Confessions of a Wall Street Analyst (40 page)

It’s worth mentioning here that liking a stock and liking a company are not the same thing. There are very few stocks that are not worth buying at
some
price. Investing is a relative game, and smart investors look for mispriced or misunderstood stocks. Often, the most underpriced stocks are those of companies or managements that have stumbled. Qwest seemed to fit the bill: it looked as if it had been beaten up more because of Joe’s big mouth and some insignificant accounting issues than for fundamental business reasons. I felt that this would correct itself over time, as long as Qwest continued to grow its revenues and operating cash flows as it had for the last few quarters.

Although the fiber glut was becoming more and more apparent, Qwest had something the Level 3s of the world didn’t—a true blue, nuts-and-bolts local phone company in the form of US West. To me, a longtime fan of the Baby Bell stocks, this was a huge plus and a substantial hedge against the long distance market. So rather than downgrade the stock, I decided to hold firm. I reiterated my Strong Buy, or “1,” rating and countered the Morgan Stanley arguments in a conference call that I hosted for buy-side clients. It would prove to be a horrible decision.

The Analyst Plays the Villain

Life as an analyst had always been busy, but suddenly our job seemed a lot more like that of Bill Murray in
Groundhog Day
than anything else: hear bad news, absorb it, lower estimates or ratings, try to quickly interpret it for clients, wash, rinse, repeat. Gone were the deals and the road shows plugging IPOs for the most part, since falling stocks meant most companies had a terrible time raising capital. This meant a lot more time for research and a lot less traveling. It was the one benefit of the downturn.

Yet just when I should have been using my extra time to really dig into
the numbers behind all the companies I covered, I simply slowed down. I don’t know if I was burned-out or depressed or preoccupied by the carnage around me, but I didn’t go the extra yard that might have helped me uncover the numerous frauds. The timing was perfect. I had a great staff with the skills and brains to do it, and a lighter schedule. I should have focused more on the IRU business, which might have led me to uncover the growing number of swaps that were being used to boost revenue numbers. I didn’t.

As the market continued to tank, the press, formerly fawning lapdogs, turned into attack dogs. And what these dogs dug up put everyone in my world on the defensive. The media’s story line went like this: every little guy got ripped off, while every big executive or Wall Street insider walked away, pockets bulging with ill-gotten gains. But it was not quite as simple as that. Greed is a very democratic emotion. There were some little guys who picked up their chips and walked away at the right time, just as there were others who bet everything on the pass line and came up craps. There were big shots who truly believed that their companies were changing the world, and others who used their insider connections and information to take advantage of a bubble.

No longer big swinging dicks, geniuses, or industry power brokers, suddenly everyone on Wall Street bore the scent of scandal. The biggest fingers pointed at analysts, who had been lionized as “power brokers” on the way up and now were being made into buffoons on the way down. The guru days were clearly over. What had become celebrity was beginning to become notoriety, and even those of us who had tried to stay on the straight and narrow were beginning to be looked at with scorn. We were crooks, manipulators, swindlers, or—best case—incompetents who never saw it coming.

In some kind of weird karmic boomerang, the biggest winners in the bubble economy quickly became the biggest losers. First to fall had been the Internet analysts, the most famous of whom were Henry Blodget of Merrill Lynch and Mary Meeker of Morgan Stanley. In March of 2001, Henry Blodget’s role as analyst-cum-banker was highlighted in a series of articles in
The Wall Street Journal,
and subsequently an investor brought a suit against him, claiming Blodget had recommended stocks that he thought were dogs. Merrill would settle the suit a few months later for $400,000, unleashing a tidal wave of similar lawsuits. In May 2001,
Fortune
ran a cover story, “Can We Ever Trust Wall Street Again?” featuring a very unflattering, sinister-looking picture of Mary Meeker.
⁷
I didn’t know either of them very well. But I thought the accusations were still far from hitting the bull’s-eye. After all,
Merrill hadn’t really been all that successful in the technology banking sphere, and neither of these analysts seemed to have used their insider information and connections to vault themselves to power the way many thought Grubman had.

But Jack quickly became the third Musketeer in this very public hanging. WorldCom’s continuing disappointments weren’t helping, nor were the seemingly monthly death knells of the startup carriers he’d recommended for so long. Most frustrating for many investors was Jack’s refusal to admit he’d been wrong. The anger went beyond the press to his own clients and brokers, who suddenly chomped on the hand that had fed them. If he had such great inside connections to these companies, they wanted to know, how could he not have known that they were in trouble? I was sure that finally, Jack’s dealings were on the verge of being exposed, and I looked forward to that moment.

Suddenly, the regulators and the politicians woke up from their decade-long hibernation with hearty appetites. The damage was already done, but that didn’t stop anyone from sounding as if they’d suddenly discovered that the earth did, in fact, revolve around the sun. Led by Louisiana Republican Richard Baker, the House of Representatives announced it would hold hearings on the topic of conflicted research. Arthur Levitt, the chairman of the SEC, had resigned in early 2001. His temporary replacement, acting Chairwoman Laura Unger, announced in June an investigation into conflicts of interest on Wall Street, focusing particularly on analysts’ own holdings of stocks they may have recommended. At the end of June, the SEC finally issued an alert to investors identifying what it called “key issues that could compromise the objectivity of the research.”
⁸
There were also rumors that the New York State attorney general, Eliot Spitzer, was launching his own investigation into conflicted research.

In the meantime, the finger-pointing was beginning to affect senior executives at the banks as well. One of the first to take the fall was Allen Wheat, the CEO of CSFB. In December of 2000,
The Wall Street Journal
had reported that the SEC and the U.S. Attorney’s Office in Manhattan were investigating the way in which investment banks were doling out IPO shares. The allegations were that CSFB, and possibly other banks, were involved in a kind of kickback scheme, in which some institutions and hedge funds would receive large allocations of shares in hot technology IPOs if they agreed to pay higher-than-normal commissions.

I had heard nothing about the investigation and knew only what I’d read
in the papers, but CSFB had opened its own probe into the events—centering on Frank Quattrone’s institutional sales group—and by June, three brokers from Quattrone’s San Francisco office had been fired. A few weeks later, on July 12, 2001, in a weekend coup, Wheat was unceremoniously canned by his Credit Suisse bosses in Zurich. His replacement was none other than “Mack the Knife,” John Mack.

John had resigned from Morgan Stanley earlier in 2001 after Morgan Stanley merged with Dean Witter and he lost the battle with Phil Purcell for the top job. The intracompany battle would keep raging for many years after Mack left, and would culminate in a virtual civil war between Dean Witter and Morgan Stanley factions that led to Purcell’s resignation and Mack’s reinstatement in 2005.

With Mack’s reputation for cutting costs, it was clear that there would be many changes and probably a lot of layoffs. Many expected Mack to reduce the power of Frank Quattrone’s technology group. Poor Wheat, I thought. What a naïve guy. He had delegated too much and paid the price. But I was happy to see John Mack again. It had been six years since he tried to entice me back to Morgan Stanley. I hoped he’d clean up the place fast and work to get the regulators off the firm’s back.

But the first thing John Mack did gave all of us in research a little bit of pause. Right around the time that he took over, Mark Kastan downgraded McLeodUSA, a startup local carrier that was buckling under the weight of the enormous debt it had taken on. Mark didn’t tell the CSFB bankers or anyone at McLeod before doing so, of course. It turned out that the top guys at Forstmann Little, a giant buyout firm that had invested $600 million in McLeod, were furious about not being alerted and complained to John Mack.

So within weeks of getting there, Mack’s research department promulgated a new and very scary rule: all analysts had to give advance notice to both the relevant banker and the company when they were planning a downgrade. I supposed the idea was to give the banker a chance to call the CEO and soften the blow, but Mack’s rule put even more fear into the hearts of CSFB’s analysts. It seemed to give the bankers and company management yet another opportunity to pressure us either by giving the banker and company one last chance to argue with the analyst or by discouraging downgrades altogether. I found Mack’s move particularly strange at a time when the SEC and Congress were finally bringing the symbiosis between bankers and analysts under the microscope.

Changes were underway at other banks as well, but in the other direction. On July 10, Merrill prohibited its analysts from owning or buying shares in companies they cover. The previous month, it had started disclosing on the front page of its research reports whether the firm had or might have investment banking relationships with the companies its analysts were covering. (The former had always been disclosed in fine print at the end of its reports; the latter was a new disclosure.)

I figured this move couldn’t hurt, but it didn’t address the crux of the research-banking conflict, which in my view was that some analysts were writing opinions they didn’t believe, and some were using over-the-Wall information improperly. I had always avoided trading in stocks that I covered anyway, because I knew that occasionally I would go over the Wall and receive nonpublic information. What if, a day before an acquisition was announced, I unwittingly bought shares of the acquiree? It would look as if I was profiting from advance knowledge.

Jack, the All-Knowing

You would think that by this time Jack might have toned it down a bit. But just like the feisty boxer he claimed to be, when pushed into a corner Jack didn’t cover up but instead came out swinging even harder, trying to remind people that he still ruled the roost and knew more about what was going on than anyone else. He loudly and frequently repeated his bullish views on his long list of favorite stocks, as if they were neglected children who needed his unconditional love in order to grow. Earlier that year, he had come out with a report he titled “Grubman’s State of the Union: Does He Ever Stop Talking?,” a massive tome on the telecom industry whose title might have seemed merely arrogant in his glory days but now sounded completely detached from reality.

In Jack’s conference call to discuss the report, held on March 15, 2001, he had first made sure to point out that there were over 500 people listening in. “Over the next 12 to 18 months,” Jack concluded, “which seems like an eternity…you will probably look back on some of the prices today and say gee, I wish I had loaded up…[on startup telecom stocks].” Jack was increasingly on the defensive, and since it was
I.I.
voting season, I didn’t mind a bit. I wasn’t looking too hot either, with my disastrous Strong Buy, or “1,” rating on Qwest and a Buy, or “2,” on Global Crossing, but I was getting ac
colades from clients for my cautious call on WorldCom and my long-held view that incumbent long-distance stocks were losers and the Baby Bells were winners. With the local startup collapse, the Bells were looking even better, since they would likely face less competition and lose less market share.

On July 24, about 30 cable and telecom sell-side analysts showed up at the Four Seasons Hotel in New York for a private dinner hosted by AT&T. About two weeks earlier, Comcast, the large Philadelphia-based cable television company, had made a $44.5 billion bid for the cable TV properties that AT&T had acquired with much fanfare over the previous few years, and we were there to hear more.

One very large conference table was set up for dinner. Each of us was assigned a seat next to a specific AT&T executive. I sat next to Mike Armstrong, AT&T’s CEO, while Jack sat across from us, next to Armstrong’s CFO, Chuck Noski. Although Armstrong had already said publicly that Comcast’s bid was too low, many investors and telecom specialists believed that it was a good offer and that AT&T was simply bluffing and would ultimately accept it. I remained restricted on AT&T shares because CSFB was the banker for its three-way split-up. So, unlike most of the analysts in the room, I couldn’t make predictions or issue an opinion.

After Armstrong and Noski had finished their prepared comments, it was time for Q&A, and Jack was one of the first to speak up. He brought up the Comcast bid. “You know, uh, frankly,” the eternal know-it-all blustered, “when I was talking with one of your board members the other day, it was clear you have no intention of accepting the current Comcast bid.”

The room hushed. We all swallowed whatever we had in our mouths (dessert, I think), and my jaw grew slack. Had someone slipped a mickey into my mousse? Had Jack Grubman just publicly declared that an AT&T board member, perhaps his boss, Citigroup’s CEO, Sandy Weill (that’s who immediately came to mind), was telling him what was going on inside AT&T’s board meetings?

“Did he really say that?” I whispered to the analyst next to me, shocked at Jack’s recklessness. “Amazing what that guy gets away with,” he responded.

AT&T’s board had already announced that it wasn’t interested in Comcast’s initial bid, so the information wasn’t officially insider information. But what Jack was doing—not in front of clients this time, but in front of competitors and executives, the oddest of all audiences, since this didn’t
help him win business or impress investors—was announcing that he was privy to what was supposed to be the most private forum a company could have. Jack was saying he knew something only the board could know—that it was not bluffing and that it had no intention of accepting that bid even if Comcast refused to up its offer. He was also insinuating that his source would tell him what was happening as the negotiations with Comcast—or any other bidder—unfolded.