Greed, hypocrisy, and folly: the crux of the subprime fiasco.

• Author: Smick, David M.
• Position: FROM THE FOUNDER - Analysis of financial crisis

If you listen carefully to the defensive noise spewing out of the mouths of Washington policymakers, the message regarding the subprime crisis is that "the global devil made me do it. In other words, a global environment of excess savings over investment after the Berlin Wall collapse led to a decline in global real interest rates, which created an unavoidable worldwide housing bubble and subsequent subprime mess. Translation: Don't blame Washington. Blame the Soviets for allowing the Berlin Wall to collapse!

The situation, of course, is significantly more complicated. Indeed, here is how to connect the dots. The failure of America's bank regulators to foresee the onslaught of predatory lenders luring hopeful low-income families into unrealistic mortgages is understandable. Bubbles often create a false sense that "this time things are different." And who could not have a heart for lower-income families experiencing for the first time the joys of home ownership. What is hard to comprehend is the irresponsible performance of the bankers themselves, and their regulators, which has left the entire financial system dangerously at risk.

How the banks got in trouble is a story of greed, hypocrisy, and sheer folly. After the collapse of the hedge fund Long-Term Capital Management in 1998, the global banking community with great panache tightened credit controls over the hedge fund community. Ironically, with help from the unraveling of Glass-Steagall restrictions, the banks at the same time adopted a much looser approach to their own trading desks with less-defined risk management standards. Not surprisingly, bank risk soared as the banks, hoping to be like the hedge funds and investment banks, searched desperately for ever-higher profits. Standing as a huge complication to this expanded risk were, of course, the Basel H capital adequacy standards, which offered the banks an unattractive choice: either go for the greater risk and larger returns (but maintain higher levels of internal capital), or accept lower risk and smaller returns (putting up no additional capital). The banks accepted neither choice, and the results have been catastrophic.

To maneuver around this Basel II dilemma, the banks (joining the nonbank financial institutions) resorted to a legal gimmick in the form of a kind of dual market. There was the well-known main institution with its visible "on-balance-sheet" obligations, but also under the same bank umbrella the establishment...