Why is a pro-market, Republican congressman from the Bible Belt leading what some call the biggest government attack on Wall Street since the Milken era?
By Justin Schack
February 2002
Institutional Investor Magazine
Part of appreciating the creation that surrounds us is understanding the role of our solar system,” says Representative Richard Baker.
He’s bouncing along in a white Mazda sedan on a back road through the piney woods of Livingston, Louisiana, waxing philosophical. It’s the middle of an August afternoon, the air thick as gumbo, and Wall Street’s congressional overseer - home for summer recess - is speeding past tin-roofed shacks and grazing cattle. We’re off to check on a massive piece of pork that Baker delivered to his downstate district three years ago: the Laser Interferometer Gravitational Wave Observatory.
An amateur astronomer, Baker is as happy talking about black holes and gravitational waves as he is about high finance and politics. And the 2.5-mile sprawl of lasers, vacuum tubes and mirrors is something to behold. One of just two such facilities in the world, it aims to detect waves that scientists believe were emitted during the early expansion of the universe. Unimpressed, shotgun-toting locals have used the observatory’s massive exterior for target practice, prompting the scientists inside to line the walls with steel plates.
Representative Baker likes to think big. But many of his ideas have received a similarly disrespectful response. A career politician who came to Congress in 1987, Baker endured several years as a back bencher before becoming chairman of the old House Banking Committee’s subcommittee on capital markets when Republicans won the House in 1994. Since then he has marked himself as a free-market advocate with a fear of systemic failures, a crusading iconoclast with an appetite for headlines and a willingness to take on some of Washington’s sacred cows.
In particular, Baker has fought doggedly to reform government-sponsored mortgage lenders Fannie Mae and Freddie Mac, concerned that their ballooning balance sheets could necessitate a taxpayer-funded bailout if they ever falter. A sweeping reform bill sponsored by Baker failed despite support from Federal Reserve Board chairman Alan Greenspan, a friend who shares Baker’s concern about systemic risk. But the effort did yield some results, including the implementation of a rule requiring the lenders to boost capital reserves.
Now Baker is pointing an accusatory finger at Wall Street - in particular, at its securities analysts - charging in a series of highly publicized hearings that the analysts have touted lousy companies to enrich themselves and their firms. The war against terrorism pushed the issue to the back burner following September 11, but Baker is renewing the fight. His goal: to pressure regulators and industry executives to implement their own reform plan or face federal legislation. He has been emboldened by the need for public confidence in the markets amid uncertainty stemming from the terrorist attacks and the spectacular collapse of Houston energy trader Enron Corp., to which analysts continued to give high marks on the eve of its record $63 billion bankruptcy filing in December.
“The Enron matter has brought this into very sharp, clear focus,” says Baker. “If there was any political hesitancy for members of Congress not to be supportive of our direction on analyst reform, the difficulties with Enron have made it clear that they have to act. I see a window of opportunity to bring about some changes.”
Baker is tapping a rich vein of investor anger. Since riding America’s infatuation with the stock market to fame and fortune during the late 1990s, analysts have come to symbolize everything that went wrong with the market. Investors gripe that as Wall Street grew ever more reliant on fees from underwriting securities and arranging mergers for corporate clients, analysts ceased being independent arbiters of value and instead became little more than corporate cheerleaders. They also grouse about analysts who own shares of the companies they cover - in some cases, shares obtained at huge discounts before the companies went public and the analysts issued glowing reports (Institutional Investor, April 2001).
“I think the castigation of the analysts going on right now is probably a little overdone,” says legendary Windsor Fund manager John Neff, now retired. “But [reform is] long overdue.”
The very wariness with which powerful Wall Street executives speak of Baker is testimony to the power he wields, especially in the wake of the analyst and Enron scandals, to ram through legislation that would make their lives miserable. Says the director of research for a major securities firm: “We certainly have to take him seriously, because he has public opinion on his side, and he’s willing to press the issue. He wants results.”
The Securities and Exchange Commission and the New York State Attorney General’s office also have been investigating questionable research practices, including analyst share ownership and compensation, for several months. The SEC is moving forward with enforcement actions against certain analysts who it says sold stocks in their personal accounts while recommending them to investors. The agency is also probing how a host of Wall Street firms allocated shares of hot IPOs. In a settlement with the SEC, Credit Suisse First Boston agreed last month to pay $100 million and revamp its IPO allocation policies. A flurry of lawsuits have been filed on behalf of individual investors, alleging that prominent Wall Street analysts touted lousy stocks for their own or their firms’ benefit, resulting in huge losses for small investors. At least one - an individual’s claim against Merrill Lynch & Co. and former Internet analyst Henry Blodget - was settled by the firm.
It’s a good bet that few of those plaintiffs live in Louisiana, one of the poorest, least literate states in the union, according to U.S. Census Bureau figures. At $26,000, the median annual household income in Baker’s district is 13 percent lower than the national median. One in five of Baker’s constituents lives in poverty.
Why then is Baker, a professed supporter of free markets, a conservative Republican who consistently earns nearly perfect voting-record scores from such right-wing groups as the American Conservative Union, the National Rifle Association and the Christian Coalition of America, playing Torquemada in Congress’s inquisition of Wall Street? “I have a responsibility as chairman of the capital markets subcommittee to see to it that we rebuild confidence in our markets,” says Baker. “It serves no one’s interests if the average investor cannot trust the numbers they receive from corporations or the proclamations and projections of analysts.”
Nevertheless, Wall Street is unhappy. “We were told that he was going to have one hearing, issue a report and go on to something else,” says the head of government relations at one major securities firm. “Now these show trials are going to go on for months. We are mystified as to why he and the subcommittee - and the full committee - would launch the first orchestrated attack against Wall Street since the Milken days.”
Says another Street lobbyist: “This is a pivotal moment for Baker. He’s already alienated Fannie and Freddie. If he continues to attack the financial services industry, which has contributed quite a bit to his cause, then who’s next? And what’s the difference between him and a Democratic chairman?”
“I just believe, having watched him operate and having spoken to him and worked with him, that he cares about doing what’s right,” says former SEC chairman and lifelong Democrat Arthur Levitt Jr., who during his tenure often clashed with Baker on accounting issues. “Even though he’s supportive of the free market, he also has a populist streak.”
Baker plays assiduously to his home crowd. Unlike most legislators, he flies home every weekend while Congress is in session. Lobbyists say that he never goes on the junkets they sponsor at lush resorts to “discuss issues.” Even those working for Wall Street who are wary of Baker as something of a loose cannon praise his intellect and independence. “The guy’s like a choirboy compared to many of his peers,” says one.
Born in New OrleansN in 1948, Richard Hugh Baker Jr. inherited his fervor for upright conduct and fair play - not to mention his love of science - from his father, a geologist who became a Methodist preacher after serving as a naval aviator in World War II. Indeed, as a young man Baker thought about following his father into the Methodist clergy. But the younger Baker had a tougher time turning the other cheek: “I like to fight back too much,” he says.
Baker moved to Baton Rouge at age seven, when his father was transferred to a church there, and went on to earn a BA in political science from Louisiana State University. Within one year of graduating, he married his sweetheart, Kay Carpenter, started his own real estate brokerage and was awaiting the birth of the first of his two children.
Both Kay’s mother and paternal grandfather were political junkies. “They were real political activists, but in the very basic sense,” Baker recalls. “You know, have meetings at your house where about 75 people would come over for those awful little sandwiches and talk about issues and campaigns.” The 23-year-old Baker caught the eye of a faction of local Democrats who were looking for an up-and-comer to run in 1971 for a newly created state legislature seat in Baton Rouge. He polled high enough in a wide-open field of candidates to make the runoff, where he handily beat a local chiropractor.
From the beginning, Baker’s conservative, pro-market beliefs have been tempered by a prototypical Louisianan populist streak. Baker’s district includes the birthplace of the renowned Huey (Kingfish) Long. As governor, U.S. senator and presidential candidate during the Great Depression, Long, an avowed enemy of Wall Street and corporate interests, advocated a systematic transfer of wealth from rich to poor that would have guaranteed every family a net worth of at least $5,000.
Baker’s no Kingfish, but a bit of Long’s legacy lives on in every Louisiana politician. “It certainly doesn’t hurt him with his constituents to be fighting for Everyman against the big Wall Street fat cats,” says one longtime Louisiana politico.
As a Democratic state lawmaker during the 1970s and early ‘80s, Baker earned a reputation as a crusader against corruption and patronage. He championed a series of bills that standardized the process by which money was doled out for highway and other transportation projects. Representing a heavily unionized district, he strongly supported the rights of organized labor, voting against a right-to-work law in 1982.
But just three years later, Baker switched parties at the urging of Republican officials who saw him as their best hope to retain the seat of W. Henson Moore, who was leaving the House of Representatives to run for the Senate. Baker won the seat by a slim margin. There was more than political expediency involved in his decision to switch parties. He was one of several conservative Louisiana Democrats who defected after clashing mightily over the management of the state budget with then-governor Edwin Edwards (who was convicted in May 2000 of fixing the state’s riverboat casino licensing system to enrich himself and others but remains free on appeal). At the same time, the national GOP had begun a drive to convert conservative Democrats - both voters and officeholders - across the country. “Edwin Edwards was pushing me, and Ronald Reagan was asking me,” says Baker. “The combination of those two forces was undeniable.”
Baker came to Capitol Hill in 1987 with a strong interest in housing policy - Louisiana’s public housing projects are among the worst-run in the nation. But as a minority freshman he had no chance at a spot on the influential committee overseeing the issue. Among the assignments he settled for was a seat on the House Banking Committee. In 1994 Baker became chairman of the committee’s subcommittee on capital markets, where he championed a far more radical reform of the Glass-Steagall Act (which separated banking, securities and insurance activities) than the version that eventually passed in 2000. He also began his quixotic quest to rein in Fannie Mae and Freddie Mac. Both issues were extremely popular with banks and insurance companies, two groups that would play a large role in funding Baker’s reelection campaigns.
The congressman took plenty of lumps in the fight against the mortgage lenders, government-sponsored enterprises that have long been a political third rail because of their vast, bipartisan network of supporters on Capitol Hill. In February 2000, with the backing of Greenspan and then-Treasury secretary Lawrence Summers, Baker sponsored a bill that would have weakened the ties between the federal government and the GSEs, subjecting them to tighter regulation under the Fed. All three were concerned that the GSEs’ ties to the government allowed them to issue mountains of debt on very favorable terms - debt for which taxpayers could be liable if the enterprises failed. But the GSEs used their political muscle to protect their special status, and Baker’s bill died in the fall of 2000.
Still, Baker was able to press the agency that regulates Fannie Mae and Freddie Mac to impose in July a long-anticipated rule that will require them to boost capital reserves; this eases some of Baker’s concerns about the systemic risk posed by their huge debt loads. Baker has continued to push for GSE reform in subtler fashion, floating the idea of creating additional GSEs to compete with Fannie Mae and Freddie Mac.
Baker’s rising influence with the captains of finance nearly cost him his seat in 1998. Democrat Marjorie McKeithen, granddaughter of a former governor, mounted a formidable campaign depicting Baker as a tool of Wall Street. One of the television ads McKeithen ran during the race featured a picture of Baker’s head floating above the Manhattan skyline to the tune of “New York, New York” and carried the tag line, “Richard Baker: the best congressman the Wall Street bankers ever had.” The campaign oversimplified Baker’s record, but it resonated with the district’s populist voters. Baker beat McKeithen by fewer than 3,000 votes, or 1.4 percent. Immediately after the election the formerly media-shy Baker hired his first press secretary to make sure that the full scope of his activities in Congress would be better publicized back home. After a much more lightly contested reelection last November, Baker became chairman of the new House Financial Services Committee’s capital markets subcommittee, which oversees the securities business.
Baker Clearly didn’t expect the research issue to catch fire the way it has. Reports of his first hearing in June were carried not only by financial media such as The Wall Street Journal, CNBC and CNNfn but found their way onto doorsteps in communities across the nation, picked up by local papers like The Grand Rapids Press in Michigan and The Sun-Herald in Biloxi, Mississippi. “Frankly, I’m surprised about the level of interest given to this,” admits Baker.
He says that he will sponsor legislation to reform research only as a last resort, if the Street doesn’t take the proper steps on its own. Other lawmakers, however, are pushing for action. Representative John LaFalce, a New York Democrat, has publicly stated his belief that, short of new SEC rules, legislation is the only way to ensure that the industry cleans up its act. Even Republicans were angered by the findings of an initial SEC probe into analysts’ activities. Then-acting SEC chairwoman Laura Unger testified at Baker’s second hearing in July that nearly 30 percent of the analysts her agency surveyed had obtained pre-IPO shares of companies they covered and that a handful sold their shares while continuing to recommend the stocks. One even sold a company’s stock short despite rating it positively. “I said at the outset that I didn’t want to legislate on this matter,” said Representative Michael Castle, a Delaware Republican. “But I’m just not sure anymore.”
Whether it gets to that point depends in large part on Wall Street - and on its many friends inside the Capital Beltway. On June 12, just two days before Baker’s first hearing, the Securities Industry Association, Wall Street’s main trade group, released a set of “best practices” for research that attempt to mitigate the various conflicts analysts face. Among the recommendations, which carry a disclaimer that in essence suggests that member firms are free to ignore them without fearing enforcement action: Research should not report to investment banking; ratings should be transparent and easily understandable; analyst pay shouldn’t be linked to deals; companies should not be allowed to vet research before it is published.
Too little, too late, says Baker. “The timing was a little questionable, and these recommendations just basically made public prevailing market practices,” he notes.
The SIA sees things differently. “I take issue with that characterization of our best practices,” says SIA president Marc Lackritz. “We have 15 very large investment banking firms agreeing here. That, in and of itself, is unusual. Our firms are very competitive. They have trouble agreeing on the time of day with one another.”
Since Baker’s hearings began several firms have moved to reduce conflicts. Merrill Lynch took the lead by barring its analysts from owning shares of the companies they cover. Retail brokerage Edward D. Jones and high-tech investment bank Credit Suisse First Boston soon followed suit. Morgan Stanley did the same in December. In August Goldman, Sachs & Co. stopped short of barring analysts from owning the stocks they track but mandated fuller disclosure of such positions.
Although Baker considers these positive steps, he remains unsatisfied. “I would rather not see a new set of standards develop in piecemeal fashion,” he says. “It makes more sense for everyone to sit down and talk about what the right way to go would be.”
Many securities firm executives believe that Baker is unfairly singling out analysts in a search for someone to blame for the markets’ collapse. And they question whether Congress is the right venue for sorting out the problems of an already heavily regulated private marketplace. “We’d rather let the SEC and the regulatory bodies that exist now handle this,” says John Hoffmann, global head of research for Citigroup’s securities unit. “We are certainly subject to lots of criticism, and some of it is justified. But in general we’ve done a reasonably good job, and a lot of the abuses we heard about in the hearings we can say pretty confidently our guys don’t do.”
It’s possible that Baker is being hard on the industry in response to his near loss in 1998. He denies this, and others doubt that that’s what motivates him. Close aides argue that the pending redistricting based on the 2000 census will make Louisiana’s Sixth District even more solidly Republican. On the other hand, speculation persists that Baker might run for governor in 2003, in which case appealing to the state’s populist voters will be far more important than coddling the financial services industry.
Before the September 11 attacks temporarily shunted the issue aside, Baker had been negotiating with the SIA on a series of reforms that would go beyond the group’s underwhelming best practices recommendations. More recently, he turned up the heat again, working with SEC Chairman Harvey Pitt to broker a compromise. In November Pitt met in New York with the CEOs of securities firms; they agreed to form a working group of research executives that in late January was finalizing a reform proposal for an expected joint announcement with lawmakers this month. Ideally, these recommendations would be incorporated into a sweeping rule proposal from the National Association of Securities Dealers, which has regulatory authority over most Wall Street firms, for SEC approval.
There are a number of potential remedies that would, to varying degrees, better protect investors from conflicts of interest. But many argue that the only effective fix would be to erect a permanent regulatory wall between research and investment banking. Former SEC chairman Levitt, among others, has advocated this approach. “As a purist, I think you have to take away banking influence. And the only way to do it is to take away the money,” says Ronald Glantz, who retired in 2000 after 32 years of analyzing automobile stocks for such firms as Mitchell, Hutchins & Co., PaineWebber, Smith Barney and hedge fund Tiger Management. Glantz testified at Baker’s July 31 hearing. “When I ran the research department at PaineWebber, the bankers’ attitude was, ‘We pay part of your budget, so when we have an assignment, you’re going to help us,’” he says. “In those days they contributed about 15 percent of my budget. Now I’d say the figure across Wall Street is closer to 80 percent.”
But even Levitt concedes the difficulties involved here: “The ideal is the total separation of research from investment banking. Whether that’s practical economically for the Wall Street firms is another issue entirely.” Adds a sell-side research director, “You can’t pretend that May Day [the unfixing of brokerage commissions in May 1975] never happened and that we can just pay analysts with commission dollars.”
Pitt has said that he doesn’t necessarily mind analysts owning stocks they cover but objects to them making money on pre-IPO stakes of companies in their sectors. Baker seems to agree: “I am not necessarily of the opinion that it’s inappropriate for an analyst to hold a stock on which he’s issuing a recommendation. But you shouldn’t sell before you downgrade.”
Although the firms say their policies prevent abuse, the SEC’s examination of actual practices “tends to color that a little differently,” says Baker. “In fact, Ms. Unger came in and said many of the firms’ requirements, the codes of conduct in pretty, bound volumes, apparently are just sitting on the shelf. There’s no compliance function. And that’s what I see our role as.”
It’s unlikely that Baker or any of Wall Street’s regulators will mandate that banking revenue may no longer pay the bills for research or that analysts may no longer own the stocks they cover. But it’s a good bet that the NASD will, at the very least, strengthen its rules regarding the disclosure of conflicts. So far discussions between Baker and the industry have centered on making these disclosures clear and prominent, rather than buried in fuzzy legal boilerplate at the end of research reports. Baker also wants analysts to divulge the size of any positions they hold. “They say the analyst ‘may’ have an interest,” he says. “Well, what does that mean? Is it $100 or $100,000 or $100 million? There’s a big difference.”
In the end, it will be difficult for Wall Street to argue against sunshine. Improved disclosure should go a long way toward better informing investors about what, besides company fundamentals, may be determining analyst ratings.
“More prominent disclosure would clearly benefit all investors,” says Baker. “It may not be necessary to do a great deal beyond that. I’m not advocating direct regulation by Congress, nor does the SEC.” He won’t provide details of the pending reform proposal but suggests it will beef up disclosure while mandating penalties for noncompliance, unlike the earlier SIA guidelines. “This will be an initial first step toward rebuilding confidence in the markets. But we will be watching how the industry responds. This committee’s not going away, and neither is the SEC. At the very least, there will be a year-to-year examination of practices, and if we find it’s not working, we will take legislative action.”
Baker has also heard testimony on such topics as the adoption of international accounting standards, and he’s looking into whether the morass of state insurance regulations should be melded into a uniform federal charter. The day after Pitt’s Senate confirmation last August, Baker spent two hours with the new SEC chairman, discussing the possibility of reforming the Securities Acts of 1933 and 1934, to update outmoded provisions and eliminate unnecessary government involvement in the markets.
And don’t look now, but Baker appears to be regrouping for another tilt at Fannie Mae and Freddie Mac. He had meetings scheduled late last month with Bush administration officials - among them, a former Baker staffer who now works on GSE policy for the Treasury Department - to discuss potential legislative or administration action later this year.
Wall Street had better get used to this ragin’ Cajun. He’s not through making waves.
