Rx for Cleaning up Wall Street

Wall Street is finally getting its comeuppance judging by all the calls for more regulation. As a sign of how big an issue it has become, the Presidential candidates have announced reform-minded plans. But I wonder if they are truly keyed-in with all these supposedly "sophisticated" instruments that are commonplace on Wall Street, many of which precipitated the current economic malaise.

However sophisticated Wall Street shenanigans have become, the crisis itself is quite easy to comprehend: Wall Street these past few years has quietly created largely unregulated shadow markets that even the brightest minds in the universe can't value. Lest you think I'm spouting mere hyperbole, consider the following admissions:

• Alan S. Blinder, a former vice chairman of the Federal Reserve and an economics professor at Princeton, admits that even he has only a "modest understanding" of complex derivatives and "if you presented me with one and asked me to put a market value on it, I'd be guessing."


• Major Wall Streets banks use a metric known as value-at-risk (VAR), which measures how much money their traders could potentially lose on a given day. At the end of last year, Citigroup's VAR was $191 million, nearly double from a year earlier. But as noted by research firm Audit Integrity, Citigroup's VAR figures don't even include the bank's exposure to collateralized debt obligations – which the bank admits "are tough to value." CDOs were responsible for nearly $20 billion in investement-banking losses last year for Citi.


• Oppenheimer analyst Meredith Whitney lowered her earnings estimates for several major U.S. banks, including Citigroup, for the 30th time on Wednesday and warned "we are confident this will not be our last reduction in 2008."

It is almost beyond my comprehension how any company, particularly major financial institutions, took on such a dizzying degree of credit exposure they readily admit can't be quantified. Byron Wien, chief investment officer at hedge fund Pequot Capital, perhaps best explains how this came about. "These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models. You put a lot of equations in front of them with little Greek letters on their sides, and they won't know what they're looking at."

Some legislators are just now waking up to the magnitude of the problem and talk is brewing on Capital Hill about the need for regulatory reform. Senator Schumer's op-ed in the Wall Street Journal is indicative of Washington's reactive stance. Though I've been a critic of Mr. Schumer's in the past, his suggestions are all sound. Risk, regulatory consolidation, transparency and getting a handle on Wall Street's shadow markets (such as the $516 trillion global derivatives market) are all critical issues.

Even Jamie Dimon, J.P. Morgan's CEO, has grudgingly conceded there is a need for more regulation. "We have a terribly global world and, over all, financial regulation has not kept up with that."

However, couching recommendations with worry about global competition sets the stage for a classic Congressional cop-out. And simply creating more regulations and oversight won't protect investors from Wall Street's pervasive wrongdoings. There has to be a radical philosophical overhaul on the part of regulators in their oversight of the major Wall Street firms. America is badly in need of watchdogs that will bark with a vengeance and are willing to impose meaningful and painful punishments when Wall Street firms run afoul of regulations, as they frequently do.

Take the conflicted research scandal. Although Wall Street firms routinely peddled research to investors they knew was woefully bogus, they were allowed to settle the matter for a measly $1.4 billion. That didn't even amount to a wrist slap.

Or consider the collapse of the auction rate securities markets. The SEC uncovered considerable wrongdoing in this market as early as 1996, but imposed an insignificant $13 million penalty on 15 firms. Not surprisingly, the wrongdoing not only continued it actually escalated, and countless individual investors were left holding the bag.

In a letter to the nongovernmental Basel Committee of Banking Supervision, S.E.C. chairman Christopher Cox attributed the collapse of Bear Stearns to "a lack of confidence, not a lack of capital." That may be true. But had the S.E.C. intervened more aggressively when Bear Stearns' mortgage-backed hedge funds began imploding last June, regulators could have imposed measures that perhaps could have ensured a measure of confidence and staved off the firm's collapse.

Wall Street is dominated by some of the smartest people in the world. Regretfully, most of these people are driven by unadulterated greed and typically put their own interests ahead of the clients. This greed is now wreaking havoc on the lives of ordinary Americans and has badly hurt our economic standing in the international community. Its high time Wall Street was held accountable for their actions.