Reuters Money

When I think about what government officials and banking executives knew before the blowup of 2008, I think about the people of Fortuna, a small town nestled next to an active volcano in Costa Rica.

Like the residents of Fortuna, Federal Reserve and Treasury officials knew they were watching a soon-to-erupt volcano with the combination of residential lending, derivatives and banking abuses. The regulators, rating agencies and banking industry were clearly in denial about the worst-case scenario.

As the consensus conclusions of yesterday’s Financial Crisis Commission (FCIC) report showed, “the captains of finance and the public stewards of our financial system ignored warnings and failed to understand and manage evolving risks within a system essential to the well-being of the American public.” Human folly, greed and hubris caused this $11 trillion debacle.

Not only did regulators fail to regulate, certain tainted parties (AIG, Citi, Goldman, Bank of America) were rescued during and after the crisis. Although the commission has said it “has referred” certain matters to the Department of Justice, no indictments have been announced.

The most vexing part of the report is the realization that all the major players knew there were problems and did nothing to stem the blowup.

Alan Greenspan and the Fed knew about toxic predatory lending and subprime mortgages. One of the Fed’s only true watchdogs, the late governor Edward “Ned” Gramlich, warned of these lending abuses as early as 2000.

The “maestro” of disaster Greenspan even encouraged homeowners to take out risky adjustable-rate loans as he was measuring and reporting on how much they were tapping their home equity.

Because they knew regulators weren’t going to act until lava was flowing into their offices, players like Goldman gamed the system and not only got bailouts for their derivatives positions, they were able to make even more money  during the confusion.

While I agree with the crisis commission’s major points, they missed some key details that still need to be addressed:

Fannie Mae and Freddie Mac were printing money.
The mortgage giants were originally created to insure home mortgages for the middle class. In reality, they were a profitable machine that enriched mostly their top executives and investors during their bull run. Using borrowed money, they resold and securitized their debt along with home mortgages with a 75-to-1 leverage ratio. That meant they only had $1 in capital to cover every $75 they borrowed. The market had this nod-and-wink understanding that Congress would bail them out if they got into trouble, which is exactly what happened. Now wards of the state sitting in a financial holding cell, these entities weren’t protecting the American Dream, they were printing funny money. They should be broken up and their portfolios sold off. If the government wants to stay in the mortgage business, guarantees should be based on real assets, not leverage.

The Fed was impotent.
The Federal Reserve Bank of New York, under now-Treasury Secretary Tim Geithner, discovered that Lehman Brothers had 900,000 derivatives contracts outstanding and decided to investigate — only one month before the firm collapsed! In the Dodd-Frank financial reform law, the Fed was granted even more power to regulate the banking system, a big mistake. The Fed is the banking system. It’s like pilots doing their own air-traffic control. If it wants to do the right thing, the Fed should start by dismantling the “too big to fail” doctrine and break up Citi and Bank of America.

You can’t over-regulate derivatives.
FCIC member Brooksley Born, who chaired the Commodity Futures Trading Commission (CFTC), had sounded numerous warnings about derivatives during her tenure. After the Clinton Administration signed off on deregulation of over-the-counter derivatives in 1999, the market exploded to $673 trillion without any regulation or transparency. There are still loopholes in financial reform that will not shed enough light on these dangerous vehicles that she said “were the center of the storm.” They should all be covered by stringent capital requirements and policed by the CFTC, which along with the SEC, needs real money from Congress to do its job.

Ratings agencies need to be policed.
They rubber-stamped some 45,000 defective mortgage securities with AAA ratings. They need a real government watchdog checking their work (paging the GAO). The ratings sheriff was in the saloon when the bad guys came to town.

Change the compensation system.
Every major private player — from the Fannie/Freddie execs to the Bear Stearns traders — had the same incentive. If profits go up, so does your bonus package. So every short-term move you make is geared toward making you rich from a quick commission on a subprime loan to goosing up the perceived quality of a mortgage securities tranche.

Greed will never be eliminated from the human character and the commission’s report didn’t explore the psychology of this flaw. Yet Congress should either enact a tax on short-term trading and speculation or force financial service companies to compensate based on other performance measures that have more social value. Otherwise, the volcano will blow again. The next time, though, there won’t be enough money in the world to repair the devastation.