Michael Brush

Company Focus10/24/2008 12:01 AM ET

5 ways to fix Wall Street

Billions of our dollars are flowing in to save the financial system, but investor confidence won't return until trust is restored. Here's the work that's needed for real reform.

By Michael Brush

When Wall Street came begging for a bailout and folks like Hank Paulson and Ben Bernanke said we had to act fast, the message was pretty clear: money now, reform next.

Well, the money's flowing. Some $700 billion is on the way via the big bailout from Congress and the president, plus trillions from governments around the world.

But apart from mild executive-pay provisions in the bailout bill, including some restrictions on golden parachutes and limits on much base salary companies can deduct for tax purposes, reform hasn't begun. That's too bad, because it will take more than the taxpayers' credit card to fix a system built on reckless debt and largesse for the guys at the top.

Here are five fixes to start on right away that would help restore investors' trust -- and make sure this never happened again:

Fix No. 1: Start the 'perp walks'

No one on Main Street trusts Wall Street anymore, and you can't blame them after what's happened. This is a huge problem because the Street is supposed to channel money to the entrepreneurs who invest it to create businesses and jobs that keep our economy rollicking. This won't happen when so many people prefer cash to stocks.

To restore confidence, we need lots of "perp walks" to prove that those who committed fraud are being rooted out and punished. Not long ago, after another set of scandals, seeing ex-Enron CEO Kenneth Lay and former Adelphia Communications chief John Rigas paraded on TV in handcuffs helped restore confidence that the system would be cleaned up.

We need the same assurances now. News releases about what the FBI may do aren't enough. President Bush needs to direct his attorney general to set up a task force that draws on the resources of the main law enforcement and regulatory bodies, just as he set up a corporate-fraud task force to deal with the last round of fraudulent behavior.

Fix No. 2: Rein in executive pay

There's nothing like dangling the potential for untold riches in front of someone to make him do stupid things that hurt all of us. That's exactly what happened over the past few years. Excessive executive pay was clearly one of the main causes of this mess.

After all, if you were a CEO like former Countrywide Financial chief Angelo Mozilo, and you had the chance to take home $361 million over three years, wouldn't you be tempted to encourage your underlings to rev up the subprime-mortgage machine to produce record profits? On Wall Street, this temptation lead to excessive borrowing, or leverage, to bring greater returns, but instead it created too much risk and disaster. (For more on Wall Street executives who cashed in while leading banks into trouble, click here.)

This "rush to high leverage" was the product of a compensation system that encouraged CEOs to focus on the short run, says John Coffee, a Columbia University law professor. In the process, they did things that destabilized our financial system.

How do we fix this? Government can't set executive pay. But it can write rules that give shareholders greater say in pay and a bigger voice in selecting the boards that set CEO pay. Shareholders have a big stake in policing the companies they own.

Two proposals in the air would move things in the right direction. First, Congress needs to mandate so-called say-on-pay rules that give shareholders an annual vote on executive compensation. These votes would not be binding, but they could send a message to board members on pay committees that heads will roll unless they create incentives that reward execs for creating real long-term value -- instead of gaming the numbers.

Second, shareholders need greater access to the corporate proxy voting machine so they don't have to pay the costs of putting an issue in front of fellow shareholders. This access would make it easier for investors to run alternative board candidates -- presumably independent voices who wouldn't overpay the CEO. The Securities and Exchange Commission has the power to make this happen on its own, says Patrick McGurn, a special counsel for RiskMetricsGroup (RMG, news, msgs), but a push from Congress would help.

Fix No. 3: Get a stronger accounting watchdog

Just as during the tech bubble, underlying problems in the real-estate bubble became far worse than they should have because they were hidden by companies playing fast and loose with accounting rules.

Many companies violated a basic tenet of accounting that says management is supposed to present the most conservative picture possible when reporting results. Instead, lots of financial companies painted overly rosy pictures -- assuming, for example, that housing prices would soar forever. And the SEC let them get away with it.

"The current crisis was allowed to fester for several years because the results of operations reported by many firms in the financial sector bore little resemblance to economic reality," says Donn Vickrey of Gradient Analytics.

Vickrey's shop is among the best at uncovering the tricks companies use to hide problems. Gradient was warning clients, years in advance in some cases, of looming problems at companies such as Washington Mutual (WAMUQ, news, msgs) and American International Group (AIG, news, msgs).

In contrast, many investors believed the numbers presented by management and got burned. "Very sophisticated people got fooled by it," Vickrey says. That's acceptable, if unfortunate. People lose money in the market when they fail to do their homework.

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What's inexcusable is that the SEC missed the problems or failed to act. Let's look at two examples.

More than a year before the demise of Washington Mutual, Gradient pegged it as a bank that was overstating earnings because it was not setting aside enough money to protect against loan losses. Gradient noticed that problem loans were piling up at a much faster rate than write-offs for losses. But the SEC didn't act.

Perhaps even more egregious, AIG auditor PricewaterhouseCoopers stated in February that it thought the company had significant shortcomings in how it was valuing insurance derivatives known as credit default swaps, a kind of insurance on debt payments.

At the same time, Gradient described AIG as "downright frightening," in part because it had increased the estimated worth of credit default swaps virtually overnight by switching to a new valuation model. "It was as if Santa Claus himself had visited AIG the night before, leaving gift certificates with value derived by higher mathematics," Gradient wrote in a report.

The SEC didn't launch an investigation until many months later.

Continued: SEC needs to toughen up

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