First in a series

In the face of an epic credit freeze and vicious recession, the U.S. government found the stop-gap measures needed to ward off an unfathomable collapse.

But more than a year later, the financial system remains weakened by the cracks exposed to such devastating effect during the crisis, with some vulnerabilities running even deeper than before.

"We were in the middle of a downdraft without a sense of a bottom then, so in that respect I feel safer now," said Rob Johnson, director of financial policy at the Roosevelt Institute in New York and a former managing director of Soros Fund Management and Bankers Trust Co. "But I do not feel structurally safer about finance, about the incentives involved or the people who manage it."

Three of the four largest banks are bigger now, while new capital requirements have yet to emerge.

Few reforms have come to a ratings system that let undeserving securities masquerade as triple-A credits, and little headway has been made in devising pay structures that are more responsive to soundness concerns than to executive greed or populist anger.

And the country has not even begun to re-evaluate home ownership goals or other thorny issues embedded in the topic of housing finance.

Against that backdrop, the policy and industry responses to the crisis seem far from adequate for taming a system that just last year seemed almost beyond control.

Delaying the day of reckoning is not an altogether unwise approach. There is something to be said for giving the economy time to mend itself before taking more drastic action than might be necessary — a practice that any bank that has successfully applied the "extend-and-pretend" strategy to a troubled commercial loan can attest.

But given the potential ripple effects demonstrated by last year's credit freeze, it might be wise to do more than just hope that the system can absorb any hits if the downturn persists or if new trouble spots emerge.

And it might be preferable to have banks' creditors presume that they will share in the absorption process, if discipline is to be restored to the markets.

Understandably, those issues were not the chief concern of the Treasury Department last fall, when the staff was putting in heroic numbers of hours to pull together the centerpiece of its bailout proposal, the Troubled Asset Relief Program.

"The goal was not to reform the financial services industry through Tarp," said David Nason, who helped design the program as a principal policy adviser to then-Treasury Secretary Henry Paulson. Nason, now a managing director at Promontory Financial Group LLP in Washington, summarized the mission as "prevent failure, continue economic activity, worry about reform through the regulatory and legislative process."

The Federal Deposit Insurance Corp. followed a similar line of thinking as it rushed to create new programs, including one that expanded customer protection on certain accounts, and one that let banks issue FDIC-guaranteed debt, ensuring the paper would find a home in an otherwise unreceptive capital markets environment.

"We were mindful the entire time that when we got through this, this was going to have some lessons for us about how the system was going to have to be reformed, because we had to address what had led us to the crisis," said Arthur J. Murton, director of the FDIC's division of insurance and research. "But at that very moment it was more important to stabilize the system and leave the reforms for when the system was stabilized."

Since then, politics appear to have stood in the way of reforms that last fall seemed all but inevitable.

The powerful financial lobby has successfully fought back some of the toothier proposals, including limits on overdraft fees and bankruptcy protection for mortgage borrowers.

At the same time, the Obama administration has had to balance public furor over the bailout of Wall Street with a desire to avoid taking actions that could be viewed as destabilizing for the financial system.

The frailty of that balance was illustrated under the last administration when Lehman Brothers was allowed to fail. The move was widely interpreted as an attempt to set limits around the concept of moral hazard, but the markets effectively called the government's bluff.

"We survived it, but boy did the Fed and Congress have to do a lot to get us through that, and we're still not sure of the long-term effects," said Rich Levin, a partner in the restructuring practice at the law firm Cravath, Swaine & Moore LLP, and one of the authors of the 1978 U.S. Bankruptcy Code.

Moral hazard now looms even larger thanks to a crisis-driven consolidation — much of which was facilitated by regulators — that made some of the biggest institutions even bigger.

Bank of America Corp., two years ago a $1.58 trillion-asset company, now has $2.25 trillion of assets after buying Countrywide Financial and Merrill Lynch & Co.

Over the same period, assets on JPMorgan Chase & Co.'s balance sheet have swelled from $1.48 trillion to $2.04 trillion as it took over both Bear Stearns Cos. and Washington Mutual Inc.

Wells Fargo & Co. more than doubled in size to $1.23 trillion in assets after it acquired Wachovia Corp.

"This is the single most potentially negative legacy of the crisis: the Tarp and other actions have potentially created six, eight or even 10 entities with a fairly explicit 'implicit' federal guarantee," said John Ryan, an executive vice president with the Conference of State Bank Supervisors.

"Not only does that push a problem down the road; it consolidates and concentrates a problem, and exacerbates the risk."

With the "too big to fail" question still unresolved, the government faces the awkward task of preserving confidence in systemically important institutions while also extracting reforms from them.

Treasury Secretary Tim Geithner has been applauding banks that have repaid their Tarp money, without explaining how institutions are being determined fit to do so.

The government has allowed management teams to remain largely intact at the banks deemed important enough to undergo a government stress test last spring, while bailout recipients General Motors and American International Group have been cycling through CEOs with abandon.

"On some level, any given crisis has so many peculiarities that you really need to be flexible in the design of a response. On the other hand, you need to convince the public when you're forking over that kind of money that things are being done properly," said the Roosevelt Institute's Johnson, a former economist for the Senate Banking Committee.

"We turbocharged moral hazard in this last episode because we made sure nobody got hurt and nobody got fired. We didn't show them any tough love in that first go-around."

In the next go-around, if there is one, tough love may be the only rational option left.

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