Investment Banking: How Asset Management can Cause Conflicts - dummies

Investment Banking: How Asset Management can Cause Conflicts

By Matt Krantz, Robert R. Johnson

The lifeblood of investment banking is information. Managing who has that information, how that information is disseminated, and who can act upon that information is central to mitigating the conflicts of interest created from having an investment banking operation that serves so many masters. The following represents a sampling of the conflicts that exist in investment banking firms.

Let’s put lipstick on this pig

One of the biggest potential areas of conflict involves investment banking firms that both provide investment banking services to a corporate client and have analysts producing research reports with buy or sell recommendations on that same stock. The potential conflict is obvious.

Investment banks could offer favorable research coverage and in return expect the company’s investment banking business. Companies, on the other hand, could penalize investment banks who have unfavorable research opinions by going to other firms for their investment banking business.

One famous episode in Wall Street history that allegedly stepped over the line of conflict of interest involved the dot-com bubble in the late 1990s and early 2000s. Jack Grubman was a rock-star telecommunications analyst at Salomon Smith Barney who reportedly earned in excess of $25 million one year by issuing favorable opinions on firms and fueling the speculation in the markets that led to the bursting of the bubble.

The problem was that his recommendations were fraught with conflicts and appear to be based upon more than simply the firms’ investment prospects. One conflict was that Grubman was both making buy recommendations to investors and allegedly providing investment banking advice to those same firms.

These firms included some of the spectacular failures of the dot-com boom such as Global Crossing, WorldCom, and Qwest. In another instance, in some e-mails, Grubman admitted that he changed his hold recommendation on AT&T to a buy recommendation in order to get his kids into a highly competitive New York City preschool.

Blodget found himself in a similar bind with regulators. In 2003, the SEC charged Blodget with civil securities fraud for allegedly publishing misleading research reports while at Merrill Lynch. Blodget found himself banned from the securities industry and agreed to a fine of more than $2 million.

Mom likes me best

Investment banks often serve somewhat of a parental role for corporations. They don’t want to appear to favor one client over another, just as parents try to treat all children equally. Investment banks often broker deals between companies and between clients.

In one of the most infamous cases from the financial crisis, some pundits alleged that hedge-fund titan John Paulson’s bet that the housing market would crash was arranged by investment banks that specifically created packages of mortgage-backed securities at the behest of Paulson.

These securities were sold to clients of the investment banks so Paulson could wager against them. By the way, this seemingly clever strategy backfired on the investment banks because they ended up not being able to sell all the mortgage-backed securities. The result? When the real estate market tanked, the investment banks were left holding big losses.

The bottom line here is that it appears to be a major conflict of interest to create securities designed to make one client fabulously wealthy, while at the same time, lining up buyers for that same security. Can someone truly serve two masters?

Say it isn’t so?

Investment banks manage money for client accounts, execute trades on behalf of clients, and trade using the firm’s own capital — a practice known as proprietary trading. Information on order flow — the buy and sell orders in the pipeline both from firm clients and from funds managed by the investment bank on behalf of others — is extremely valuable information for anyone in the markets to have.

For instance, if you know that there are a large number of shares of a certain stock to be liquidated for a major client, you have a pretty good idea that the stock is likely to go down in value. Likewise, if you know that a firm is a takeover target through your investment banking analysts, you know that the stock price will likely advance when that information goes public.

There is a temptation for investment bankers to take such privileged information about what clients are doing and trade on their own behalf prior to conducting trades on behalf of their clients. This is a practice known as front running, and it’s both illegal and unethical.