Wall Street needs its watchdogs

Daniel Akst is a member of the Newsday editorial board.

If there's one thing we should have learned from Sherlock Holmes, it's that when a watchdog is silent, we ought to be alarmed.

Arthur Conan Doyle's "The Adventure of Silver Blaze'' is about the disappearance of a racehorse, and as Holmes discovers, the dog in the stables didn't bark because the culprit was someone so familiar.

I couldn't help thinking of the story after one of Andrew Cuomo's last official acts as attorney general. Cuomo filed suit against the accounting firm of Ernst & Young for allegedly helping Lehman Brothers "engage in a massive accounting fraud" before the investment bank collapsed.

This is not the forum for deciding whether Ernst should pay for any part of Lehman's failure, although the audit firm didn't seem to mind that, at the end of a quarter, Lehman (its client) would make deals that temporarily pumped up its balance sheet with cash. This made Lehman look more liquid when its financial statements came out. A few days later it would unwind these deals.

Like our giant banks, Ernst is too big to fail. It's now one of only four global accounting giants, a shrinking tribe that used to be known as the Big Eight some years ago, before mergers and disasters winnowed their number. We need these firms to handle huge, complex audits - and stay efficient by competing with one another.

But the repeated failures of these firms to root out problems raise a question: In the world of business, is it possible for any watchdog to emit more than a whimper around someone so familiar - and so good at handing out treats?

You see, however narrowly auditors define their job, they do have a watchdog function. Investors are supposed to be able to rely on a company's financial statements, and the auditor is supposed to provide some objective review.

Yet auditors are hired - and paid millions - by the companies they are supposed to audit, which means they don't compete on how rigorously they delve into a client's finances. The whole arrangement just proves that you can't violate one of the basic laws of the universe: He who pays the piper calls the tune.

In this way auditors are like the bond rating firms, which proved themselves so catastrophically inadequate as watchdogs during the financial crisis. Investors rely on bond ratings in judging the riskiness of fixed-income securities. Like audits, bond ratings are embedded in law as well as finance.

Yet bond rating firms are hired by companies that want to issue bonds. It's as if you were going to borrow money from a bank - and got to hire your own loan officer. Would you pick the sourpuss with the green eyeshade? Or the friendly chap with a reputation for being unable to say no?

There's been a lot of talk about tougher regulation to head off another near-death experience for our financial system. Of course, we already had regulation, and thanks to Congress and President Barack Obama, we are about to get more.

But until we change the way auditors and bond-rating firms are hired and paid, we'll be needlessly vulnerable.

One option would be to have companies buy insurance for their financial statements - and have the auditors hired by the insurers, who'd have some skin in the game. Perhaps some new species of bond insurers could take over bond rating.

Or Uncle Sam could just impose a tax equal to whatever companies now spend on audits and bond ratings - and use the proceeds to hire the firms to do the work.

We need watchdogs who will bark. That means changing who pays for the Alpo.