U.S. was ill-prepared for financial crisis: Paulson

The gravel-voiced former Goldman Sachs head said he had misgivings when he took over Treasury in mid-2006 about the potential for financial trouble but had been surprised by the scale of the crisis that unfolded.

He warned the nature of markets meant another crisis was likely, probably within a lifetime.

What wasn't clear to me was the scale and degree of the problem, he told the Financial Crisis Inquiry Commission looking into causes of the severe downturn. Nor were officials ready to deal with it.

There wasn't a plan in place when I arrived, I think we put a plan in place, he said. The Bush administration persuaded Congress to set up the $700-billion Troubles Asset Relief Program and bailed out major banks, a controversial move that angered U.S. taxpayers, who put up the money.

Debate in the United States on the crisis, its causes and what to do to prevent a future repeat has grown heated as legislation makes its way through Congress, but the panel's questioning of Paulson was polite and sober.

At the end of 2-1/2 hours of questioning, Paulson said he thought most of his mistakes had been ones of communication, especially the need for bank bailouts.

I was never able to explain to the American people why these rescues were for them and not for Wall Street, he said. I sure wish I'd communicated better a lot of the time.

Geithner said loosely-regulated non-bank financial firms had grown to a size nearly equal to the traditional banking system, with $8 trillion in assets.

Financed with short-term funds and with thin cushions of resources, the shadow banking system was particularly vulnerable to a classic run or banking panic, Geithner said.

While all financial firms need to be brought under tougher regulation as part of a broader regulatory overhaul, Geithner cautioned against preventing banks from engaging in some risk-taking on behalf of customers.

We cannot make the economy safe by taking functions central to the business of banking, functions necessary to help raise capital for businesses and help businesses hedge risk, and move them outside banks, he said.

CAN'T TURN CLOCK BACK

Democrats are battling staunch Republican resistance and a blizzard of amendments to the Obama administration's reform of Wall Street as a bill makes its way through the U.S. Senate ahead of November elections.

Paulson said while regulation needs to be tightened, the country can't go back to the former system of monolithic commercial banks that are walled off from investment banking.

Goldman Sachs itself has been sued by the Securities and Exchange Commission over allegations it hid from investors the fact that securities underlying a risky debt transaction were chosen by a hedge fund firm that bet they would lose value.

Paulson said he had not been intimately aware of the derivative products for which Goldman has drawn fire publicly in the United States over the past month but defended banks' rights to short securities as long as clients are given appropriate information.

He attacked credit ratings agencies as a crutch allowing banks to think less carefully about risk and said he was surprised at the lack of focus by so many market participants and regulators on the importance of liquidity in the crisis.

A central issue in the bill now in the Senate is whether to rein in banks' trading in some financial instruments to curb risk. Both Geithner and Paulson agreed it was necessary to regulate trading of derivatives more closely, and to put more of the trading on central exchanges.

Geithner said regulators could have stepped in earlier to get some control over the activities of non-bank financial institutions. But a principal cause of the crisis was the failure to provide legal authority to constrain risk in this parallel financial system, Geithner said.

He said reform proposals, if approved, would stiffen regulation and make the system safer by subjecting all financial firms to stronger capital levels.

A company like AIG or Lehman Brothers will not be able to escape consolidated supervision by virtue of its corporate form, and will have to operate on a level playing-field

with large commercial banks and traditionally regulated financial institutions, he said.

(additional reporting by David Lawder, Kim Dixon, Doug Palmer, Lisa Lambert and Karey Wutkowski)

(Reporting by Glenn Somerville, editing by Patrick Graham)