After the stock market crashed in 1929, Congress hauled in Wall Street bosses to explain how bankers helped companies inflate earnings for a decade through complex structures. Congress scrutinized bank practices for years, then passed the Glass-Steagall Act, splitting commercial banks from brokerages. That checked the Street's temptation to monkey with clients' finances while flogging their stock.
Now Congress needs answers from Wall Street's chiefs again. Congress repealed Glass-Steagall in 1999, under pressure from bankers who swore they would manage such conflicts of interests. They would erect so-called Chinese Walls that forbade sharing information between those selling a company's stock and those arranging its financing.
But the Chinese walls are porous. Bankers ignore them when it's convenient: They take analysts on roadshows of investment-banking clients--their way of making it clear they don't want downgrades of those companies. The walls also provide cover for bankers, who let analysts push a client's stock even when they know the company is in trouble. That's why analysts recommended Enron to the end, though the bankers behind its complex financing knew it was on the skids.
Congress has made a show of resolve. In late March, the House Financial Services Committee is likely to grill top execs about conflicts of interest between analysts and bankers. The House Energy & Commerce Committee wrote to the heads of 10 investment banks demanding records on Enron by Mar. 20. Unlike the usual discreet inquiries, these letters are on the committee's Web site for the world to see.
Wall Street isn't sweating yet. Investment banks, a powerful lobbying force, expect to deflect this unwanted attention with reams of paper and testimony from lesser execs. And the Energy & Commerce Committee chairman, W.J. "Billy" Tauzin (R-La.), remains undecided on whether bank heads should testify.
So far, hearings have focused on Enron's management and its accountants. But the role of some of its investment bankers has been largely unexplored. Congress has to talk with top brass to get the complete picture. The bankers need to explain why they link analysts' pay to deals and invest in clients' off-balance sheet partnerships just to win future business.
Lower ranking bank officials won't be much help. Consider research analysts' testimony in February. True to form, they blamed their flawed "buy" recommendations on Enron's financial statements and pleaded ignorance to their employers' other ties to the company--those famous Chinese Walls again.
The analysts' lame defense highlights one thing that hasn't changed much since the 1930s: The securities industry's abysmal record of self-regulation. Over the past nine months, the industry has proposed a series of basic reforms such as stopping analysts from owning stocks in the companies they cover. Yet investors remain skeptical. A March survey of 300 investors by online market research firm InsightExpress LLC shows that roughly one in four trust their own judgment over any financial guidance. With good reason: Only 1.8% of analysts' recommendations are "sell" or "strong sell." Why? Mainly because they don't dare anger investment banking clients.
Lawmakers have a golden opportunity to show they're not in the pocket of big political donors. Securities and investment firms gave $91.7 million to candidates and parties in 2000, making them the third-highest givers after law firms and retired individuals, says the Center for Responsive Politics in Washington. Tauzin, among others, backed the 1995 Private Securities Litigation Reform Act, which shields companies and investment banks from lawsuits.
This is the moment to fix the damage. Don't just force banks to yank buy recommendations when they know better. Make them at least disclose the sweetheart deals behind investments in off-balance sheet partnerships. If that means legislating compliance, so be it.
"If they don't pass legislation after [Enron], there's no chance they'll ever pass legislation," says Charles R. Geisst, professor of finance at Manhattan College. Congress hauled in tobacco and auto executives on grave public issues. Why should the Masters of the Universe be any different?
By Emily Thornton
With Amy Borrus in Washington