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In Defense of Goldman's Research Practices


The best clients get the best access. What's so unusual about that?

Question: What's a Wall Street research scandal without Eliot Spitzer, Henry Blodget, or Jack Grubman?

Answer: Not much.

The Wall Street Journal published a 2,242-word, front page article today describing what it deems questionable practices by Goldman Sachs' (GS) research and trading departments. Evidently the bank holds weekly meetings where its research analysts share trading ideas that are then passed on only to its biggest trading clients. The tips usually involve expectations for short-term swings in stocks they cover, and they sometimes differ from what the official ratings on the stocks reflect. The information is typically shared with about 50 "favored clients" of the bank, including Citadel Investment Group and SAC Capital Advisors. Smaller Goldman clients are unhappy with this.

There are many reasons why this is not grounds for a government investigation, a multimillion dollar settlement, or sweeping regulation like we saw earlier this decade. Like it or not, this is simply another example of how the world works.

First, these analysts are (hopefully) not providing insider information during these huddles. If an analyst thinks a stock might move up before its earnings announcement, as the one example in the Journal story illustrated, why shouldn't the firm's biggest clients know that? It doesn't make it true. Like a lot of predictions that come out of Wall Street research departments, it's a hunch. No one knows that better than the traders at places like SAC Capital and Citadel.

Research analysts have been marginalized since the banks were forced to impose a Chinese Wall between research and banking after the Spitzer settlement. Their pay was cut, and many of the more seasoned analysts left the Street for more lucrative jobs. During the financial crisis, research departments have experienced even deeper cuts.

Meanwhile, institutional investors, like SAC and Citadel, have come to depend more on internal analysis or research provided by independent shops that cater specifically to them. They rightfully take Wall Street analysts' words with a grain of salt. How easy was it to criticize Wall Street researchers for mostly missing the boat on the severity of the damage from the credit crisis and recession? Too easy! Who believes that the buy, hold, and still much rarer sell ratings are in any way meaningful? No one! So why all of a sudden is it unfair that they aren't sharing their every thought with every single client? Why does it suddenly matter what they think might happen with the stocks they cover?

Second, research only exists at Wall Street firms at all because the largest trading clients pay for it. Research isn't a revenue generating business for banks. It exists only because the firm can pay for it from the more lucrative parts of the business, like trading.

In return for the huge fees they pay, the banks' best clients should receive the best access. In what business or industry do the best clients not receive special treatment? Why should this be regarded in a different way? The Journal points out that Morgan Stanley (MS) has similar meetings and it disseminates the information to its entire client base at the same time. Big trading clients at Morgan should not be happy about this.

It bears reminding again here that this is not insider information that's being shared. It's not illegal. The firm's compliance officer sits in on the meetings, and the information is expected to convey developments that could potentially move the stocks that week. If an analyst has a change in rating or an earnings forecast, he or she still must disclose that to all clients at the same time.

In the example in the Journal story, Goldman's analyst upgraded shares of Janus Capital (JNS) in April 2008 just a few days after giving clients the tip that its shares could rise before its earnings announcement. The shares did rise 3 percent one day, and then erased those gains the next. Did SAC and others easily pocket that 3 percent or was it just that the analyst's hunch right and investors broadly bid it up ahead of earnings? We may never know.

In his published upgrade report, the analyst recommended investors buy the stock because he expected equity flows to increase during the second half of the year. Janus shares traded at $25.77 that day. A year later they were trading at $6.47. Some influence.
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