Confessions of a Wall Street Analyst (7 page)

It was a rare period in Wall Street history. People were on their best behavior, in part because of the spate of insider-trading cases that had rocked the world just a few years earlier. Ivan Boesky had recently been convicted of insider trading, using inside information to profit on deals that hadn’t yet been announced. That inside information had been leaked to Boesky by some investment bankers. In this context, few people wanted to push the envelope. And the market was puttering along as well. The operative word of the day was
steady.
And steady was a concept I felt very comfortable with.

Although the mere mention of insider trading was enough to strike fear
into any Wall Streeter’s heart at the time, no one got too up in arms over the interaction between research analysts employed by investment banks and the banking business itself. In part, that was because analysts exist thanks to the banking business; they don’t generate enough profit to support themselves. In effect, analysts are loss leaders for banks. Their work is funded by the fees brought in by bankers and the commissions brought in by salespeople and brokers.

That’s why there were and are strict rules governing the interaction between the two. At Morgan Stanley, a written policy given to me upon my arrival at the firm officially and emphatically declared the independence of the research division from pressures by the investment bankers.

“Morgan Stanley’s research is totally separate from the investment banking of [
sic
] and merger and acquisition activities of the Firm,” it read. “Rigid rules ensure the separation of association and information. A basic tenet of our philosophy is that research must have integrity and therefore requires absolute and impartial freedom of judgment.”
²

In practice, however, it was slowly becoming a different story. Although I had not experienced any overt pressures, some sordid stuff was beginning to swirl around the firm.

One of these was the Clay Rohrbach memo. Clayton J. Rohrbach, III, was the head of stock capital markets, in other words, a big-shot banker. The way I remember the story of Clay’s memo, a young guy named Sandy Cohen was Morgan Stanley’s utility analyst at the time. Like me, Sandy had been mentored by Ed Greenberg and had developed a habit of speaking his mind, even if it angered the companies he covered. He had developed a special methodology for rating his companies, a very technical one that spit a lot of components into a formula and came out with an opinion.

One of the criteria he plugged into his model was the quality of management. Some of the people who ran companies were true dolts, while others were real strategic thinkers. Anyway, Sandy ranked one of his utilities low in the management department, and Clay, as the keeper of the flame, or that “special relationship” with the company, apparently got an earful about it. From Clay’s perspective, research must have seemed like something of a waste of time. It didn’t make any money—and was, in part, paid for by the fees generated by bankers like him. So wasn’t it logical that an analyst, whose salary and bonus inevitably came from the money earned on deals, shouldn’t do anything that could jeopardize that deal flow? Ticked off by Sandy’s conclusions, Clay wrote a memo in September 1990 that shocked
all of us on the 20th floor, which was where Morgan Stanley’s research analysts worked.

“As we are all too aware,” it said, “there have been too many instances where our Research Analysts have been the source of negative comments about clients of the Firm…. Our objective is to have a zero failure rate on this subject and to adopt a policy, fully understood by the entire Firm, including the Research Department, that
we do not make negative or controversial comments about our clients as a matter of sound business practice.”
³

This, of course, was absurd. Did Clay think we should rave about every stock in the entire stock market, even if it was a dog? Although Clay’s memo was later portrayed as a one-off outburst, he clearly felt strongly about the issue. Earlier that year, Clay had written a draft memo proposing that research-analyst pay be determined partly by how much they had helped bankers win deals, with analysts getting an A, B, or C grade depending on how “instrumental” they were in the firm’s winning of a transaction.
⁴

What Clay was trying to do, in effect, was make the analysts earn their keep. He, and some others, were trying to change the analyst’s job from giving good advice to investors to helping bankers do deals. For me, it was the first example of the crossing of that supposedly sacred line between banking and research.

What Clay was experiencing was the end of the genteel old world of banking, in which belonging to the same country club and living in the same town was as much of a draw for a corporate executive choosing a banker as the actual services the bank was offering. As banking became more competitive, these relationships weren’t enough anymore. Banks needed to offer something extra, some special sauce. As time went on, that special sauce would often involve bullish research.

I guess I was lucky, both because I had an old-school banker in Bob Murray, who didn’t interfere with my opinions, and because the telecom sector did virtually no deals at that point, so there was no reason to meddle and no way to assess my level of “cooperation.” At the same time that my colleagues were murmuring that they were starting to get heat for their opinions, I had a Sell rating on one stock, Ameritech, and Holds on most of the Baby Bells, and never heard a peep about it from anyone.

In any event, someone eventually leaked Clay’s memo to
The Wall Street Journal,
which ran a front-page story on the shenanigans in July of 1992. It was a huge embarrassment for Morgan Stanley—the most highbrow firm now essentially being caught red-handed trying to influence research. As far
as I know, Clay was never disciplined. He went on to have a long career as a senior banker at several major houses. The whole episode is a reminder that the scandals of the late 1990s, as shocking as they were, had plenty of precedent and plenty of warning.

I heard these things but reacted to them a little bit like an ostrich. No one was bothering me, so it didn’t seem like something to get worked up about. In my world, Morgan Stanley seemed pure. I didn’t see anyone daring to put the squeeze on Ed, my mentor. He managed to have strong opinions—positive and negative—without being pressured by anyone, not bankers, not management. As his protégé, I felt insulated and protected.

By now, Ed had initiated coverage of the cellular, or mobile, phone industry with negative views. He predicted much lower prices resulting from increased competition, as the federal government was awarding many new licenses. He assigned Sell ratings to five of the seven cellular companies he covered and Hold to the remaining two. Several of the companies were even Morgan Stanley investment-banking clients. Yet no one seemed to raise an eyebrow. Ed’s Sell ratings made sense in the context both of his detailed analysis and of the overall stock market. Indeed, the major stock market indices had been trading sluggishly for quite a while and there was nothing to suggest that was going to change anytime soon.

Ed’s report was outstanding, perhaps the best I had ever seen. It was deep in its analysis, thorough in its consideration of the numerous variables that would drive the future of the cellular industry, and prescient in its prediction that the federal government would allow many more competitors.

Yet contrary to Ed’s predictions, several of the cellular stocks took off, driven by a massive consolidation wave throughout the industry. Several large companies, including AT&T and the Baby Bells, went on acquisition binges, paying hefty prices for the stocks Ed disparaged in order to fill in geographic holes in their cellular coverage. And technological improvements and lower prices meant customers began to use cell phones more than anyone could have imagined.

More significant than all of these factors, however, was the suddenly turbocharged bull market. In the 12 months after Ed’s bearish report, the Dow Industrials rose 17 percent and the NASDAQ index, where most of the cell phone stocks traded, rose over 20 percent. Once that bull began to rage, bearish calls like Ed’s were ruthlessly stampeded: within four years of his call, for example, the Dow had risen almost 50 percent and the NASDAQ by 67 percent. Ed was lucky. He was a top-rated analyst, had a stellar reputa
tion, and was about to move to banking anyway. Many other bears, however, found themselves overrun by the roaring bull market of the 1990s, and were never heard from again.

There were two very simple lessons to be learned from Ed’s experience with the cellular stocks. The first was to never get on the wrong side of a major bull or, for that matter, a major bear market. Either one can flatten you, no matter how astute your insights and sophisticated your analysis.

The second lesson was that Sell ratings offer little payoff to a Wall Street analyst. This is because, for the most part, institutional investors are paid to pick stocks that go up. They need to outperform the overall stock market by enough to compensate for the risks, fees, and trading costs they incur. As a result, stocks that perform in line with the market are of no interest to these money managers.

If a stock falls or performs in line with the market, the Wall Street analyst who rated that stock Hold or Neutral looks almost as good to his clients as the one who rated it Sell. As a result, analysts didn’t have much incentive to go out on a limb with a much riskier Sell rating, even before the banking pressures emerged.

At that time, I didn’t fully understand any of this. And I soon learned that Ed had been protecting me from other matters as well. One morning in October of 1991, I was toiling away on a very long report on a local phone company called Centel. I had spent about two months working feverishly on it, and was just about finished, when I looked up at my computer screen to see a news flash: “Centel Board to Put Company up for Sale.” Even more surprising to me was the fact that the board had hired none other than Morgan Stanley to be the banker in charge of this auction. How could I not have known?

Ed walked in that morning and said, “I have to apologize to you, Dan. But I couldn’t tell you.” It turned out that Ed had known all about the pending announcement for weeks and had been asked to give his opinion to the bankers on whether Centel should sell itself to a larger company or go it alone. Ed’s expertise and knowledge of the industry was eagerly sought by Morgan Stanley bankers and telecom executives. Because he had been brought “over the Wall” to the banking side, he said, using a cryptic—and compelling—term I had never heard before, he couldn’t tell anyone, not even me, without possibly running afoul of insider-trading rules. If he told his wife, his colleague, or his plumber, he’d be improperly sharing proprietary inside information with other people.

The wall that Ed was referring to going “over” was something commonly known on the Street as the Chinese Wall. Meant to be as big and impenetrable as the Great Wall of China, the Wall was a metaphor for keeping information about pending deals or transactions in the hands of the bankers who helped put those deals together. If that information leaked out to the rest of an investment bank—anyone from traders to research analysts to even the cafeteria workers—someone could use that information to buy or sell the stocks involved, making an unfair and illegal profit. This was what Ivan Boesky and bankers from Drexel Burnham Lambert and Kidder Peabody had been convicted of just a few years before. I knew all about the Chinese Wall, of course, but I had had no idea until that moment that there were exceptions to this rule for analysts. Apparently bankers didn’t have all the answers when it came to deals. In some cases, analysts could provide some added perspective that might never have occurred to the bankers and company executives.

My first reaction was frustration. I had just spent two months learning everything there was to know about Centel, and my own bank couldn’t even tell me it was being sold. This deal also meant that I’d now be “restricted” from publishing my report while Morgan Stanley’s bankers handled the auction, which could take several months. And if the bankers did manage to sell the company, the report would become irrelevant anyhow, so I’d essentially wasted two months of my life.

But Ed had done the right thing by keeping quiet, I soon realized. This was the way the game was played, and if I lost a few weeks but managed to avoid the temptation of insider information, well, that was just fine by me. At the same time, the more I thought about this over-the-Wall stuff, the more intrigued I became. I was fascinated—and wondered if my views would ever be respected enough to be asked to come over the Wall one day.

1992–1993

Most people would have seen a 30 percent increase in pay as a pretty fantastic raise. I would have, too, if I hadn’t had that sizzling offer burning a hole in my pants pocket. I had no intention of staying at this point, but this game had rules and I had to play it out.

Climbing Over the Wall

T
HIS MYSTERIOUS CONCEPT
of going over the Wall quickly receded into the back of my mind. But one day in November 1992, it suddenly reappeared. Ed strode into my office, closed the door, and said “Get up. We’re going upstairs to a meeting of the Corporate Finance Executive Committee in the Morgan Stanley boardroom. There’s a deal that Jeff [Williams, Morgan Stanley’s head of telecom banking] and Paul [Taubman, its head of telecom and media mergers and acquisitions] want us to react to.”

I exhaled with irritation. Yeah, this over-the-Wall stuff had sounded intriguing at the time, but now that intrigue had been buried under a pile of paperwork. I had almost a dozen phone calls left to return that afternoon and he wanted me to go to some banker meeting?

“Huh? How long will this take?” I griped. “Where the hell is the boardroom and what the hell am I going to do in there?”

“I’ll do most of the talking,” said Ed. “Just come with me.”

Still muttering, I hopped on the elevator and walked into the boardroom, where I felt an instant jolt of electricity. Someone handed me a three-page outline, and I quickly scanned it. AT&T was about to purchase a big
piece of McCaw Cellular, the country’s largest independent cell phone company. McCaw had received a lot of attention in recent months when it won a bidding war against BellSouth for Lin Broadcasting’s cellular assets. In my world, it was a seismic event, as if IBM bought a portion of Apple. No wonder these guys, some of the top bankers in the firm, looked as if they had ants crawling around inside their Brooks Brothers pants.

“Here’s the deal,” said one banker. “Tomorrow morning, AT&T is going to announce that it’s buying 33 percent of McCaw Cellular. AT&T is paying $42 a share for 47 million new shares of McCaw, a 57 percent premium over its trading price, and $49 per share for 38.5 million shares held by British Telecom. That makes the transaction worth about $3.7 billion. Ed and Dan, what do you think of this move?”

Whoa! Suddenly we were on the spot. Because Morgan Stanley had been AT&T’s lead banker for years and years and AT&T seemed to always have a deal pending, I had not been allowed to write reports on the company or rate its shares. According to federal securities regulations at the time, anything I wrote could be perceived as putting Morgan Stanley’s interests ahead of investors. That was because Morgan Stanley had a huge incentive to plug AT&T’s stock, since it received fees whenever a deal involving AT&T went through. Rating AT&T a Buy could be considered an attempt to convince shareholders to vote for the deal, which of course would benefit AT&T and, by extension, Morgan Stanley. So Morgan Stanley’s lawyers required Ed and me to stay mute.

This silence had become something of a problem for me, since not only was AT&T—the original blue-haired grandma stock—in the news virtually every day but its stock was held by just about every investor on the planet, and I wasn’t able to make a call or advise my clients on what to do with it. (The SEC would later choose to not enforce the rule requiring analysts to recuse themselves, facilitating a huge wave of banker-research conflicts of interest.) I didn’t feel particularly good about AT&T—influenced by my MCI days, I thought of the company as a huge, lumbering oaf that was going to lose its shirt to all of the new rivals out there—but I did intuitively like this deal. I wasn’t sure what to say.

Fortunately, Ed jumped in first. “I think it’s a brilliant deal,” he said. “McCaw is the largest independent cellular company in the U.S., cellular is a very rapidly growing business, and the ability to jointly provide long distance and cellular services ought to give AT&T an edge over MCI and Sprint [neither of which offered cellular].” Ed did point out that AT&T’s earnings
would drop as a result of the acquisition, which would probably cause the stock to fall a bit initially, but said that overall the impact on future growth would be very positive.

Then it was my turn. “Anything to add to that, Dan?”

“What strikes me,” I said, “is that AT&T is declaring war on the Baby Bells. It’s acquiring a technology that could be used someday to connect directly to customers, potentially displacing the Baby Bells’ copper wires.” I said I thought most large investors would think it was good news for AT&T and bad news for the Baby Bells.

That was all the bankers needed to hear. I wondered why Ed and I were there; would they have scrapped the deal if we’d thought it was a terrible idea? I doubt it, given the buckets of banking fees they would earn if the deal went through. But the bank had a committee that required all parts of the organization to be consulted. The guy running the meeting asked if anyone around the table had any questions or concerns about Morgan Stanley’s involvement in this transaction. Was there anything that the press, other investment bankers, or my clients, the institutional money managers, might criticize us for? Was there anything in the deal’s structure or valuation that might harm our venerable investment banking reputation? No one said anything, so the committee voted to approve the deal.

We all got up to leave. And I found myself in possession of information that was going to make and lose many people billions of dollars in less than 24 hours. Owners of AT&T shares would likely lose a bit, as would owners of Baby Bell shares. Investors in other cellular companies would benefit, since the possibility rose of takeovers of other independent cellular companies. And obviously McCaw shares would surge when the news hit the next morning.

As I walked out of the room, I felt confused and a bit giddy. No one had told me why I’d been called over the Wall this time but not other times, or how I should handle the confidential information swirling around in my brain. None of the seemingly important managing directors in the room had said hello or introduced themselves. Although they had asked for our reaction, it wasn’t clear they had listened. We analysts still didn’t command a whole lot of respect.

So now here I was, with almost a dozen clients to call back and another hour of trading to go in the market. I felt like a newly minted secret agent who now had to return to my regular life. The telecom analyst at Fidelity had called earlier in the day. So had Tim Armour, the telecom analyst at Capital
Group, and several other well-connected buy-siders. I had to call them back. I had already learned that prompt responses to clients were a must if you wanted to get their votes on that survey of institutional investors. Yet now I was in possession of information that could make my clients—and myself—rich, if I used or shared any of it.

Even though no one told me what to do, I knew that I couldn’t breathe a word about the announcement. If I said anything, I’d be passing on insider information and perhaps violating federal criminal laws. Luckily, I didn’t cover AT&T, given its perpetual “restricted” status, and I didn’t cover McCaw either. So it was unlikely that clients would be asking me about either one. But I still had to call them back. What if, somehow, rumors of the deal started to build? I’d be hit with a barrage of calls from money managers and buy-side analysts, as it was no secret that Morgan Stanley had done banking for both firms. They’d ask what I thought of the amount AT&T might be paying and how the shares of each would respond. I had no idea how to respond to these kinds of queries. I’d lived through the insider trading scandals of the late 1980s and remembered how those ended: with those bankers in handcuffs paraded in front of a band of photographers jostling each other for the best shot. I instinctively knew that if anyone asked me about a deal involving AT&T or McCaw, I’d have to play dumb. I got lucky; no one did. But my job had suddenly gotten a lot more complicated.

“You’re the Only One.”

As the 1990s went on, the planets of the bankers and the analysts slowly began to orbit more closely around each other. While there had always been interactions, now the bankers, long the alpha dogs, were beginning to realize that research could wag its tail too. If used in the right way, those nerds in the back room might help them make big money.

My first strategy session with Morgan Stanley’s bankers happened long before my first over-the-Wall experience. Late in July of 1990, a group of bankers and analysts had gathered in Vermont for a few days of brainstorming at the bucolic Woodstock Inn. It was kind of funny to see all these hardass New Yorkers out of their element: most of them looked as if they’d hit the deck if a deer trotted out of the woods.

On the first day, we got together with the bankers who covered telecom. Ed and I sat on one side of the conference table, while the bankers, facing us
like opponents in a chess game, sat on the other. Among them were Jeff Williams and Paul Taubman, Morgan Stanley’s main telecom bankers. Also sitting across from us was a man who worked in Morgan Stanley’s San Francisco office and was responsible for relationships with technology companies. His name was Frank Quattrone.

The mood was congenial—no one was bellyaching over our investment ratings—but still, the bankers needed our help ginning up deals that made sense for their corporate clients. After all, they got paid a percentage of the total value of the deal. We discussed each telecom company.

“Any holes in BellSouth’s portfolio?” the banker responsible for BellSouth asked, hopefully. “Do they need to make an acquisition? Will they need to sell stock or to refinance any soon-maturing bonds?”

Ed and I did our best to answer all their queries. I saw nothing wrong with this—after all, many of these companies were certainly going to do deals as the sector consolidated—and we weren’t suggesting anything we didn’t tell our investor clients. We were there for just a day, and then left so the bankers could go back to their side of the Chinese Wall, discussing secret deals that were already in progress.

Shortly after the retreat, Morgan Stanley split up its telecom and technology banking departments, in large part because of Frank Quattrone. Frank, a dapper, low-key guy from Philly with a Tom Selleck mustache, had joined Morgan Stanley in 1977 and quickly built up a reputation as a banking stud. Among his early initial public offering (IPO) successes were Cisco Systems and Silicon Graphics Inc. One of the first to lock in on the growing number of small technology companies using the public market to raise money, Frank was well-respected at Morgan Stanley, largely because he was bringing in so much in the way of fees.

But he was aware, even then, of the benefit of a positive analyst report. According to
The Wall Street Journal,
after handling an IPO for a company called Mips Computer Systems Inc., Frank allegedly pushed an analyst, Rick Ruvkun, to put out a positive report on the company in 1990. Ruvkun wrote a report, but rated the stock Hold, not Buy, showing that there were limits to Frank’s clout.
¹
Frank denied the account in the
Journal.

In 1986, Frank moved to Silicon Valley to start Morgan Stanley’s California-based banking group devoted to technology. It was seen as a huge affront to Morgan Stanley telecom banker Jeff Williams, who believed he was in charge of both tech and telecom. But Frank was onto something. Where other people saw obscure technology and engineers who forgot to shower,
Frank saw possibilities. He was fast becoming one of the most powerful forces within Morgan Stanley and in Silicon Valley as well.

B
Y THE BEGINNING OF
1993, after three and a half years on the job, life at Morgan was finally becoming comfortable. Coming to the Street had absolutely been the right move for me. I felt more confident about my performance. I occasionally left my attic on the weekends, and I’d started to get some attention on the Street for my calls. I even found myself enjoying some of the social side of the business—not the schmoozing per se, but the discussions with my clients over the future of this new industry.

The period was a real turning point for telecom, a time in which everything was possible and no one company had the obvious edge. Everything was open to debate, and debate we did, hour after hour, trying to decide the investment implications of this new world. Telecom had seemed like something of a backwater at first, but it was gaining momentum, thanks to the regulatory reforms that were creating competition and the increasing popularity of cell phones. I was thankful that I wasn’t in some dead or dying sector like steel or chemicals.

One blustery day in early January, the phone in my office rang. My assistant put through the call, which I thought at first came from a client. “Dan, we hear you’re doing great work,” Les Carter barked. Carter ran recruiting firm Carter Stone, one of the many firms recruiting Wall Street analysts.

“I’m sure you’re happy at Morgan,” Les said, “but Merrill Lynch is really interested in you. You’re the only one.” Les invited me to breakfast, and I accepted, more out of curiosity than anything. I’m the
only one?
The guy knew how to make a man feel good. Even if it was a bald-faced lie, which it was, I liked what I heard.

I hadn’t been looking for a change, but the call came at a good time. I had been ranked as a runner-up in the
Institutional Investor
survey in October 1991, which meant I was in the second tier, below the top three analysts, and then moved up to third place in the most recent poll, which had been published in October 1992. Robert Morris of Goldman Sachs was number one in both of those years, as he had been for the past eight years, and Jack Grubman was number two in both surveys.

Normally, this would have meant a big bump in my pay, but 1990 had been a terrible year for the investment banking business, with lots of ana
lysts getting canned. I was cheap compared to the other analysts, so there wouldn’t have been much point in firing me even if I hadn’t made the
I.I.
list. Even so, in 1991, Morgan had doubled my compensation to $350,000, and my ego was getting healthier by the day. I wondered if it was time to break free from Ed.