a horizontal player knows has yet to discover. The values they share - data integrity, for example - are pretty common. Yet as a whole, they have failed to influence Wall Street's opinion-formers, who have decided, without any serious thinking about what they might lose, to consign this period of history to the dustbin. These Wall Street guys aren't very bright: they follow the money, which right now dictates that horizontal models are cool, and vertical models suck.
Let the supply chains take care of it, they say. For lack of vision or political will, the leaders of the systems companies have failed to assert themselves in capital formation. This must be fixed, pretty damn quick: the systems companies need to assert their values, and fast. This, apologies, was a heretical digression.
To avoid the next bubble (actually another bubble would be just fine by us - it's the next crash-after-the-next-bubble that we're worried about here) we do need extreme vigilance and to recognize patterns of behavior from the actors who hype bubbles. The first tech bubble gives us plenty to identify.
Bubbles require two things a) an absence of rational expectations and b) a consensus to maintain the irrational: to keep the balloon aloft, the hope that one day, we'll all cash in - if only we keep believing.
What can happen on a macro level can happen on a micro level too. You probably know this because you've worked with one somewhere in your organization at some point, some crazy scheme that didn't work out.
Take for example the imminent WiFi bubble. While never the most skeptical publication, Wired magazine went into overdrive in a (sponsored) supplement extolling the riches that lie ahead - if only we simply overthrow the telcos, deregulate the spectrum, and believe. There was very little rational talk of revenues - as you know, users of public WiFi like and expect it to be free - but much delirious enthusiasm for this future that lies ahead of us. If only we believe.
And you can see the hype work on a very micro scale.
Japanese VC and tech socialite Joi Ito [Hates reading books - Lunch - Lunch - Segway - Lunch - Lunch - Fawning Parody - World Blogging Forum!]) has spent months hyping the couple who started the Movable Type weblogging software Ben and Mena [buys banjo]Trott.
The cute, but strangely synthetic twosome were showered with advanced publicity in the form of flights and lunches and "party games" (the latter is filed under "Humor / Leadership and Entrepreneurship" ), before Ito's company invested in Movable Type last week.
Will we be able to trust Ito's ongoing research analysis about his investment?
We shall see.
(The examples above were sent in by Register readers - thanks.)
The world has dozens, hundreds of such games being played. Whether they eventually represent a bubble, or simply a social circuit, no one is in a position to say, just yet.
Truth or dare
So do Spitzer's structural reforms go far enough or not? Certainly without strong legislation (New York state has the unique Martin Act) the miscreants can bubble again, without fear. And a determined prosecutor was needed to bring the case on behalf of individual shareholders.
But it certainly suggests that vigilance has its part to play too. Given the choice between those who warn against bubbles and those who promote them, we know who our money's on in the long run.
Technology attracts utopians and it attracts speculative capital.
But as the old, overused saying goes:- "It's good to keep an open mind, but not so open your brain falls out".
So with your help, we'll keep watching. Please keep sending 'em in. ®