What's wrong with Wall St. - and how to fix it

Wall Street's second tragic flaw is its love of leverage. "Wall Street's leverage is enormous, unbelievable, and it greatly exacerbated their problems," says John Bogle, founder of mutual fund giant Vanguard. Since 2002, the five firms' leverage, measured by assets as a multiple of equity, jumped from 30 to 41 (see chart on previous page). Brad Hintz, an analyst for Sanford C. Bernstein, reckons that half the huge gains in Wall Street's profits from 2003 to mid-2007 could be attributed to increased leverage - otherwise known as gambling with borrowed money - that magnified earnings in a boom. Again, it's the curse of too much debt: If a firm's portfolio is leveraged at 33 to 1, it takes a mere drop of 3% to wipe out its entire capital.

To understand why Wall Street's players are losing big chunks of its capital, it's important to look at the securities they borrowed so heavily to buy. Typically firms hold highly liquid assets they can unload quickly. That's because they rely on a constant flow of short-term funding from banks and the capital markets to finance their portfolios. But this time around Wall Street loaded up not on Treasury bills or top-rated corporate bonds but on exotic CDOs and CLOs. The credit crunch makes those instruments extremely difficult to sell, except at steep losses. Even if the firms hold those securities for months, there's no assurance their prices will rebound.

It's the third weakness, Wall Street's profligacy with pay, that encourages outrageous risk taking. "Wall Street's compensation system is a fundamental problem," say Bogle. The system rewards swashbuckling behavior by everyone from traders to CEOs. If traders can generate big profits for a year or two by taking risky bets, they can amass bonuses large enough to retire on. In good years Wall Street's big dogs collect grants of restricted stock and options far out of proportion with the size of their companies. In 2006 the top six managers at Lehman pocketed $150 million, and Bear Stearns's then-CEO James Cayne earned $40 million. Bear's profits were driven largely by excessive leverage and a frothy market, not, to put it mildly, by enlightened management. Employees of the big five investment banks hold restricted stock and options that on average equal 26% of the companies' outstanding shares (and that doesn't count shares they own outright). "Wall Street is arranging management buyouts by stealth," says Jack Ciesielski of the newsletter The Analyst's Accounting Observer.

So what's the solution? First, Wall Street banks must return to their roots in fee-based businesses. They need to learn to live on the revenues from underwriting, brokerage, asset management, and M&A advice. That means adjusting their bloated costs: Those businesses would still be highly profitable if Wall Street could put itself on a diet.

The firms should also reduce their reliance on using privileged client information to trade for their own accounts - a practice with serious ethical problems. To some extent technology will take care of that for them. With the demise of the antiquated specialist system at the NYSE and the rise of automated trading systems, clients have far more opportunity to buy and sell large blocks of stock anonymously than they did in the past. Look for that trend to accelerate.

Second, the leverage ratios are irresponsible and must come down. Indeed, Jamie Dimon, through a career that took him from Shearson to Citigroup (C, Fortune 500) to the top spot at J.P. Morgan Chase, forged a reputation as one of Wall Street's most prudent managers by demanding that his trading operations place severe limits on leverage.

Third, the compensation system must be revamped so that managers and traders bank their bonuses forward. Their pay should be released only if the firms are profitable over a sustained period of, say, five or six years. That reform is probably just a dream, given what stars expect on Wall Street. But it would finally favor shareholders over employees, a dream worth achieving.

Because the government stepped in to rescue Wall Street from itself, it's almost certain that a new wave of regulation will force major changes. Today the firms are supervised by the Securities and Exchange Commission and face far lighter restrictions than the tough regime applied to commercial banks by their main overseer, the Federal Reserve. The meltdown in the mortgage market already had lawmakers calling for far tighter regulation of securities firms. But the watershed event was the Bear Stearns bailout. Before that the Fed made emergency loans only to the banks it supervised. To avert a run on the investment banks, it took the radical step of granting them the same privilege, as well as providing the $29 billion that enticed J.P. Morgan to salvage Bear Stearns.

The bailout handed the champions of regulation a powerful argument: If investment banks can borrow from the Fed, they should be subject to the same rules as commercial banks. Treasury Secretary Hank Paulson has called for greater regulation of securities firms (the department has drawn up a blueprint), and House Financial Services Committee chairman Barney Frank and Senate Banking Committee chairman Chris Dodd are drafting legislation to broaden oversight. The proposals focus on two issues: the low capital requirements for investment banks and their unreliable risk-management systems. Today securities firms have wide discretion in determining how much capital they need, and they use their own risk-management systems, all under the trusting supervision of the SEC. The result is that investment banks use far less capital than commercial banks - explaining their awesome leverage - and get away with risk management that's easily undermined by profit-hungry traders.

Hence, it's likely that Wall Street will face far tougher capital requirements in the near future. That will change the game drastically. The massive profits that Wall Street enjoyed in past bull markets will be severely muted, since the firms will be forced to substantially reduce the borrowing they count on to multiply their gains. Although that will make the firms safer, it will also eliminate the periods when Wall Street embarks on streaks of spectacular earnings growth. That will explode the myth that investment banking, as practiced now, is a great business.

Another source of reform is lurking. With their share prices as much as 50% below their peaks, the four remaining independents are highly vulnerable to takeover. The most likely acquirers: big domestic or foreign commercial banks. In Europe investment banks are mainly arms of diversified banks. It was only the artificial separation of investment and commercial banks that kept Wall Street firms independent for this long. But Wall Street has blown it. Over time the big diversified banks, equipped with far more capital and infinitely more discipline, will tame Wall Street. It just happened with J.P. Morgan's deal to buy Bear Stearns. And that's simply the beginning.

While that may mean the end of independence for the publicly traded, full-service investment banks, it will hardly bring an end to the kind of behavior that led to today's crisis and many similar ones before it. As long as we have capital markets and as long as it's possible for people to make vast sums taking big risks with borrowed money, we will have the kinds of booms and busts that are a way of life on Wall Street. The big gamblers will most likely work for hedge funds, private equity firms, or some new entity that hasn't been invented yet. We won't see tumbleweeds on Wall Street. Its cowboys may not be geniuses at making money. But they're geniuses at raising it and, above all, at perpetuating Wall Street's black-box mystique. 

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