Money Made Simple - How To Flawlessly Control Your Finances In Minutes A Year

Book by Johnson Stacy

1

A Tale of Two Pities

Finance is the art of passing currency from hand to hand until it finally disappears. —Robert W. Sarnoff

It was the best of times; it was the worst of crimes.   In this chapter, I’m going to pluck a few items from recent news, pretty much at random, that should serve to convince you that it’s really not safe to trust anyone else to help you with your money, no matter how well known or trusted the names may be.

If you do nothing more than watch national news on TV, you may know that Wall Street has not been acting in your best interests for some time now. Recent examples? Two of the most respected names in the financial services industry: Merrill Lynch and Salomon Smith Barney. But before I begin, I want to make something clear. I’m not telling you this because these examples are the exception. I’m telling you this because these examples are the rule. Always have been, always will be.

Let’s talk about Merrill Lynch first.

In terms of number of retail investment advisers, Merrill Lynch is one of the largest financial services firms in the world. And even when the stock market is lousy, it still makes a ton of money. According to its Web site, www.ml.com, Merrill’s profits for a recent three-month period (a period when stocks stunk) were $693 million. Its chairman, David Komansky, was paid $16 million in 2001 while the stock market fell 7 percent that year. Of course, there’s no law against making money. That’s the backbone of capitalism. But let’s consider how some of it was made.

To fully understand this story, you’ll have to learn some basics of financial advisory firms like Merrill Lynch. These firms make money several different ways. One way is to collect commissions from little guys like you and me when we buy investments. We could go to places that charge a lot less in commissions to buy investments, but we’re willing to pay extra to “full service” firms like Merrill Lynch because they promise that in exchange for paying them more than necessary, we’ll get something we couldn’t get at cheaper places: unbiased, expert advice. The process of exchanging our hard-earned money for their objective advice is part of the business known as “retail brokerage.” But there’s another completely different way financial advisory firms make money. They collect huge fees from big companies when these companies raise money by selling stocks and bonds to the public. This business is called “investment banking.”

If you’re a company that wants to raise money by selling stock to the public, a firm like Merrill is a great place to go. That’s because it has so many investment advisers who will help the stock get sold. For example, say you’ve got a great idea for a new Web site: www.ineedthemoney.com. But as you put your idea on paper, it turns out that developing your new Web site will cost $50 million, and you’ve only got 150 bucks in the bank. Where will you find the other $49,999,850? A place like Merrill Lynch. You visit its investment banking division and explain your slight cash shortfall. If your idea seems reasonable, the folks there might just offer to take your company public by selling stock. They help you issue five and a half million shares of stock and sell them for $10 each. (Notice

that although you needed only $50 million, Merrill raised $55 million for you . . . that’s because it’s charging you $5 million for its assistance.)

But how will Merrill sell millions of shares of your stock to the public when nobody outside your immediate family knows you’re alive? Simple. Its thousands of retail brokers—the advisers paid to give small investors objective advice—will do the selling. This they do by calling their many clients and advising them to buy your stock.

But there’s still something missing. Retail investment advisers are sales experts, but they’re rarely investment experts. They don’t have nearly enough training to examine your business plan, projections, and market analysis and reach a conclusion as to the value of your stock. That’s where a research analyst comes in. Even before the investment bankers are putting together the paperwork pertaining to your initial public offering, Merrill’s analysts are studying your business plan and profit projections. If they like what they see, they advise the investment banking people to do the deal, then they write a research report that says your stock will go up and should be bought. In fact, because these reports can have lots of big words and numbers in them, the analysts will even make the process simple by boiling down their opinion into a one- or two-word rating. For example, they’ll assign it a “buy” rating. Or hopefully even “aggressive buy.” Then they’ll send that report and that investment rating to all their retail brokers, who in turn wave it in front of their retail clients and thereby convince them that www.ineedthemoney.com is going to the moon.

In a perfect world, this is a great system because everybody wins. You raise $50 million, Merrill makes a $5 million investment banking fee, retail investment advisers earn commissions by selling stock in ineedthemoney.com, and small investors own a stock that goes to the moon, just like they were promised. But this isn’t a perfect world. What happens if Merrill’s analysts look at your business plan and decide that your idea is stupid and will never fly? If they put out a negative report on ineedthemoney.com, retail advisers won’t recommend the stock, it won’t get sold, you won’t raise the money you need, and, most important, Merrill won’t earn a $5 million investment banking fee. So there’s great pressure for analysts, who are supposed to be totally truthful and objective, to help everyone out (except you, of course) by saying good things about bad ideas. And this pressure doesn’t happen just the first time a company goes public. You’d think that once you’ve raised $50 million, you’d never need more, right? Wrong. A lot of companies find that their initial cost projections were low, or maybe they forgot they needed a heated swimming pool in the CEO’s office. So there may come a time when ineedthemoney.com raises more money with what are called secondary stock offerings, or maybe by selling bonds. Since Merrill wants this business, too, its interests will be best served by keeping your investment rating favorable. After all, would you pay the company five million bucks for a secondary offering if it had your stock rated as a “sell”? Not likely.

It should be patently obvious from this simple explanation that any firm that cares about its customers—or its future, for that matter—should never allow an analyst to compromise his objectivity in favor of potential investment banking fees. Because if an analyst lies to small investors to earn the firm a fee, he would be committing fraud. (Here’s Webster’s definition of “fraud”: “intentional perversion of truth in order to induce another to part with something of value.” This precisely describes the process of lying to small investors to fatten corporate coffers.) Just as important, while allowing your analysts to commit fraud might result in short-term gain in the form of investment banking fees, it will cause long-term pain because when the recommended stocks go into the toilet, investors won’t trust your company anymore and you’ll be toast. Therefore, if you were an executive focused on either your company or your customers, you’d have a system in place to deal with the possibility of this obvious potential problem. And most companies do. If, on the other hand, you were focused on short-term profits and didn’t really give a damn whether your customers would ultimately lose money, you’d ignore these policies and allow this conflict of interest to fester, or even foster it by flat out paying your analysts to not say things that might hurt your investment banking business, and say other things that help it. You might, for example, give them bonuses based on the amount of investment banking business they helped bring to the firm.

In any case, if you were a top executive with one of these firms, since this possible conflict of interest is so obvious, the one thing you could never do is pretend that you didn’t know it existed. Or, if you had policies in place to address this conflict of interest, pretend you didn’t know they were being violated.

Now let’s step out of the classroom and into the real world. In May 2002, Merrill Lynch agreed to make civil payments totaling $100 million to settle a complaint that some of its analysts hadn’t been objective when recommending some stocks to retail investors. (Interestingly, however, none of this $100 million went to the retail investors who were hoodwinked. New York State took about half, and the rest will flow to the coffers of the other forty-nine states.) The reason New York State is getting Merrill to write such a huge check is that it did an investigation and uncovered a bunch of e-mails written by various Merrill analysts suggesting that their objectivity had been compromised. To be more specific, the analysts wrote e-mails among themselves admitting that certain stocks were losers while maintaining “buy” ratings on them for small investors. Here’s the press release from the New York State Attorney General’s office concerning the settlement, issued April 8, 2002. I added the bold print, and the part in parenthesis followed by the word “NOTE.”

Merrill Lynch Stock Rating System Found Biased by Undisclosed Conflicts of Interest

State Attorney General Eliot Spitzer today announced a court order requiring immediate reforms in investment counseli...