End of Wall Street as We Know It (Shawn Tully)

Financial firms have relied on a highly flawed business model for years. The time has come to fix it.

(Fortune) -- Until the recent tempest, Wall Street firms looked like just about the world's best businesses. Year after year, they posted sumptuous returns on equity, ever-rising share prices, and if you believed their claims, a new breed of CEOs who'd mastered the art and science of risk management. True, it was hard to decipher exactly how they made all that money. But make it they did.

The standards that rule most businesses­­ - avoiding excessive leverage, reining in rampant pay and the massive dilution that goes with it­­ - didn't apply to Wall Street. So what if investors didn't understand all those arcane instruments and sophisticated hedging strategies? Wall Street was the black box on the Hudson that worked its own brand of magic.

Today, the magic is fading fast. It's time to step back and analyze how financial firms actually operate.

The truth is that they've been relying on a highly-flawed business model for years. Put simply, Wall Street firms used towering leverage to make tons of money in a long-running bull market that blatantly underpriced risk. At the same time, they handed a huge chunk of the gains to employees in the form of excessive pay.

Now that run is over, and the price of risk is rising dramatically. That's driving down value of everything from junk bonds to mortgaged backed securities. Wall Street's addiction to leverage is cutting the wrong way. The Bear Stearns (BSC, Fortune 500) meltdown is a primer in the Wall Street curse: When portfolios are built on a mountain of debt, a firm's entire equity base can vanish overnight. The same curse is now taking its toll at Lehman (LEH, Fortune 500), Morgan Stanley (MS, Fortune 500), and Goldman Sachs (GS, Fortune 500).

Read More: CNN/Fortune