5 ways to fix Wall Street

Former SEC Chairman Arthur Levitt, who ran the SEC from 1993 to 2001, took the agency to task Oct. 14. "As an overheated market needed a strong referee to rein in dangerously risky behavior, the commission too often remained on the sidelines," Levitt told the Senate Banking Committee. "The SEC has been reactive at best or has shown no real willingness to stand up for investors."

So what's the fix? One obvious answer is to give the SEC more money so it can hire more accountants to work alongside its many lawyers. Critics say the SEC has too many lawyers, who may not have accounting skills, and not enough accounting sleuths.

Next, more corporate auditors need to be like PricewaterhouseCoopers -- willing to bite the hand that feeds them. Auditors should be forced to change clients every three or four years, Vickrey says, so they won't hold back on criticism for fear of losing clients.

He also thinks board members serving on audit committees need to have at least some accounting expertise. Astonishingly, they typically don't. "We very rarely find any evidence that they have accounting experience," Vickrey says.

It may be time for a more innovative approach. I like an idea proposed by William Ackman of Pershing Square Capital Management: He thinks the SEC should meet regularly with short sellers like him to hear their ideas.

Short sellers bet against companies by borrowing stock -- hoping to replace it later at a lower value after problems emerge and the stock price falls. They often make lots of money by doing painstaking research that reveals funny business early on. Who better to point the SEC to companies fudging the numbers?

And if short sellers profit in the process, so be it. People should be rewarded for doing research that reveals problems management wants to hide, so that capital flows to more worthy companies.

Fix No. 4: Make dramatic regulation reforms

Our financial system runs under the most fragmented system of regulation in the world. Every agency from the Fed to the Office of the Comptroller of the Currency in the Treasury Department to the SEC to individual states has a say in regulating our banks, brokerages and insurance companies.

It's a maze that makes it difficult to know what agency is supposed to regulate what. In the early stages of the subprime crisis, for example, many government agencies failed to act quickly because they didn't know if they had the authority, maintains former SEC Chairman Harvey Pitt, now with Kalorama Partners, a consulting firm.

He thinks creating a single agency to oversee the various pieces of the financial services industry would solve this problem. A broad responsibility for the soundness of the financial system would also give this agency jurisdiction over hedge funds, now only lightly regulated. And that would take insurance regulation away from states and give it to this single federal agency.

Another fix would bar banks from owning securities unless they were registered with the SEC, a process that would increase underwriting standards and visibility on what's inside securities. It would also help if banks had to keep a portion of any securities they underwrote, to make them more careful about the securities they produced.

The same could be said for the mortgages at the heart of this problem. If banks and brokers had to keep some of them on their own books instead of turning them into securities and selling them off, writing high-risk loans might not have seemed so attractive.

Fix No. 5: Regulate credit default swaps

Credit default swaps serve a good purpose. They allow banks and investors who lend a lot of money to reduce their risks by purchasing insurance (the credit default swap) in case the money doesn't get paid back.

But credit default swaps aren't regulated as insurance is. So companies such as AIG could issue huge amounts of insurance for high-risk mortgage-backed securities without keeping adequate reserves against potential losses, as an insurance company must.

That gave the system a false sense of security.

Another problem is that credit default swaps trade over the counter, or informally among various players in the market. There's no exchange to ensure they put up enough collateral to make good on their obligations, as is the case with options traded on a formal exchange.

All of this has to change. Credit default swaps have to trade on an exchange. Or they have to be called what they are -- insurance -- and regulated as such, meaning that issuers would have to keep adequate reserves against potential losses.

Above all, the overall financial system needs an overhaul. Pumping in money may get things moving again, but until we make the needed repairs, it won't be something we can count on. These steps would be a start.

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column.

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