Spitzer Central Plan for Stock Research Backfires

September 20, 2005 9:08 PM by J. Henderson | Other posts by J. Henderson | Comments (4)

The $1.4 billion Wall Street research settlement, devised by New York politician Eliot Spitzer, compels investment banks to pay their “independent� rivals to publish competing investment research reports. This is necessary, Spitzer argued, to give investors access to research that is not tainted by conflict of interest. Banking conflicts, he said, make Wall Street analysts overly bullish on stocks.

Well, it turns out that independent research firms are actually more bullish than investment banks. According to Thomson Financial, 47.4% of independent firm stock recommendations are rated “buy,� versus 43.7% of Wall Street brokerage analyst ratings of the same set of stocks. “Sell� ratings account for 8.9% of independent firm recommendations, slightly less than the proportion of brokerage firm negative ratings (9.1%).

As for conflict of interest, the Wall Street settlement creates even more. Since the Spitzer settlement makes it too costly for investment banks to cover small cap stocks, two startup research ventures are trying to fill the void. But the Spitzer settlement only subsidizes duplicate research on stocks already covered by investment banks. Research undertaken outside the Spitzer settlement must be paid for with trading commission dollars. However, there is not enough trading commission in small cap stocks to make stock research profitable. Therefore, the startups must charge small and mid-cap companies for the service of coordinating independent research of their stocks. While these outfits have set up procedures to minimize the obvious conflict of interest (as the investment banks have), this demonstrates the futility of trying to eliminate potential conflicts completely.