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6 simple steps to fix Wall Street

By Allan Sloan with Doris Burke Fortune
Sunday, May 9, 2010; G01

The first thing you learn when you start looking at Wall Street, which I've been doing for 40 years, is to never trust the salesmen. What they promise you isn't necessarily what you get. You need to use common sense, watch out for your own interests and at least make an attempt to understand the fine print.

The same principle applies when you examine plans to reform Wall Street. The Street certainly needs to be fixed, heaven knows. Its excesses are largely responsible for the financial crisis that brought markets crashing down in 2008 and plunged the economy into recession. The government needs to step in: to stop people from being cheated, to help capitalism regain some of the public trust it's lost, and to make markets transparent enough that people other than a handful of elite insiders can figure out what's going on.

Salesmanship, however, isn't confined to Wall Street. President Obama's recent speech at New York City's Cooper Union college, just north of Wall Street, sure was a great pitch. Who can disagree with wanting "a commonsense, reasonable, non-ideological approach to target the root problems that led to the turmoil in our financial sector and ultimately in our entire economy"?

What we'll get from the legislation, however, isn't necessarily what we heard from the Salesman in Chief.

As I write, it's impossible to predict what will emerge from the legislation -- one bill passed by the House, one pending in the Senate -- kicking around in Washington. But something will. Hey, even Goldman Sachs chief executive Lloyd Blankfein seems to think so. "Clearly, the world needs more regulation," he told the Senate. 'Nuff said.

The point of the legislation shouldn't be to do what's easily sellable or to punish Goldman, everyone's favorite whipping boy. It should be to make the financial system work better for all of us.

So with assistance from some of my Fortune colleagues, I'd like to propose six simple steps to help fix the financial system. They would change Wall Street's incentives to make game-playing more expensive for the firms and the players; force both institutions and individuals to put serious amounts of their own money at risk, which would reduce future taxpayer losses; and give regulators, creditors and the general public access to information that Wall Street now hoards to enhance its profit margins.

These proposals aren't a perfect solution -- nothing is -- but had they been in place, AIG might have avoided a meltdown; Lehman Brothers' collapse wouldn't have been as messy; and Goldman's infamous Abacus deal, in which taxpayers in Britain and Germany indirectly forked over $990 million to Goldman might never have taken place. But it did, sending those $990 million to John Paulson's hedge fund.

I'll get to the Simple Six in a minute. But as someone who's seen many "reform" plans -- remember Sarbanes-Oxley? -- fail to achieve their goals, let me offer my negative take on two widely touted ideas that sound great but that just don't seem workable in the real world.

First, it would do more harm than good to create a systemic-risk office. We already have a body that's supposed to guard against risks to the financial systems of the United States and the world. It's called the Federal Reserve. The Fed's primary job, like that of the world's other central banks, is to keep the financial system functioning properly. We don't need a startup bureaucracy trying to do that. The new office and the Fed would end up tripping over each other. Worse, the giant, "systemically important" institutions subject to the riskocrats' rules would carry an implicit federal guarantee against failure. It would give them an unfair advantage by allowing them to raise money more cheaply than smaller institutions, which would not have a federal safety net against failure. That would encourage financial gigantism, which is not good.

Second, we shouldn't adopt the Volcker Rule. Named after former Fed chairman (and current Obama adviser) Paul Volcker, this is a cornerstone of Obama's proposal. But like Obama's speech, the Volcker Rule is better as a sound bite than a solution. Volcker's idea -- separating risk-taking from insured deposits -- sounds great. Implementing it strikes me as impossibly complicated. It's much better to inject more capital -- and more fear of failure -- into the system than to try to define "proprietary trading" and micromanage complex financial companies.

So let's move on to what we should do. Elements of our Simple Six are in the pending legislation. If they're part of what's adopted, we could get true and lasting reform. If they're not, it won't be long before Wall Street is back to business -- and bailouts -- as usual.

1 Increase capital requirements

Any reform plan worth its salt should greatly increase capital requirements -- the amount of money that stockholders have at risk, relative to an institution's assets. This is what people mean when they talk about reducing leverage. Lower leverage would make institutions less likely to fail and any bailout of them less expensive.

Our most recent financial crisis, in which a relative handful of U.S. mortgages metastasized into a worldwide financial cancer, started with loans in which borrowers had nothing or almost nothing at risk. Neither did the companies that made the loans and sold them to other companies that bundled them, turned them into securities and sold the securities to investors. At the end, these players walked away incurring little or no cost from the mess they created, and stuck investors -- and society as a whole -- with a steep bill.

The fix? First, require any institution that turns loans into securities to keep at least 5 percent of each issue in its portfolio. Second, require a cash down payment from the home buyer's own resources of at least 10 percent for any mortgage that's sold as part of a security or package of loans. (Lenders could make and hold lower down-payment loans, but not sell them as securities.)

In addition, Congress should revisit the policy allowing the Federal Housing Administration and the Department of Veterans Affairs to guarantee mortgages made with down payments of as little as 3.5 percent and zero percent, respectively. These programs made sense in the long boom era after World War II, when house prices almost always rose and homeownership was a route to wealth. However, it may not make sense now. If those loans are continued, the government should sharply increase the insurance charged to borrowers, because residential mortgage lending is far riskier than it used to be.

2 Increase fear of too much risk

If any financial institution fails or needs extraordinary help from the government, the United States should be able to claw back five years' worth of stock grants, options profits, and cash salaries and bonuses in excess of $1 million a year. That would apply to the 10 top executives, current and former, with a five-year look-back period. It would also apply to board members, present and past. (People brought in by regulators for rescues that ultimately fail would be exempt.) Anyone subject to the clawback would be permanently barred from executive positions or board seats at any institution that has federal deposit insurance or protection for brokerage customers from the Securities Investor Protection Corp. This provision would give executives and directors a huge incentive to make sure the institutions they supervise don't take on excessive risk.

3 Expose the derivatives trade

Warren Buffett famously called derivatives "financial weapons of mass destruction." My colleague Carol Loomis somewhat less famously calls them "the risk that won't go away." They're both right.

Simply put, derivatives are contracts whose value derives from that of an underlying asset. They were once relatively simple, socially useful things -- instruments that allowed a farmer to lock in the price of wheat or an airline to know how much it would pay for jet fuel. Over the years, the derivatives market has morphed into a monstrous game consisting of speculation piled on speculation piled on speculation. At the end of last year, there were $30.4 trillion of credit-default swaps outstanding -- almost as much as the entire U.S. debt market -- according to the International Swaps and Derivatives Association (ISDA). There were also $426.8 trillion of interest-rate derivatives outstanding. A lot of this is double (or triple or quadruple) counting, but any way you look at it, the numbers are scary.

The market is essentially a vast black box in which no one ever knows who's got what obligations outstanding. So when problems began appearing in mid-2007, fear froze the financial system because many big institutions didn't know who was solvent and who wasn't. Regulators, lenders and stockholders couldn't tell, either.

The near consensus is for derivatives to be handled by clearinghouses that guarantee payment and require collateral to be posted and for them to be traded on exchanges. That way, regulators, creditors and investors can see the price at which the market values them. Derivatives players wouldn't have to worry as much about whether the "counterparties" on the other side of their contracts could make good on their obligations, thus solving much of the too-interconnected- to-be-allowed-to-fail problem.

Under this system, AIG wouldn't have been able to guarantee a staggering $80 billion of subprime (i.e., junk) mortgage loans without posting collateral. So even if AIG had failed -- it also had a huge problem with its "stock loan" business -- it wouldn't have required anything approaching the $180 billion bailout package Uncle Sam gave it.

4 Beef up the bankruptcy laws

In a perfect world, Step 3 would solve the derivatives problem. In the real world, lobbyists are making sure that won't happen. Inevitably, the new rules will let many derivatives players get their contracts deemed "custom." Custom derivatives won't have to trade on exchanges and might not even be subject to clearinghouses. (And, of course, the more custom derivatives there are, the happier Wall Street will be, because the profit margins on them are far larger.)

This means we have to worry about what happens when institutions holding custom derivatives fail. That forces us to fix the flaws in the bankruptcy code that made Lehman Brothers' bankruptcy much worse than it had to be. Because of changes that have crept into the code since the 1980s, Lehman's counterparties could terminate their deals and dump vast numbers of hard-to-unload positions onto the market without being subject to the "automatic stay" of bankruptcy. Chaos ensued.

Stephen Lubben, a bankruptcy professor at Seton Hall Law School, is one of the many academics who say the law needs to be changed. (Among bankruptcy mavens, it is a topic of raging debate.) "Derivatives counterparties should be treated like other secured creditors," he argues, rather than be able to seize and sell collateral without bankruptcy-court permission. Secured lenders get to seize their collateral relatively quickly, but you don't get chaotic messes like the Lehman bankruptcy.

Together, steps 3 and 4 would prompt derivatives players to demand far more collateral, making the markets far smaller and less liquid. The folks at ISDA, the derivatives trade association, argue that forcing derivatives into clearinghouses and exchanges would introduce "excessive rigidity" into the system. They warn, also, that changing the bankruptcy law would have negative consequences. "Reform proposals encourage or require use of collateral, but collateral will only reduce risks if a party can use it when it matters most -- when its counterparty goes bankrupt," ISDA executive vice chairman Robert Pickel says.

Call me a troglodyte, but I think we'd be a lot better off with a lot fewer derivatives, a lot more players' capital at risk and an orderly process rather than a free-for-all when a counterparty goes broke.

5 Create a mortgage-securities database

One of the major problems that led to the meltdown was that it was impossible for many investors to figure out what collateral supported the mortgage-backed securities and derivatives they owned. We can solve that problem by setting up a publicly available database for all mortgage-backed securities that would include up-to-date payment statuses for each mortgage in each security, as well as the estimated market value of each house. Investors, regulators and creditors could use this powerful tool to do their own analysis rather than having to rely on credit-rating agencies. Such a database would help close the information gap between the big players (who have access to customized information through high-priced, high-powered services) and the rest of us.

"We could use some of the [Troubled Assets Relief Program] money like a Superfund and clean up financial toxic waste," says Richard Field of financial consulting firm TYI, who has been trying to get backing for years to set up such a database. There's talk in Washington of adopting the idea. Let's hope it gets done. Quickly and effectively.

6 Truth in credit ratings

A major reason for the worldwide mortgage disaster is that Moody's, Standard & Poor's and Fitch, the big three credit-rating agencies, gave "AAA" ratings to toxic waste securities that should have been rated "ZZZ." Investors at the mercy of the ratings stocked up on this trash, to their detriment.

A widely recognized part of the problem is that the agencies are paid by the issuers of the securities, which want the highest ratings possible. But the bigger problem is that the world has become too complicated and fast-paced for the agencies' formulas to work as well as they once did. They've missed corporate debt problems, been late to downgrade European sovereign debt and so on. When house prices began falling rather than continuing to rise, as rating formulas assumed they would, the ratings were toast.

Washington is flogging the agencies in public, but the dirty little secret is that the government relies on ratings heavily and shows no sign of changing. Regulators use credit ratings to decide how much capital banks should set aside for securitized loans, what qualifies as good collateral under government borrowing programs and what kinds of securities retail money-market funds can own.

If nongovernment investors want to use these ratings rather than doing their own research, good luck to them. But Washington should open the market for government-sensitive ratings to the upstart raters who are paid by investors, not issuers. Let the big three raters and the upstarts compete -- on quality, speed and track record -- for the right to have their ratings used by the government. Competition is better than oligopoly.

Much of what I'm saying is unconventional, maybe heretical. But conventional fixes haven't served us well. We can't just tinker at the margins and set up a new agency or two and expect Wall Street to give up greed. Salesmen will always be salesmen. But if we change incentives and add transparency, they'll be pitching us a less toxic product.

Allan Sloan is Fortune magazine's senior editor at large. Doris Burke is a senior reporter at Fortune.

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