Another way to address the crisis on Wall Street

Once the $700 million bailout package is sorted out, the federal government will have to roll up its sleeves and figure out what went wrong and how to fix it.  I suspect that whatever they come up with will not fundamentally address the problem.  Here’s why:

1. Wall Street has gotten exponentially more complex in the last decade

2. Most lawmakers really do not understand all of this complexity

3. Regulation and oversight is an unbelievably blunt instrument

4. Things will just get more complex and more global, and if we overregulate we’ll fall behind the Middle East and Asia’s financial centers

So here’s another idea.  What if Wall Street CEOs had real downside risk, and real chance to lose not only what they earn in a given year but also what they earned in previous years?

Right now, the income of your average top-flight Wall Streeter might look like this: $10M; $20M; $25M; $55M; $130M….   They kept on taking on more leverage and paying out more and more until the music stopped.  It’s like being at a casino and playing with the house’s money.

Imagine you have that kind of money coming in.  Then your firm goes bankrupt and you make nothing in a given year (unless you’re the CEO of Morgan Stanley).  Big deal.  Sure it hurts, and your unvested stock loses value.  But you are going to land on your feet because you’re incredibly smart and good at what you do, so you’ll start another firm or get hired by another firm.

So what about putting previous years’ pay at risk too?  Then all of a sudden the equation changes, and you really lose when the firm loses.  It could be as simple as: “Make all the money you want, but if the firm goes bankrupt or there are material restatements in earnings, you owe us everything you made in the last 5 years.”

Of course this will never happen.  But until we realize that CEOs and top management were doing exactly what makes the most sense under the current incentive structure (“go big, because you get all the upside and the downside really isn’t that bad”) we won’t get at the root of the problem.