Banks in the firing line (The Economist) 
 

Economic crisis section        
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> In the firing line
> Oct 4th 2002 
> From The Economist Global Agenda
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> In a week when prosecutors have finally charged the former chief financial
>officer of Enron, New Yorkâ€ôs feisty attorney-general, Eliot Spitzer, is
>joining forces with the Securities and Exchange Commission to root out
>corporate wrongdoing in America. Investment banks beware
> AP  
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> Spitzer sues again

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> THE might of Wall Street is under attack from all sides. In filing charges
>alleging fraud, money laundering and conspiracy against Andrew Fastow, the
>former chief financial officer of Enron and the first of the companyâ€ôs
>â€úinner circleâ€? of senior executives to be indicted, federal prosecutors
>have also pointed the finger at Merrill Lynch. A criminal complaint, filed
>in a Houston court on October 2nd, alleges that the investment bank helped
>Enron to conceal debt and hide its true financial position. One of the
>charges against Mr Fastow, who was given bail of $5m, involves a Nigerian
>company which Enron is said to have sold to Merrill and then repurchased in
>order, it is claimed, to inflate Enronâ€ôs earnings. The transaction was a
>â€úshamâ€?, say prosecutors, in which Merrill assumed no risk. 

> Such allegations, which have been vehemently denied by Merrill, are an
>example of the whirlwind of claim and counterclaim that is engulfing Wall
>Streetâ€ôs finest and many of its former clients. On the day that Mr Fastow
>gave himself up to FBI agents, a Congessional committee was chipping away
>at the reputations of Goldman Sachs and two other investment banks. The
>House Financial Services Committee accused Goldman, Credit Suisse First
>Boston and Salomon Smith Barney, part of Citigroup, of making preferential
>allocations of shares in sought-after initial public offerings (IPOs) to
>their favoured clients, so that the latter could make a quick profit by
>selling the shares on. In return, the banks are said to have received
>lucrative banking mandates. Among the executives named was Kenneth Lay, the
>former chief executive of Enron. The committee concluded that the practice,
>known as â€úspinningâ€?, had not only led to the false pricing of IPOs but
>had harmed ordinary investors. â€úThere is no equity in the equities
>market,â€? lamented the committeeâ€ôs chairman, Michael Oxley, the
>Republican member for Ohio.

> Congress is not the only body making accusations about the cosy
>relationship between investment banks and their clients. On September 30th,
>Eliot Spitzer, New York's attorney-general, filed a lawsuit seeking that
>once high-flying telecoms executives return over $1.5 billion in profits
>allegedly obtained illegally thanks to their links with bankers at Salomon
>Smith Barney. Most of the money was made when the executives sold stock in
>their own companies that was inflated by overly optimistic reports from
>Salomonâ€ôs recently departed star analyst, Jack Grubman. The executives
>also pocketed some $28m when they sold shares they were allocated in IPOs
>of â€úhotâ€? technology clients of Salomon's, allegedly as a payback for
>giving investment-banking business to Salomon.

> The executives involved include Bernie Ebbers, the disgraced former boss
>of WorldCom, which filed for bankruptcy in July and which has admitted
>overstating profits by $4 billion; Philip Anschutz, former chairman and
>founder of Qwest Communications; and Joseph Nacchio, Qwestâ€ôs former chief
>executive. Neither Salomon nor Mr Grubman were named, but correspondence
>that embarrasses them has been included in the evidence. In one e-mail, Mr
>Grubman wrote to the head of research, explaining why certain stocks had
>not been downgraded: â€úMost of our [investment] banking clients are going
>to zero and you know I wanted to downgrade them months ago but got huge
>pushback from banking."

> &&&T and United Technologies, â€úas part of our continuing effort to
>assure that our corporate governance reflects best practices.� On the
>same day, Citigroup announced that Michael Masin, currently vice-chairman
>of Verizon, a regional telecoms firm in the north-eastern United States and
>a Citigroup director, would become chief operating officer. Mr Masin is to
>chair a committee reviewing Citigroup's business practices.

> Citigroup is also in negotiation with both Mr Spitzer and the Securities
>and Exchange Commission (SEC) over new arrangements that would remove
>conflicts of interest inherent in having analysts and investment bankers
>under the same roof. The SEC worries in particular that analysts are being
>rewarded on the basis of investment-banking mandates they help their bank
>to win rather than the quality of their research.

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> Citigroup is reported to have already offered to create a separate company
>to house its investment-banking research, though this would still be within
>the Citigroup empire. The spin-off would serve mainly institutional
>investors as well as the small number of retail investors who trade through
>Salomon. Its analysts would no longer be allowed to attend â€úpitchâ€?
>meetings with investment bankers. Citigroup has resisted making any changes
>unless and until they can be imposed on other Wall Street firms as well.
>CSFB, which is under scrutiny itself over the alleged allocation of shares
>to â€úfriends of Frankâ€?â€ĒFrank Quattrone, its star technology
>bankerâ€Ēis known to be willing to go along with such changes. Merrill
>Lynch, which has already made some changes to the way its analysts are
>organised and paid, and which has paid a $100m fine following an earlier
>investigation by Mr Spitzer, is opposed to further reform. 

> In bringing his latest charges, Mr Spitzer has not only upset Wall
>Streetâ€ôs big banks. He has also upstaged the SEC and its chairman, Harvey
>Pitt, a former securities lawyer who stands accused of being too soft on
>the big firms that used to count among his clients. The SEC, along with the
>New York Stock Exchange and the National Association of Securities Dealers,
>Wall Streetâ€ôs self-regulatory organisation, have been looking into IPO
>spinning for years, but have yet to bring any actions. This may now change.
>Messrs Pitt and Spitzer have patched up their differences and are joining
>forces to press for changes in the way investment banks go about their
>business. Egged on by Mr Spitzer, his opposite numbers in other states have
>also divided up their investigations into the big investment banks: Utah is
>looking into Goldman Sachs, Texas J. P. Morgan Chase, and Alabama Lehman
>Brothers, for instance. This will not please those who believe that the
>zest for re-regulation is getting out of hand. Siren voices including that
>of Bill Harrison, chief executive of J. P. Morgan Chase, are beginning to
>warn that a raft of new regulations and moves to break up the industry
>could shackle investment banks at a time when their profits are already
>under strain. 

> Nevertheless, reform of how research is conducted by investment banks now
>seems inevitable. There are few examples on Wall Streetâ€ĒSanford Bernstein
>is oneâ€Ēof truly independent research houses. It is notoriously difficult
>to get investors to pay for research, especially since academic studies
>suggest that it is extremely difficult to beat the market consistently.
>Still, observers increasingly believe that the collapse of the bull market
>will lead to the break-up of financial â€úone-stop-shopsâ€? such as
>Citigroup, because no firm will want to risk the sort of
>conflict-of-interest lawsuits to which it is now being subjected.

> Quite apart from any fine, Citigroupâ€ôs share price has fallen by nearly
>40% this year, despite healthy operating profits. Even if it does not come
>to break-ups, it is hard to see analysts retaining the status they enjoyed
>in the late 1990s. Briefly masters of the universe, they will return to
>being the backroom geeks they once were.
 

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