an interesting article in today's FT! I love the ending... aren't the Republicans great?

A truce on Wall Street
By Gary Silverman
Published: December 10 2002 20:17 | Last Updated: December 10 2002 23:20

In ordinary times, Morgan Stanley and Goldman Sachs, the traditional titans of investment banking, are rivals, often fierce ones. But this summer the two banks had a bigger worry than each other. They had to deal with Eliot Spitzer, the New York attorney-general, and that meant they would work together.

Mr Spitzer had just secured a big victory in his investigation of conflicts of interest in investment banking research, wresting a $100m settlement from Merrill Lynch. Pressure was growing on the Securities and Exchange Commission to act and Wall Street feared regulators would force banks to restructure radically - even to get rid of their analysts.

Senior executives at Morgan Stanley and Goldman Sachs began meeting to discuss alternative remedies and their ideas found a receptive audience in a surprising place: Mr Spitzer's office. Participants say conversations between the banks and Mr Spitzer helped produce a concept that now occupies the heart of his reform agenda: the requirement that leading investment banks pay for independent research for retail investors. As Mr Spitzer said in a speech last week: "It was the investment bankers who first proposed this."

The interaction between regulator and industry provides a revealing glimpse into a process that has come to dominate Wall Street life. For months, national and state regulators have been sparring with a dozen leading banks over a "global settlement", one that will bring to an end investigations into conflicts of interest in Wall Street research and initial public offering (IPO) allocation procedures.

A pact is now in sight. Starting today, regulators will begin three days of meetings with bankers to discuss the fines that each will pay and the findings against them. Disputes about details could drag on. Concerns remain as to whether all the state regulators involved will stay on board. But there is, as Mr Spitzer acknowledges, "a desire among the parties to get to the finish line". And for all the fear the investigations have inspired, the talks seem to be heading towards market-friendly reforms, rather than outright revolution.

This is hardly the kind of plea- bargaining that takes place in police stations. In this case, the alleged perpetrators arrive in double cuffs, not handcuffs, and bring glossy pitch books outlining their positions - as Morgan Stanley did when it met Mr Spitzer to discuss third-party research.

"This is a very subtle game that is being played," says Samuel Hayes, professor of finance at Harvard Business School. "The industry isn't flat on its back in the way it was in the late 1920s and the early 1930s and it has many more resources . . . to bring to bear, to protect its interests."

Since October, when Mr Spitzer joined forces with the SEC, progress has been fitful, reflecting the difficulties of keeping so many participants together and the turmoil at the Commission. Only yesterday did the White House name a replacement for Harvey Pitt, the former SEC chairman who resigned in November.

The regulators' basic complaint is that banks compromised their standards during the 1990s bull market. To win investment banking work, banks published overly rosy research. In some cases, regulators say, banks steered shares in "hot" IPOs to important executives - a practice known as "spinning".

In response, regulators have been moving on two tracks - determining penalties for past misdeeds and fashioning reforms. The most straight- forward part of the talks has involved IPOs. The banks have no excuse for practices such as spinning and the settlement is likely to make it harder for top corporate executives to receive IPO allocations.

Research has proved a trickier issue. The simplest way to limit investment banking influence over analysts would have been to spin off research departments into separate companies. But the economics of Wall Street make that difficult. Research is a loss leader, paid for by fees from deals. Requiring analysts to go out on their own would have amounted to mass job losses - an unappetising prospect for a New York politician such as Mr Spitzer. At the same time, analysts can play an important role in dealmaking, helping banks determine which companies they will take public, for example.

The solution under discussion involves new checks and balances. Banks will be able to keep their analysts but will have to fund third-party research intended to give retail investors alternative views. Whether these outside opinions will really help is an open question but securities lawyers say they will give banks a defence against lawsuits alleging they have duped retail investors.

Mr Spitzer initially wanted a board to oversee third-party research. But his idea was shot down in favour of a less bureaucratic approach, in which each bank will have a monitor overseeing independent research. In addition, there will be further restrictions on "touch points" - contacts between analysts and investment bankers.

The basic outline of the settlement's penalty component has also taken shape. Regulators have told banks they may have to pay more than $1bn in fines but the size of the penalties could go down after this week's talks, particularly if banks agree to make more sweeping reforms. Citigroup's Salomon Smith Barney investment banking unit will probably pay the biggest fine - regulators originally put the bill at $500m.

A bigger monetary worry for bankers is the potential cost of class-action litigation. Trial laywers intend to use evidence uncovered in the investigations to press suits on behalf of aggrieved investors. Some analysts have predicted that damages in such cases could run into billions of dollars.

Also awaiting resolution are cases involving individual bankers, although the findings released as part of a settlement could signal where regulators are heading. Perhaps the greatest individual drama involves Sandy Weill, chairman and chief executive of Citigroup, who has said he asked Jack Grubman, Salomon's telecommunications analyst, to take "a fresh look" at AT&T several months before the bank won a choice underwriting assignment from the telecoms group.

The very different motivations and business models of the banks have made it difficult to craft the agreement. But the betting on Wall Street is that a solution will be found, if only because bankers need one to regain public confidence. The investigations have turned into a seminar in the inequities of the markets - and that has been bad for Wall Street.

"We have a crisis and the industry itself is calling for a settlement," says John Coffee, a Columbia University professor who specialises in securities law. "Both sides want to get a settlement fast and the normal process is a little too slow."

This urgency is itself a victory for Mr Spitzer. When the attorney-general began his investigation into conflicts of interest in research, many on Wall Street simply shrugged. Research conflicts were an old story. Wall Street's tendency toward bullishness was well known; sophisticated investors generally ignored the recommendations of analysts and focused on the details of their arguments. Banks also made no secret of the fact that having well regarded analysts helped attract underwriting assignments from corporations.

Mr Spitzer's insight was in arguing his case from the standpoint of consumer protection. While institutional investors understood the game on Wall Street, many retail investors did not - particularly those drawn to the markets by the rise of all-day financial television. Mr Spitzer was particularly well positioned to act because the broad provisions of New York state law allow prosecutors to allege securities fraud without having to prove intent.

However, in the end, analysts were undone by their own words. E-mails unearthed by regulators detailed rampant cynicism among bankers. In one, Merrill's Henry Blodgett likened a stock he was recommending to excrement. In others, Mr Grubman linked his decision to upgrade AT&T to Mr Weill's help in getting his children into a well regarded Manhattan nursery school. (Mr Weill has denied helping Mr Grubman's children to influence their father's views on AT&T.)

This kind of evidence transformed bankers into tabloid fodder and the damage to reputations, such as that of Mr Weill, could have lasting consequences for them and their companies.

But the regulators have proved accommodating in structural matters. The contrast with previous episodes of reform in the US is illustrative. In just a few months during the early 1930s, President Franklin Roosevelt and his allies pushed through laws that created the SEC and separated investment and commercial banking.

This time, regulators are working out reforms in secret with bankers at the bargaining table, giving the sinners, in a sense, a chance to influence scripture. The prospect of broader changes in US law are practically nil since the Republicans solidified their control of Congress by retaking the Senate in mid-term elections in November. "There is a very strong belief on the Republican side of Congress that the market ought to be allowed to work," says Mr Hayes of Harvard.

The changes envisaged also could wind up benefiting big banks at the expense of small ones. Hiring star analysts was a way for banks to break into equity underwriting. With analysts playing less of a role, the advantage in winning underwriting mandates could go to established banks with big sales forces. "The guys who are going to win this things are the guys who have market share in IPOs - the Merrills, the Morgan Stanleys, the Goldmans and the Salomon Smith Barneys," says Brad Hintz, securities industry analyst at Sanford C. Bernstein.

But Mr Spitzer made clear during his speech last week that his goal has not been to reorder Wall Street. Rather, he said, he was trying to save the markets from a "deregulatory spasm" inspired by economists from the conservative Chicago school. Retail investors, he added, did not have sufficient information to make good decisions - and market mechanisms were not responding to that distortion. "Markets have structural flaws and market failure is an issue that has to be addressed. The market will not independently correct itself."

That places Mr Spitzer in a long line of US reformers who have tried to save capitalism from the capitalists. As he said of himself: "I am as close as you will get a genuine free-market voice." His audience - a hotel dining room filled with bankers feasting on lobster and filet mignon - hardly demurred.