Preventing another crisis requires a look below the surface

The high-tech debacle of the late-nineties was followed by an unprecedented period of global economic expansion. Even those of us who've learned the lesson that all good things eventually come to an end are beginning to wonder if it really is different this time.

Who could have imagined the root cause of the financial meltdown would not be triggered by a reversal of global economic prosperity, but by dysfunction within the financial industry? The first bitter harvest of this dysfunction grew out of a commission structure that rewarded sales staff for the number of mortgages written, regardless of the borrower's ability to make the house payments. While the U.S. mortgage debacle is the most wrenching in human terms because so many low-income families are losing their homes, most shouldn't have been given a mortgage in the first place.

The other side of the mortgage debacle is the hundreds of billions of losses incurred by the holders of those failed loans. This includes the vast majority of the population of the G8 and beyond. Why? Because whether you are a knowledgeable investor in the shares of Merrill Lynch or Bear Stearns, traditional banks like Citi or UBS, or a member of a pension plan holding broadly based international equity and debt securities; your financial future has been affected. The market players had the benefit of knowing a lot about the game. It's the people trying to build a nest-egg for the future and earn a little extra income on their savings who are the most unfortunate victims.

Mortgage originators handed off most of the repayment risk to investors in mortgage-backed securities. These are just one member of a family of sliced and diced loans packages called collateralized debt obligations (CDOs) that were marketed as secure investments. They also included consumer borrowing such as credit card payables and auto loans. Other CDOs contained high-yield (low-credit rating) corporate paper wound into endless ingenious, but opaque, structures. Here again it comes down to perverse incentives where highly creative people were paid huge bonuses for devising Byzantine securities containing risks that proved impossible to evaluate. All this and I haven't even gotten to derivative instruments tied to debt obligations, including credit default swaps sold by the now distressed mono-line insurers to those wanting loan default protection.

Now that you have a better idea of the risk you or your grandmother were taking in purchasing one of these structured products, you'll be interested to know that many of the professionals who make a living by evaluating securities according to risk level also got it terribly wrong. For example, the $32-billion in Canadian asset-backed commercial paper that Purdy Crawford is working diligently to rescue were given the highest possible credit rating by Dominion Bond Rating Service.

Deep out of sight, in this submerged financial market iceberg, are the multitrillion-dollar highly leveraged hedge funds. No one really knows how much the credit crisis has destabilized the hedge sector, but a decade ago when the demise of hedge fund Long Term Capital Management threatened to bring Wall Street to its knees, the U.S. Federal Reserve came to the rescue.

The market will work its way through this crisis, provided governments don't try to micromanage the inevitable pain. But what do we do to prevent a recurrence? Besides fundamental reform of the toxic incentive systems for mortgage brokers and investment dealers, we need to hoist the whole iceberg out of the water where we can all see what's hidden below the surface.

This will require a fundamental shift in what regulators focus on. Experience on bank boards has shown me the enormous regulatory disparity between the traditional banks and the shadow banking sector, which includes investment dealers, hedge funds, mortgage mono-lines and consumer finance companies.

Reserve and reporting requirements by Canadian, U.S. and European banking regulators border on overkill. By contrast, there are no solvency control thresholds and very little in the way of reporting on that part of the sector presenting the greatest meltdown risk. And now that meltdown has happened, it is the banks who are being asked to do a lot of the heavy lifting out of the deep hole created by the shadow banking players. The huge injection of liquidity by G8 central bankers is intended to help the traditional banks take over the credit load that has been abandoned by unstable shadow bankers.

To be clear, I'm not suggesting that massive regulation and bureaucracy be imposed on financial markets. That would just stifle the ingenuity and flexibility needed to put this crisis into the history books. What's needed are international disclosure standards that provide transparency so investors can see clearly what they're buying.

It's time for regulators to spend less time focusing on the minutiae of the over-regulated traditional banks and recognize where the real risks to the financial system lie.