The Financial Crisis Report's Wakeup Call

NEW YORK (TheStreet) -- There's been a lot going on lately. Between the shootings in Tucson, massive winter storms across the U.S., and protests in Egypt that threaten to destabilize the entire Middle East, we've had a great many crises to engage our attention.

That may be why last week's release of the long-awaited report of the Financial Crisis Inquiry Commission has received relatively little coverage. (After all, what's more compelling -- riots in the streets, or a report that's almost 700 single-spaced pages long?) However, the commission's report deserves more attention than it's been getting, because it pinpoints some critical flaws in our financial system that must be corrected if we're going to avoid another major financial meltdown like the one that rocked the world economy only two years ago.

The commission very kindly provided a 14-page summary of the majority's conclusions for readers who lack the interest or stamina to read the full report. For those of us who've been actively following analysis of the meltdown, the conclusions are hardly surprising.

In a nutshell, the commission found that the financial crisis was avoidable, had the "captains of finance" and regulators recognized and heeded the warning signs. The commission observed that the Federal Reserve Bank of New York, the Securities and Exchange Commission Office of the Comptroller of the Currency and Office of Thrift Supervision all failed adequately to oversee and regulate their respective sectors of the nation's financial system, creating a laissez-faire foundation for questionable financial industry practices.

The commission blasted investment banks and bank holding companies for failures of governance and ethics. It observed that the firms focused increasingly on risky trading activities, especially those involving subprime mortgages, in order to pursue hefty profits. Some of the firms reportedly grew too quickly to be effectively managed. Compensation systems were designed to reward risk-taking rather than prudent investment. Both financial institutions and credit rating agencies relied on computerized mathematical models, rather than professional judgment, to predict risk; according to the commission, "risk management became risk justification."

The commission further concluded that risky investments, excessive borrowing both in financial institutions and private households, and lack of transparency drove the financial system into crisis. In particular, the commission focused on leverage, often hidden in derivatives positions, off-the-balance-sheet entities and "window dressing" of financial reports available to investors eroded the stability of the financial system.

It determined that the government was ill-prepared for the crisis and that its inconsistent initial response -- rescuing Bear Stearns, placing Fannie Mae ( FNM) and Freddie Mac ( FRE) into conservatorship, letting Lehman Brother fail but saving AIG ( AIG) -- increased panic and uncertainty in the market.

Perhaps most troubling, the commission concluded that there was "a systemic breakdown in accountability and ethics," observing that the system failed to account for and protect against human weakness. Collapsing mortgage-lending standards permitted predatory lending and borrowing. Mortgage securitization then permitted those risky loans to be repackaged and sold, undermining the stability of the entire financial system.

The commission found that over-the counter derivatives contributed significantly to the crisis, and blamed the credit rating agencies for failing to recognize and report on the increasing risks that financial firms were assuming.

In short, the commission found that everyone from over-ambitious home buyers, greedy bankers, incompetent rating agencies and asleep-at-the-switch regulators contributed to the financial crisis that has left the world economy in tatters.

The commission's findings were not unanimous -- two dissents were filed. The first, submitted by commission members Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas , can be roughly summarized as "yes, a lot of things contributed to the crisis, but not all of the things that the majority identified."

The second dissent, filed by commission member Peter J. Wallison, takes a different -- and disturbing -- tack. Wallison argues that the financial crisis was caused in large part by U.S. housing policies that encouraged individuals who couldn't afford houses to buy them nonetheless, not necessarily by the other factors on which the majority report relies. More troubling, however, is Wallison's description of how the commission conducted its inquiry and produced its findings.

According to Wallison, the majority ignored research that conflicted with its preconceptions about the causes of the financial crisis. Committee staff ran the process, scheduling and structuring hearings without input from commission members. Worst of all, the draft commission report reportedly was received by commission members too late for meaningful dialogue that might have generated a bipartisan report.

Is the commission's report an insightful analysis of weaknesses in the financial system that led to collapse and crisis, or just another product of shopworn politics-as-usual? It may be a little of both. In my opinion, however, it's also a call to action for anyone who has a role in protecting the stability of the nation's economy.

We'll undoubtedly see new regulations come out of the commission's conclusions, but "more" regulation alone probably won't prevent the next big meltdown. I'm also concerned that relying on government regulation alone will encourage rating agencies, financial firms, investors and consumers to delay or completely disregard the changes they need to make.

Lenders can institute more rational underwriting standards, and consumers can be more realistic about how much house they can afford to buy. Rating agencies can establish more rigorous standards. Financial firms can restructure their compensation programs and internal risk analyses to encourage more prudent practices. Yes, many of these steps have already been taken, but it will be essential for initial improvements to be maintained if they're to have a lasting, positive impact on the stability of our nation's economy.

Government has a role in overseeing the financial markets, but government can't do it all. The commission report may not be perfect, but it's certainly a wakeup call that everyone associated with financial services would be smart to heed.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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