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"It's starting to look as though the very model of the financial conglomerate is fundamentally flawed." -- Business Week ("Crisis at Citi," by Anthony Bianco and Heather Timmons, September 9, 2002)

Saving Main Street From Wall Street

Millions of investors who lost billions of dollars had followed the advice of Wall Street analysts who wrote rosy but inaccurate reports to pump up certain companies' stock to unsuspecting investors. New York Attorney General Elliot Spitzer first exposed this dynamic when he uncovered incriminating internal emails at Merrill Lynch that privately described stocks like InfoSpace (a stock they gave their highest rating) as "a piece of junk."

Although a few high-profile analysts were exposed for touting stocks -- including Jack Grubman and Henry Blogett -- the problem of analysts' conflict of interest was in fact an endemic problem in the industry.

According to Weiss Ratings (whose revenues do not come from the companies they analyze), the vast majority of Wall Street investment analysts (many tied to the same banks that underwrote the companies they were covering) advised investors to "buy or "hold" shares in Enron and other failing companies even as they were filing for Chapter 11. Forty-seven of the 50 large brokerage firms covering companies that went bankrupt in the first four months of 2002 continued to recommend that investors buy or hold shares in the companies even as they were filing for Chapter 11.

The conflicts-of-interest affected the bankers' other activities as well. For example, Salomon Smith Barney's telecom analyst Jack Grubman helped raise money for Qwest, Global Crossing, and WorldCom, helping them plot strategy and attending board meetings while he was touting their stock to unsuspecting investors.

The SEC and New York Attorney General Eliot Spitzer's "global settlement" with the banks required that banking firms sever the links between research and investment banking, including analyst compensation for equity research, and the practice of analysts accompanying investment banking personnel on pitches and road shows. The settlement also banned the "spinning" - the allocation of lucrative Initial Public Offerings (IPOs) shares to corporate executives in the position to influence banking decisions.

But the high-profile settlement did not resolve other conflicts created by the big banking conglomerates' provision of multiple banking services, which is why observers say the source of the problem -- and its solution -- may go much deeper, into questions of deregulation and market structure.

For instance, as the Senate's Permanent Investigations Subcommittee of the Governmental Affairs Committee discovered, the big banks helped prop Enron up through a series of deceptive transactions called prepays, in which Citigroup and J.P. Morgan Chase repeatedly issued Enron huge loans that were disguised as energy trades (which then enabled Enron to misstate the loan proceeds as cash flow from business operations, misleading investors, analysts, and employees who lost their life savings and jobs).

In another set of deals related to the pulp and paper business, Citigroup and Chase actively aided Enron through a number of transactions that Enron used to manipulate its financial statements or deceptively reduce its tax obligations.

These kind of financial misdeeds are likely to continue so long as the giant banks are allowed to offer multiple services structural banking, underwriting and investment banking services to the same client.

In many ways the multiple conflicts-of-interest exposed at the big banks are traceable to the repeal of new Deal-era laws like the Glass-Steagall Act, which established a strict separation between investment banking, insurance, and underwriting businesses. Although the walls between investment banking and other services were gradually dismantled, with banks being given the permission to acquire securities firms outright in 1997, the Act was finally fully repealed in 1999 in a lobbying effort led by Citigroup and other large banks, with the support of then-Treasury Secretary Robert Rubin, who was hired by Citigroup just four days after Congress reached a final ' compromise on the legislation.

With the law's repeal, J.P. Morgan Chase & Co. and Citigroup, Citicorp's successor, were free to both lend money and underwrite securities for Enron, WorldCom and others. Citigroup, for instance, was paid a total of $167 million by Enron for various services from 1997 to 2001. The big banks lent Enron billions, often without asking for collateral and often disguised as sham energy deals. At the same time, the big banks were also pivotal players - perhaps the architects - of the offshore special purpose entities that were used to hide the company's debt and which ultimately brought the company down. (In addition, bank executives personally invested in the lucrative partnerships.) The banks also coordinated huge investment deals around the world and attempted to save Enron by arranging for a last-minute failed buyout by Dynegy.

By then they were in too deep to warn anyone else, including the credit rating agencies and the other banks to whom they had syndicated billions in loans - a fee-generating relationship that allowed them to pass on much of the risk. It's no surprise, therefore, that Citi's Robert Rubin put in a last-minute desperate call to the Treasury officials including undersecretary Peter Fisher, in an attempt to prop up Enron's credit rating just before it collapsed. (Rubin was later cleared of any violation of the law by a Senate staff investigation).

"The rationale for repealing Glass-Steagall was that it would create more diversified banks and therefore more stability," Tom Schlesinger, executive director of the Financial Markets Center told reporter William Greider. "What I see in these mega-banks is not diversification but more concentration of risk, which puts the taxpayers on the hook."

Because the costs of securities research cannot be easily passed on to the retail customer, it is more difficult to establish as a self-sufficient, free-standing business. Thus, most experts support reforms that attempt to police conflicts and prevent egregious abuses. But the ability of regulators to do this is questionable. The National Association of Securities Dealer's (NASD) Rule 2711 (proposed in early 2002), for example, generally prohibits investment bankers from reviewing research reports prior to publication, but it does allow for a limited review to determine their accuracy.

For More Information:

"Oversight of the Banks' Response to Enron," Report by the Senate Committee on Governmental Affairs, Permanent Subcommittee of Investigations (12/11/02), Volume 1 and Volume 2.
Frontline: "The Wall Street Fix" (WorldCom-Wall Street Connection) Restraining Vertical Integration and Cross-Industry Ownership by Robert Weissmann
Sandy Weill: How Citigroup's CEO rewrote the rules so he could live richly Slate.com piece by Chris Suellentrop (11/02)
"The Enron Nine"by William Greider (The Nation, 4/2502)
Analysis of Gramm-Leach-Bliley (repealed Glass Stegall) by Financial Markets Center
"A Real Fix" by Hedrick Smith

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