The United States was unprepared for the 2007-2008 financial crisis, underestimated its seriousness and lagged in coming to grips with the damage, past and current Treasury chiefs said on Thursday.

Treasury Secretary Timothy Geithner told a commission investigating the causes of the crisis that it was vital now to tighten regulation of financial firms but not stop banks from taking prudent risks on behalf of customers.

In an apparent reference to a bid by some Senate Democrats to make banks spin off some derivatives trade, he said it doesn't make the economy safer to take risk-hedging activities outside of banks that offer the service to customers.

The commission's session on Thursday was the latest hearing to rake over the aftermath of the crisis, as the battle over how to prevent a repeat heats up in the Senate ahead of November elections.

There was little of the political rancor, though, in more than four hours of polite questioning of Geithner and his predecessor, former Goldman Sachs Chief Executive Henry Paulson, and Thursday's session broke little new ground.

Both men conceded the state of readiness before the subprime mortgage-induced crisis hit was woeful, and Geithner said the government's response was fundamentally inadequate.

Paulson said he was aware when he took office in mid-2006 that the potential for financial trouble was high but was taken by surprise by its severity.

What wasn't clear to me ... was the scale and degree of the problem, the gravel-voiced former Goldman Sachs head told the Financial Crisis Inquiry Commission.

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 fund to bail out major banks, a controversial move that angered U.S. taxpayers.

PROFITS BRED COMPLACENCY

Geithner, who took over Treasury in early 2009 after serving in the powerful position of New York Federal Reserve Bank president, said there had been widespread complacency in the financial system that left participants and regulators thinking they could weather any storm.

Financial crises are caused by the unwillingness of people to think the unthinkable and then to act speedily when corrective action to tighten regulation is required, he said.

If the government had moved more quickly to put in place better-designed constraints on risk-taking that captured where there was risk, the crisis could have been less severe, and if the government had moved more quickly to deal with the damage this would have been less severe, he said.

Paulson said he thought most of his own mistakes were ones of communication, especially about 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.

While all financial forms 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 their Wall Street overhaul package.

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.

The inquiry also heard from several financial firms, including investment manager PIMCO and GE Capital. PIMCO managing director Paul McCulley joined earlier criticism from Paulson of ratings agencies and said companies had relied too much on them.

Clearly the industry at large was not doing adequate due diligence and was outsourcing it, if you will, to the rating agencies, McCulley said. Paulson said earlier that companies used ratings as a crutch to avoid doing their own research.

Much of recent public anger over the crisis has focused on Paulson's former employer, Goldman Sachs, which is being sued by the Securities and Exchange Commission over allegations it hid information from investors in transactions involving a hedge fund.

Paulson said he had not been intimately aware of the derivative products at the center of the case, but defended banks' rights to short securities as long as clients are given appropriate information.

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

(Reporting by Glenn Somerville, editing by Patrick Graham and Padraic Cassidy)

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