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Former Merrill Lynch analyst Henry Blodget

Inside Salomon Smith Barney, analysts date the cultural shift in the research department to 1997, when parent company Travelers Group bought Salomon Brothers and married that firm with its focus on institutions and investment banking to retail-driven Smith Barney, which Travelers (now Citigroup) also owned. Suddenly, "earning money the old-fashioned way" made a far better ad campaign than corporate game plan. "The Salomon guys were a little faster with the rules and more focused on investment banking," says a longtime member of Smith Barney's research team. That's when big money started flying toward analysts at the firm who could help reel in underwriting deals by promising to "cover" the stock — which often meant that the analysts would praise the stock and recommend it to investors.

Salomon and other big brokerages profited nicely from this approach during the '90s boom, when a rising tide lifted all kinds of leaky stocks. Investment-banking divisions became huge profit centers for brokerage firms, which in addition to garnering lucrative advisory fees made 20 times as much in commissions on IPOs as they did on simple stock trades. Companies choosing which brokerage firm would handle their new stock issues increasingly went with those that had a star analyst willing to recommend their stock.

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Such was the climate that led to the now famous e-mails written in 1999 and 2000 by Henry Blodget and other Merrill Lynch analysts privately calling stocks "a piece of junk" or "crap" or "a dog," while advising clients to buy them. The e-mails, subpoenaed and made public last month by New York State attorney general Eliot Spitzer, have created an uproar among investors who feel they have been defrauded by brokerage firms whom they had trusted — and often paid — for honest advice. The Securities and Exchange Commission last week approved new rules meant to moderate the collaboration of bankers and analysts within brokerage firms. But some lawmakers and investor advocates view the rules as too little, too late and are calling for the resignation of SEC chairman Harvey Pitt.

Spitzer clearly hopes to ride the outrage against Wall Street to political gain, much as Rudolph Giuliani exploited the Street's insider-trading scandals as a federal prosecutor in New York City 15 years ago. And make no mistake: Spitzer is on to what has become an emotional issue for investors who want to see someone on their side. Long before he arrived, several institutions — the SEC, Congress, the New York Stock Exchange and the National Association of Securities Dealers — had looked for but failed to turn up hard evidence of what Spitzer asserts is criminal fraud. Few expect that anyone will go to jail. More likely, Merrill, which says the e-mails were taken out of context, will settle with Spitzer — perhaps this week — by agreeing to some kind of fine as well as curbs that would extend to other brokerage firms.

Merrill has said it is critical that any analyst practices forced on it be applied Streetwide to keep the firm from being at a competitive disadvantage, underscoring the pivotal role of analysts in the prevailing business model for investment banking. A recognizable analyst is often what distinguishes one underwriter from another. But even if underwriters were told they could not use analysts to win deals, they would still pull in plenty of business, says Samuel Hayes, professor of investment banking at Harvard University. Someone has to do the deals, he notes, and the large firms still have the critical sales, trading and advisory capability to trump boutique banking firms. What the Street fears most is having to duplicate the analytical staff on its banking side (while calling the analysts something else). That would drive up costs dramatically.

The Street also dreads a lengthy process to resolve the analyst flap, which, layered on top of the accounting concerns springing from the Enron scandal, is driving investors away. To help regain their confidence, brokerage firms are making a show of efforts to reform. Last week UBS Warburg initiated its coverage of JetBlue Airways — a firm whose IPO it co-managed last month — by advising investors to "reduce" their holdings. It was apparently a pre-emptive move, to show regulators that UBS Warburg is indeed capable of using the word sell.

Meanwhile, the industry absorbed a new set of SEC rules approved last week, which order that analysts' pay not be tied to specific transactions, that analysts not be permitted to share draft research reports with clients or prospective clients, and that analysts more visibly disclose conflicts of interest. There wasn't a peep of dissent on Wall Street, which, unhappy with Spitzer's bare-knuckled approach to reform, is openly begging for remedies from the industry-friendly SEC. Indeed, the big brokerages uniformly embraced a follow-up investigation the SEC announced two weeks ago, in hopes that Spitzer's state office would yield to a federal authority. But Spitzer isn't backing down. "I'm not going to go away just because the SEC is involved," he says. "I want to make sure the remedies we get ensure that analysts can honestly evaluate stocks."

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