How regulators, investors, and lenders failed to see a crisis coming
The credit crisis has reached its ninth month, but bankers, regulators, and investors are still flying blind. Every week seems to bring a new flare-up, from the panic in the auction-rate securities market to the Bear Stearns (BSC) blowup. Yet every new turn catches the pros by surprise.
Now Main Street, which is being forced to cover much of the tab for Wall Street's recklessness, wants answers to two basic questions: How could the crisis have gotten so bad? And why didn't the people in charge see it coming and prevent it?
In hindsight, the problems seem all too obvious. First, Wall Street dreamed up securities that promised beefier returns but made it harder for outsiders to see all the risks being taken. Next, a slew of fee-collecting middlemen—from mortgage brokers to bankers, securities dealers to hedge fund traders—descended on the market with powerful incentives to keep it going.
By 2006 some observers had begun warning of the excesses building in the credit markets and cautioning that regulators had fallen behind, while a few prescient investors even began betting against the market. But the early warnings were mostly ignored. Mortgage delinquencies were still low, the credit markets were supplying cheap money, and the economy was growing. Everyone from homeowners to bankers to policymakers wanted to believe the good times would continue.
Success bred blind faith. Regulators, led by then-Federal Reserve Chairman Alan Greenspan, praised the new technology of structured finance as a way of dispersing risk from banks to the far corners of the capital markets. Investors, meanwhile, took false comfort in the diversification supposedly provided by the thousands of mortgages underlying the securities. Of course, securitization also dispersed the responsibility for making sure risk was reduced when loans were made in the first place. As for any shortcomings, well, the Fed's approach was to put "high reliance on the markets to work out the problems," says veteran economist Henry Kaufman of Henry Kaufman & Co. He calls the mortgage debacle "probably the biggest mishap" in bank supervision ever. Adds Martin Fridson, CEO of research service FridsonVision: "Political pressure is always going to go toward pumping up the system" rather than toward reining it in.
By the time Wall Street's giant mortgage machine began to break down, all of the gears, levers, and flywheels were so interconnected that bankers and regulators couldn't hope to figure out how far the damage might spread.
Now it's up to the same regulators who overlooked the excesses for so long to restore stability. It won't be easy. Just as confidence builds on itself, so, too, does fear.
Back to The Financial Crisis Table of Contents