Despite the panicked gravity of the credit crisis and the troubled bailout attempt in recent weeks, David Smick must have watched the events unfold with a tinge of bemusement. Smick, chairman and CEO of Johnson Smick International, Inc., might have been puzzled that so few other financial experts saw this mess coming as clearly as he did, as evidenced by his new book, The World Is Curved: Hidden Dangers to the Global Economy (Portfolio, 2008).

"So many people were saying that we have a credit crisis because there was over-aggressive lending to poor people," says Smick from his Washington office in between nonstop interviews with NPR, U.S. News & World Report, and numerous other media outlets eager for his insights. "Well, that occurred, but how does this bring the global financial system to its knees in a way that the world has not seen since the '30s? Something far more fundamental occurred. This is an enormous failure of risk management, both by the financial services companies themselves and by the regulators."

Smick, who edits and publishes The International Economy quarterly, is difficult to pin down politically. He worked on former Republican congressman Jack Kemp's staff, supported Democratic senator Bill Bradley's presidential campaign, and counts many well-connected influencers on both sides of the political divide. This is refreshing because his insights are sharp and candid.

"This shows you the power of the financial services industry," he notes. "Any other industry that pulled this kind of marginally legitimate approach would be run out of town or locked up. I'm not saying that the people are criminals -- yet here they are, getting a bailout. It's pretty amazing. You can see why there is outrage from both the right and the left."

Smick's analysis of the credit crisis is useful to corporate finance executives and their staffs outside of the financial services sector; a discussion with him produced the following insights:

• No one is eating our salad. Thanks in large part to the easing of the Glass-Steagall Act via the Gramm-Leach-Bliley Act in 1999 (passed with the bipartisan consent of the U.S. Congress and the support of the Clinton administration and Republican-appointed Federal Reserve Chairman Alan Greenspan), the banking sector fundamentally shifted how it conducted business. Syndicated banking gave way to the process of securitization.

"This was a big move because it allowed for a very effective process for assessing risk and handling and distributing capital -- unless the entire system of securitization came under attack. And this is what has obviously happened now," says Smick.

He favors a food analogy when describing the mortgage-backed securities that corrupted so many balance sheets. Investment banks have been "making up a giant salad of asset-backed securities," Smick explains. The salad has been tossed and looks delicious, but there's one problem: Lurking beneath the lettuce are various pieces of poisonous leaves. "If you eat that piece you die," he adds. "The problem is that the United States has gotten to the point where the world isn't ordering any salad because they don't know where the bad stuff is."

As a result, bank CEOs don't trust that their counterparts at other banks know what's on their balance sheets. And central banks around the world have a similar, and understandable, crisis of confidence.

The purveyors of these salads, or structured investment vehicles (SIVs), made fundamental miscalculations: They believed that they did not need to measure the risks inherent in these new securities too carefully (because they would be sold and resold quickly), and they seemed to believe that if the SIVs did encounter trouble, the fallout would not find its way back to the companies where they originated before they were financially engineered into a so-called "independent" structure.

• This is a "monumental failure of risk management." "Any small business man would have said, 'This is a bet we're making, and if we're wrong about the bet, it could destroy our business,'" says Smick. He also believes that "a financial executive in a $5 million company would be absolutely appalled at the risk management techniques of our largest financial institutions."

• It's also a failure of regulatory oversight. The investment banks are not the only ones to blame. "Look," says Smick, "I can argue that a senior SEC official making $160,000 a year is no match for a Goldman Sachs executive making millions with lawyers who make millions and secretaries who make $200,000, apparently. You look at that situation and you realize, 'OK, if they want to hide risk ... they can figure out ways to circumvent the system.'"

However, he also notes that senior regulators, including the chairman of the Federal Reserve, his vice chairman, the U.S. Treasury secretary, and others at the highest level of the regulatory structure could have asked some fairly obvious questions six months before the collapse of the subprime credit market.

"Nobody asked, 'How can a bank get a 35 percent return on equity at a time when the premier investors are doing less than half of that? How are they doing all this?'" Smick points out. "Nobody asked such questions, and that's pretty incredible. Until it all blew up, nobody said, 'Wait, the numbers don't add up.'"

• Regulatory reform is more important than a bailout. While an immediate response, a "bailout," is necessary, Smick maintains that a massive overhaul of the existing U.S. financial regulatory structure is more important. Why? Because if global investors don't trust our banking CEOs, we're liable to repeat the mistakes that Japan committed in the 1990s when nonperforming loans were left to languish on balance sheets and the country experienced nearly seven years of an economic standstill.

"The bailout is a necessary attempt to clear balance sheets and also to buy time," Smick explains. "But ultimately ... they need to go to where the money is. The money is global." And, right now, trillions of dollars are idling in global money market funds, global hedge funds, sovereign hedge funds, and other types of investment vehicles. "The U.S. went into the slowdown before the rest of the world, and we'll probably be the first to come out if we can get our act together," Smick notes. "The U.S. financial system will be reliquefied a lot faster if we do something to attract this huge pile of capital just sitting on the sidelines globally."

This is where the need for a new regulatory structure comes in. The cornerstones of this overhaul, Smick argues, should address crucial areas with regard to the asset-backed securities market: standardization and liability protection.

By standardization, Smick means truth in labeling. "Future asset-based securities should list their DNA," he says. "Who issued it and what's inside?" In terms of liability protection, there should be penalties for being deceptive or wrong in describing the DNA. This sort of transparency will attract investors back into this market much more quickly than they might otherwise return. After all, there will be bargains to be had, much as there was in the early 1990s, thanks to the Resolution Trust Corporation, the government-owned asset management company that liquidated assets, including mortgage loans, following the savings and loan crisis of the 1980s.

• There are no new risk management lessons to learn here (only the same old behavioral lessons). There is a reason that comparisons to past financial crises are constantly cropping up in the media today: Variations of this crisis have happened before and will no doubt happen again.

"This is just greed and naïveté," Smick says, by way of answering a question as to whether there are any fresh risk management lessons to be gleaned from our latest financial crisis (answer: no). "Intense greed."

The investment bankers who first floated these sophisticated financial instruments were members of the varsity team, Smick explains. "They were pretty smart and they knew how to handle these instruments," he adds. "And then the junior varsity team took over. They weren't as smart, but they copied the varsity and things were OK. During the past four or five years, we've had the freshmen out there or the practice squad. Well, they didn't know what they were dealing with. All they knew was that they were making money hand over fist by shoving this stuff out the door. And they weren't experienced enough to ask what's in the stuff and whether it might come back to pollute the market's sense of the parent company's viability."

• The next president's first appointees will be crucial. While Smick is frequently asked which presidential candidate is better positioned to address the crisis and its aftermath as president, he says it's impossible to know -- until after the election.

He advises CFOs to closely monitor the initial appointments to key jobs the next president makes during his first several weeks on the job. "This will tell you whether they are serious about keeping the U.S. a big fat juicy target for global investment," Smick adds. "You can deny that we need global investment but until we deal with our imbalance, we're heavily dependent. Whether we get out of this current mess will determine whether we are open for business and want to keep the capital flowing."

As the failure of the initially proposed bailout plan demonstrated, public sentiment and politics will also play a key role in how quickly the U.S. recovers from the credit crisis. Whether or not the heated public sentiment about the financial regulatory structure will continue remains open to question, of course.

Just ask Smick. During his book promotional activities, one television program said thanks, but no thanks to him because they had decided to feature another book on the show during the heat of the financial crisis. The program felt that one book -- in this case Breakthrough: Eight Steps to Wellness by Suzanne "Thigh Master" Somers -- was sufficient.

Smick takes the slight with a laugh; after all, he's also deeply interested in wellness -- of the global financial system.

Excerpts from The World Is Curved are available at www.theworldiscurved.com [1].