Wall Street Prophets

Since 60 Minutes II first broadcast this story earlier this year, both Congress and the New York State Attorney General have launched investigations into stock analysts and bad advice that cost investors a fortune when the stock market tumbled.

The NASDAQ lost nearly 40% of its value last year. In all, about $1.5 trillion in investments were wiped out. A lot of money was lost following the advice of stock analysts, the experts who work for big brokerage houses. Think of them as the prophets of Wall Street. They analyze a company, look into the future, and recommend whether to buy the stock.

For seven years, Tom Brown worked at the Wall Street firm Donaldson, Lufkin and Jenrette (DLJ). He was a top banking analyst with a reputation for blunt honesty. Brown says he recalls a DLJ meeting at which an analyst explained to the group that its job was to make the stocks it represented look good.

"I don't know frankly how some of these analysts live with themselve.s I couldn't get up in the morning and look in the mirror and know that I just caused somebody to lose 50 percent of their retirement money because I exaggerated and lied," Brown said in January. "And that's exactly what I saw at DLJ."

If there is pressure to lie, it stems from a very simple conflict of interest. Wall Street's brokerage houses make 70 percent of their profits from what's called "investment banking" - simply raising money for companies that need cash. For example, when Pets.com needs money, it goes to one of its bankers, Merrill Lynch. Merrill Lynch offers Pets.com stock for sale. The higher the price, the more the brokerage makes. Imagine what that analyst is going to tell the public about stock his firm wants to sell.

Says Brown: "They really are cheerleaders because if you're - this company that you're working on is not a client of the firm - every company is a potential client, so the investment banking group wantyou to be wildly bullish about everybody."

Meaning if there's bad news about a stock, you're not likely to hear it from the analysts. A 1999 study from Dartmouth College and Cornell University says analysts show "significant evidence of bias" when they recommend stocks that are handled by their firms. The study points to an internal memo from brokerage house Morgan Stanley. It tells analysts, "We do not make negative or controversial comments about our clients." Morgan has disavowed that memo.

But look at a recent example of one of the firm's clients: Priceline.com. Morgan made millions in fees raising money for Priceline. Morgan's analyst, Mary Meeker, recommended buying Priceline's stock at $134 a share. When it fell to $78, she repeated her buy recommendation. And she kept recommending Priceline as it fell to less than $3.

"In my case, I was very critical in the 1995 to 1998 time frame of the mergers and acquisitions activity that was taking place among the largest banks. I frankly thought they were paying too much and that they were using unrealistic assumptions and that shareholders were going to be hurt."

Brown says he was fired because the banks he criticized stopped doing business with DLJ. The company says Brown was fired because of "his persistent inability to operate effectively within a team infrastructure." DLJ insisted there is a separation between investment banking and analysts and it says its analysts are encouraged to be candid.

Brown says that he thinks the average investor was hoodwinked in all of this.

The brokerage firms disagree. They say analysts disclose their conflicts of interest in every research report. So 60 minutes II checked. In one report, they do – but in a paragraph of small print at the bottom of the page. Obscure disclosures like these concern Arthur Levitt, former chairman of the Securities ad Exchange Commission. He enforced the law on Wall Street.

"I think the analyst has a responsibility to reveal a conflict of interest," he says. "And that's something that the Commission is urging upon the Stock Exchange - to see to it that their rules are changed in a way which will force the analysts to reveal conflicts."

"There's got to be much greater disclosure of the kinds of conflicts that are part of today's market," he says. Asked if the current practice is dishonest, he says: "I'd say it's less than moral."

One result of these conflicts was the inflation of so-called target prices - an analyst's prediction of how high a stock would go. In the wildly speculative Internet market, analysts set inflated targets with no connection to a company's real worth.

Is it appropriate for an analyst to set a target price? "That's been a practice as long as we've had analysts and I think if investors are prepared to take that at face value, they have to be prepared for the consequences," says Levitt.

There were consequences for some of those who invested in Amazon.com. Amazon was selling for about $243 a share when a little-known analyst named Henry Blodget, who had no conflict of interest, predicted it would go to $400 - even though Amazon had never made a profit. Incredibly, it did go to $400 and beyond. Great for Blodget - not so good for investors, many of whom got soaked when Amazon's value fell 75 percent.

Blodget has said his prediction was based on sound analysis, using new ways to measure a company's performance. Wall Street created a new verb for it, to "blodget" a stock.

Lise Buyer is a former Internet analyst who says experienced hands on Wall Street couldn't make sense of soaring target prices.

"Those of us who's been in the business for a while looked at the wild targets that people were putting out there and our jaws dropped. And then we watched the stocks follow suit."

Did Amazon go to $400 because Henry Blodget said it would or did it go to $400 a share because that's what the market demanded?

"Isn't that the key question?" she says. "I think the market that we had over the past couple of years, Amazon went to 400 because Henry said it would. It was analysts proclaiming what the stock would do, not analyzing what the businesses said they would do."

This was especially true if analysts said it on television. One of the differences in this stock market frenzy was the success of cable business channels.

The shows on these channels needed guests, so the analysts became TV stars. Many appear on CNBC's Squawk Box, hosted by Mark Haines.

"A stock would be recommended by the guest sitting next to me," recalls Haines. "And I'd look down at the quote machine and all of a sudden it had jumped five bucks or ten bucks or whatever."

This was because thousands of people, new to investing, were watching the analysts with no idea that a conflict of interest might exist on the stocks they werrecommending. CNBC now requires guests to reveal conflicts of interest before they appear.

"One of our problems is when CNBC started 10 years ago it had a relatively small audience that was almost entirely professional. There was no need to point out these relationships because our viewers knew about them," says Haines.

"The pros knew. As time went by, the so-called democratization of the market occurred, and as the audience broadened, more and more and more people were coming to this not knowing the rules.

One of the rules that many analysts live by is never say "sell," because that would drive down the price of the stock. At the time we first reported this story there were about 8,000 analyst stock recommendations before the public. Only 29 of those 8,000 were sell recommendations, less than one half of one percent.

"You rarely see sell," says Buyer. "It angers management, it doesn't help institutional investing clients and it makes a lot of people very hostile at you. So what you say is 'We're downgrading this to a hold and believe it pis romising for those with a three to five year investment horizon.' Which for those in the know means- 'see ya.'"

Not even a company's imminent collapse could force analysts to say sell. Take Pets.com. About a third of the company's financing was raised by Merrill Lynch, which made millions. Henry Blodget , by then Merrill's analyst, made a buy recommendation at $16. When it fell to $7, Blodget said "buy" again. It was a "buy" at $2 and again at $1.69. When it hit $1.43 Blodgett told investors to "accumulate," whatever that means. Pets is now a dog, literally kicked off the stock exchange.

"We had an analyst downgrade a stock the other day that's at 50 cents," says Haines. "Well, if it's already down to 50 cents, what's the point of selling it? You've already lost all your money. You might as well hang on. Maybe it'll come back a little."

Investors may have lost a fortune, but last year Blodget and Meeker were reportedly paid about $15 million each. Both analysts declined requests for interviews. Merrill Lynch, Blodget's firm, sent us an email saying its analysts "make independent recommendations based upon their best judgments." Mary Meeker, at Morgan Stanley, sent us a statement saying in part, "We maintain a strict separation of the (investment) banking and research functions within the firm. Our research is objective and has a long-term focus."

Buyer defends most of her colleagues. "I do not think 99 percent of the analysts out there have ever intentionally misled anyone," she says.

Haines says investors ignored warnings, even when there were clear indications a company was vulnerable: "We would invite the CEOs and we would interview them and we would say do you have any patents? And they would say no. Well, would it be hard for me to go into business to compete with you? And they'd say no."

"(We would ask) 'Do you have any cash?' No. And I'd look down ad the stock would be up $40. It didn't make any difference to people. You would point out the risks, you would point out how crazy it was. There was a mania going on out there where people were just throwing money. And you would grab them by the lapels and shake them and point out the risks and it didn't make any difference."

Haines says investors didn't listen when he pointed out analysts' conflicts of interest on the air. "It was put in their face and they pulled the lever on the slot machine anyway," he says.

Last year, Brown started his own investment company. He decided to leave the analyst game all together because he says there's too much pressure to be dishonest. DLJ offered Brown the usual severance deal when it fired him. But he refused, because it required him to keep quiet.

"I have no regrets. DLJ offered me $400,000 to not say anything," he says. "I decided in August of '98 that it was worth more for my pride to be able to shout it from the mountaintop that something was wrong and tell them to keep the $400,000."

Since 60 Minutes II broadcast this report, the securities industry said it would regulate itself with voluntary guidelines, including better disclosure of potential conflicts. But Congress is not sure that's enough. A House subcommittee on financial services started hearings two weeks ago to consider whether the law should be changed to protect investors.

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