- The Washington Times - Sunday, April 14, 2002

Before and after the bursting of the Internet and telecom stock bubbles, trillions of dollars of wealth was generated, often changed hands and then disappeared. Through it all, investment banks, which earned billions on both the upswing and the downswing, have insisted that a "Chinese Wall" has separated their research divisions from their banking-services arms. That "Chinese Wall," investors were assured, precluded any possibility of a conflict of interest between the research of stock analysts, who wrote glowing reports about firms, and the highly profitable services provided to those same firms by the investment bankers.
Since the market collapse in the technology sector, skeptics have been wondering whether the seemingly impenetrable "Chinese Wall" was in fact more like a Swiss cheese. After a 10-month investigation of Merrill Lynch & Co., New York State Attorney General Eliot Spitzer has produced massive amounts of anecdotal evidence strongly suggesting that the "Chinese Wall" was porous in the extreme.
During his investigation, Mr. Spitzer relied extensively on thousands of e-mail messages exchanged at Merrill Lynch and other internal communications. One e-mail that will be particularly upsetting to the investors left holding an empty bag was sent by stock analyst Kirsten Campbell to her boss, Henry Blodget, the once-legendary and now-notorious Internet hype-master who earned tens millions of dollars pushing dot-coms on potential investors. Ms. Campbell complained about the pressure she felt to issue an "accumulate" rating for GoTo.com, rather than a neutral rating. "We are losing people money," Ms. Campbell told Mr. Blodget, adding, "The whole idea that we are independent from banking is a big lie."
Mr. Spitzer provided numerous examples of instances where Merrill Lynch analysts offered glowing reports for public consumption. In private and among themselves, however, they often disparaged the very same companies. In the case of GoTo.com, one internal communication expressed the observation that there was nothing interesting about the company "except banking fees." InfoSpace, another Internet firm highly touted by Mr. Blodget, was internally considered to be "a piece of junk." [email protected], which Merrill Lynch analysts publicly praised, was privately dismissed as "a piece of crap."
What is the incentive for stock analysts to praise the growth and profit prospects of firms in public if they believe privately that such a favorable prognosis is unwarranted? The research departments where stock analysts work earn no profits for the investment banks. The real money is made underwriting stocks and bonds, including initial public offerings (IPOs), and providing merger and acquisition advice and other investment-banking services.
Memos to and from Mr. Blodget, who left Merrill Lynch last November, provided extremely interesting evidence debunking the existence of the fabled "Chinese Wall." In the fall of 2000, Merrill Lynch asked Mr. Blodget and other analysts to document the instances in which their services generated business for the banking department, which, it needs to be remembered, was located on the other side of the supposedly impenetrable "Chinese Wall." Mr. Blodget and his department had no problem identifying more than 50 cases involving pending or completed investment banking transactions. The completed transactions alone generated $115 million in fees, a fact that goes a long way toward explaining why Mr. Blodget's compensation increased from $3 million in 1999 to $12 million in 2001.

Consider Pets.com, the late Internet firm that blew millions of investors' dollars on splashy, though obviously unproductive, Super Bowl ads in January 2000 before going belly-up. With Merrill Lynch as the lead firm in the Pets.com IPO, the online pets-supply store sold shares worth more than $80 million in February 2000, one month before the NASDAQ peaked. Merrill Lynch pocketed an estimated $5 million in fees. Naturally, Mr. Blodget issued a "buy" recommendation for the IPO rollout. Yet, even as Pets.com suffered mounting losses as the Internet bubble was bursting, Mr. Blodget issued three more reports during the next six months recommending investors "buy" Pets.com. By the time Mr. Blodget got around to downgrading the stock, it had lost about 90 percent of its value. The same scenario played out for eToys and Barnes&Noble.com;, whose IPOs also involved Merrill Lynch. Altogether, between 1997 and 2000, Merrill Lynch's banking department earned $100 million for Internet IPOs.
Then, of course, there is Enron. Thomson Financial calculates that Enron, since 1986, has paid $323 million in fees to Wall Street firms for underwriting stocks and bonds. Goldman Sachs, where golden boy Robert Rubin served as co-chairman before joining the Clinton administration, pocketed $69 million. Salomon Smith Barney, which is owned by Mr. Rubin's current firm, Citigroup, picked up $61 million. And Credit Suisse First Boston two of whose investment bankers, after helping to design Enron's debt-hiding, off-the-books partnerships, actually served on the board of one of them received $64 million in underwriting fees from Enron. These off-the-books partnerships, which disguised Enron's rapidly deteriorating financial condition until they unraveled, causing the firm's bankruptcy on Dec. 2, generated huge profits for senior executives of the investment banking firms who were allowed to secretly invest in them in 1999, according to a lawsuit filed in federal court recently.
For years, as its financial machinations became ever more complex and non-transparent, Enron benefited from glowing reports by stock analysts employed by the very firms raking in its underwriting fees. Indeed, even as Enron's stock price was plummeting but before its blockbuster announcements about earnings restatements and SEC investigations in October, an analysis by Thomson Financial revealed Enron to be the second most highly rated stock in the S&P; 500.

On Aug. 15, for example, when Enron was trading at half its $90 peak price achieved the year before, Goldman Sachs analyst David Fleischer issued a report asserting, "We very much believe there is no fire at Enron." Six months earlier, an extremely prescient article by Bethany McLean in Fortune "Is Enron Overpriced?" quoted one analyst complaining that Enron had become "a big black box," to which Mr. Fleischer retorted: "Enron is no black box. That's like calling Michael Jordan a black box just because you don't know what he's going to score every quarter." Nothing could shake Mr. Fleischer's optimism. On Oct. 24, eight days after Enron announced the elimination of $1.2 billion in shareholder equity, Mr. Fleischer and his team at Goldman told their clients that concerns about Enron's financial condition were "very much exaggerated." Mr. Fleischer did not get around to removing Enron from Goldman's recommended list until Nov. 21, when the stock closed below $2, reflecting a plunge of 98 percent from its peak.
Mr. Fleischer was hardly alone. Despite its reeling financial condition, as late as Nov. 8, Enron received "buy" or "strong buy" recommendations from two-thirds of the analysts who tracked the firm. Credit Suisse First Boston's analyst rated Enron a "strong buy" as late as Nov. 29, three days before it filed for bankruptcy.
UBS PaineWebber, which had an exclusive arrangement to be the first brokerage any Enron employee would deal with regarding stock options, actually fired an analyst who expressed negative views on Enron's prospects. On Aug. 21, the same day Enron Chairman Ken Lay sold $4 million in company stock while simultaneously forecasting "a significantly higher stock price" in an e-mail to worried employees, broker Chung Wu warned clients that "Enron's financial condition is deteriorating" and recommended that they "take some money off the table." Twelve hours later, Enron's manager in charge of the firm's employee stock option plan complained to Mr. Wu's boss, telling him Mr. Wu's warning "is extremely disturbing to me." Mr. Wu was promptly fired. His boss sent an e-mail to Mr. Wu's clients, reversing the sell recommendation (Enron's stock price was $36 at the time) and telling them that UBS PaineWebber's analyst had a "strong buy recommendation." That "strong buy" rating prevailed until Nov. 28, four days before Enron went bankrupt. By then, of course, it was too late for Mr. Wu's clients.
Meanwhile, investment banks continue to insist that their impenetrable "Chinese Wall" prevents any chance that they could capitalize on the blaring conflicts of interest. In fact, the "Chinese Wall" was obliterated long ago, and the investment banks have been brazenly exploiting the conflicts of interest for years. Only a fool would rely on any investment advice from this crowd.

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