Business

12 smart ways to fix Wall St.

Time is running out to change the most harmful parts of the Obama administration’s massive financial reform bill.

Sen. Harry Reid (D-NV) is calling for a vote on Sen. Chris Dodd’s (D-CT) bill tomorrow to allow comments.

But critics of the bill — which in part could dry up market liquidity and bury many business sectors under costly and weighty new agency regulations — are not giving up.

Senate minority leader Mitch McConnell (R-Ky), in a Senate floor speech last week, attacked a portion of the Dodd bill that would leave the door open for more taxpayer bailouts. “The administration has said it wants to end bailouts. Prove it,” he said.

McConnell was talking about a fund that would be created under the bill that would be used to finance creditors in the case of a bank failure.

There is still time to change the minds of lawmakers — to get them to change parts of the bill that could unnecessarily hurt bank profits and therefore hurt New York City’s economy.

Here are 12 ways the Dodd bill could be changed to help the vitality of Wall Street — without hurting consumers.

1.) No ratings agency conflicts

The oligopoly of government-sanctioned credit agencies has a corrupt business model.

The borrowers pay the agencies to rate their credit quality. Hello!? Can you spell “conflict”?

Let’s deregulate the credit agencies, let start-up private companies get into the business, and let the market of lenders and investors decide whom they will trust.

After all, the complicated bundling of junk mortgages that were given AAA ratings, which fed the financing beast, which produced more junk mortgages, which, in turn, produced the housing bubble and foreclosures, was clearly too much for Moody’s, S&P and Fitch.

I can guarantee that once the feds and other regulators stop relying on just the big three raters, a cottage industry will start up that will rate the raters and the best and the brightest will flourish. And most importantly, the agencies that depend on borrowers to pay them will have to find a new business model because they will be the least accurate.

2.) Insurable interest

Credit default swaps shouldn’t fall under the thumb of a heavy-handed government regulator — which would surely be a waste of taxpayer money, plus deprive that market of much-needed liquidity.

But a private clearinghouse acting as regulator, like the New York Stock Exchange does for stocks listed on the Big Board, should be able to require that owners of a credit default swap have an “insurable interest” in that swap.

The often-used analogy of someone buying fire insurance on their neighbor’s house is an apt one. Betting on someone else’s investment — without an underlying stake in that investment — is too much like Las Vegas.

3.) NO Bailout Fund; no more too-big-to-fail

The current reform bill suggests taxing the banks to create a bailout fund so the taxpayer is not affected by future bailouts.

Guess what? The taxpayer will still have to pay up through higher fees at the banks.

How about this innovative idea: Let banks fail. Every bank has to have a wind-down plan on file at the Federal Reserve (this is the part of the Dodd bill I like). If a bank is on the verge of collapse, the Federal Reserve steps in, separates out the toxic assets (which the shareholders will own), and begins the wind-down process.

Let banks fail but for every failed bank define a process of separating the toxic assets from the good assets and define an orderly wind-down process on the toxic assets while having the government back all 60-day commercial paper — to prevent money-market funds from collapsing, as happened with Lehman’s collapse.

The name of the game is not bailout but orderly wind-down so one bad bank doesn’t bring down the industry. If this is adopted, then Troubled Asset Relief Program watchdog Neil Barofsky (at left) will be out of a job. And that’s good.

But the bad banks must go in order for the system to survive.

4.) Clean up the mortgage business

If the federal government does this, there will be no need for a separate and costly Consumer Protection Agency.

Let’s stop the frauds and improve lending practices.

Senator Dodd’s reform package wants lenders to keep 5 percent of a loan on their books when they securitize the loans and sell them off. In other words, the banks should have some “skin in the game” and keep risk.

However, this would dramatically reduce lending.

Forget it!

What Dodd really wants is for the banks to be selective concerning to whom they lend. For that to happen, he needs to require more disclosure from the borrowers (no more “no income, no paperwork” loans). The bill should require high underwriting standards, just not in an artificial way like the Dodd bill suggests, that will completely clamp down on lending.

Any bank that fraudulently lowers its underwriting standards will be shut down and people will go to jail. There’s no need for a Consumer Protection Agency if you start sending people who exploit consumers to jail.

Finally, let’s tell people what they are getting themselves into. No more hiding stuff in the small print. Every borrower needs to sign a one-sheet with all the loan details clearly spelled out: the size of the loan, the interest payments each year, etc.

Any lender who commits fraud on this should be put out of business and people should go to jail.

5.) Toss the ‘Volcker rule’

First off, former Federal Reserve Chairman Paul Volcker put hundreds of thousands of companies out of business when he crushed the economy in the early ’80s by spiking interest rates. Why should we be listening to him now?

Under the “Volcker rule,” banks would be limited in the amount of risk they could take — principally by separating out their proprietary-trading desks from other desks trading for clients.

This rule in Dodd’s bill has emerged as being among the most distasteful bits of the proposed legislation.

Banks diversify their revenues by trading and other activities. Prop-desk trading by banks wasn’t the cause of the financial crisis.

That said, let’s specify more clearly what trading should be allowed — with the over-the-counter, market making, 100-to-1 leverage through custom CDOs not making the cut.

6.) Uptick rule

Reinstatement of the uptick rule on short selling is a must.

The uptick rule, which limits short selling of equities to only after advances, was removed in July 2007. It’s no surprise that was the top of the market.

Nor was it surprising that when a small version of the uptick rule was put back in place in March, 2009, the market began to move up again.

Without the rule, investors are able to short a stock continuously, and ride it on a non-stop path toward zero.

It’s good for the economy when markets go up.

Let’s put the uptick rule, first enforced in 1938, back in place.

7.) Leave VCs alone

Part of the debate on financial reform is the question of whether “angel financing,” be it venture capital firms, private equity or other firms, should be regulated or not.

Let’s try this instead: get back to the basics of what makes America great: invention and innovation.

This creativity is largely funded by the venture capitalists and private-equity firms that are making bets across every sector from manufacturing to Internet to biotechnology.

The Dodd bill would force many of these angel investors to register with the SEC — which can slow down or kill job creation.

How about we let these guys do their work without interference so the American economy can continue its domination throughout the 21st century?

8.) Hedge funds

The Dodd bill wants hedge funds with at least $100 million in assets under management to register with the Securities and Exchange Commission because they pose a systemic risk.

Not exactly the right threshold.

The level should be $1 billion or more, because these are the funds that really can create systemic risk — and the higher level would be a more manageable size for the SEC to examine.

Here’s what hedge funds should be required to disclose: not just their long equity positions, but ALL positions: short equity positions, debt positions, derivative positions, etc.

Funds of hedge funds should also be required to disclose their underlying fund positions. This would avoid the scenario of the Madoff feeder funds.

9.) Farewell Fannie

Fannie Mae and Freddie Mac are the laughingstocks of the public markets.

They are living, breathing conflicts of interest every day they exist. On the one hand, they have to obey government rules on standards for lending, but on the other hand they gobbled up junk mortgages produced by Wall Street to comply with the political will for increased home ownership.

They can’t do both, and this is what cost the taxpayers $200 billion so far — and has produced $1 trillion-plus in taxpayer and other assistance.

Ginnie Mae should be the only government agency guaranteeing mortgages and mortgage-backed securities. Strip Fannie and Freddie of this responsibility. Let Fannie and Freddie sell their MBS portfolio over a period of years to the private sector, which will manage risk better — then let them disappear.

Fannie and Freddie used to be a stabilizing force in the mortgage market, purchasing mortgage-backed securities when necessary to stabilize the market. But that was then.

10.) Stop regulatory capture

When the Madoff scandal broke, it was disconcerting that the Securities and Exchange Commission had often been in his offices and, as Madoff later joked, all the SEC employees that were on-site would later send him their resumes.

This is called “regulatory capture” — when the regulator is implicitly captured by the industry it is trying to regulate.

Rather than requiring more extensive disclosure rules on hedge funds, let’s prevent employees for any of these regulators from working in the banking system or working for hedge funds until at least one year after they leave government service.

Also, I have no problem with government employees getting rich if they save investors billions. Let’s make a whistleblower program for SEC employees so if an employee exposes a fund (like Madoff’s) as a fraud, then a bonus pool is set aside depending on the size of the fraud.

This will encourage the best and the brightest to actually stay in government service rather than jump as quickly as possible to the nearest hedge fund.

11.) Bank disclosures

The banks, particularly Lehman, were creating new companies (called Special Purpose Entities (SPEs) to hide their toxic assets.

That way, the obligations would not show up as debt on the balance sheet. New regulations are trying to limit the amount of the use of these SPEs as well as limit the amount of securitization a bank can do.

Let the banks keep their special purpose entities (SPE) off balance sheet — but force much tighter disclosure.

I want to see each SPE that’s off the books and what every debt obligation is between the bank and the SPE.

This would eliminate all the Repo 105 issues — moving debt off the books into a special account before filing quarterly results then moving the debt back after the results — all the Enron-like and Lehman-like strategies for hiding losses and would restore immense faith in the banking system.

If a bank’s SPEs were so large and unwieldy as to cause systemic risk, then investors would know sooner and be able to react accordingly.

12.) Derivative oversight

One private clearing house-as-regulator for derivatives, much like the New York Stock Exchange is for stocks on the Big Board is needed.

If hedge fund titan John Paulson (above) needs to structure a CDO, this clearing house needs to approve the language, disclosures, etc.

All trading has to be done through this exchange. That goes for custom derivatives or market-making custom derivatives. These are necessary and serve a purpose and should not be legislated out of existence. We don’t need more regulation, just smarter regulation.

This would prevent all future Goldman-ACA-Paulson conflicts.

An exchange allows the customer, for the first time, to see the actual bid and ask of a security.

James Altucher is a managing director at Formula Capital. He can be reached at altucher@gmail.com