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Harvard Study: Regulators, Financial Institutions Failed to Heed Danger Signals Before Subprime Collapse

A new report by Harvard University’s Joint Center for Housing Studies concludes that major financial institutions, rating agencies, investors, and regulators all failed to heed warning signs in the days before the nation’s subprime crisis triggered a wider financial disaster in the United States.

Financial institutions also did not take adequate measures to stem the mounting systemic risk to the financial system, the authors assert. The capital markets allowed great risks to be taken in the primary mortgage market, while “financial engineering” in the markets shrouded the risks through the creation of vehicles such as collateralized debt obligations and credit default swaps.

Regulatory lapses contributed significantly to the financial meltdown, the report concludes: “Regulatory problems are at the heart of what went wrong. The stunning failure of so many large financial institutions and the rescue of several others with taxpayer dollars give weight to those who fault the regulatory system.”

Limited federal government oversight in the housing finance system and capital markets, along with deregulation and weak enforcement compounded the problems. At the same time, however, some federal policies encouraged home ownership and actually pressured banks, thrifts, and government-sponsored enterprises such as Fannie Mae and Freddie Mac to relax lending standards and aggressively pursue risky borrowers.

As pressure mounted within the financial system, other factors, including a climate that tolerated risk, worsened the situation. “The combination of a glut of global liquidity, low interest rates, high leverage, and regulatory laxity in the context of initially tight and then overvalued housing markets triggered staggering risk taking,” says Eric Belsky, managing director of the Joint Center and one of the study’s authors. “Capital markets supplied credit through Wall Street in large volumes for risky loans to risky borrowers and then multiplied these risks by issuing derivatives that exposed investors to risks in amounts much larger than the face amount of all the loans.”

“One of the biggest problems,” says co-author Nela Richardson, “is that the whole system created the illusion that risks were being adequately managed.” Rating agencies assigned AAA-ratings to large portions of securities backed by subprime and other inadequate loan pools and synthetic derivatives, for instance. “The fundamental underpinnings of the models used to rate the securities were deeply flawed and the capacity of third-party insurers and credit default swaps to make good on claims was inadequate.”

From 1985 to 1995, the private mortgage-backed securities (MBS) market grew from $3.9 billion a year to $69 billion, and increased more than 70% from $449 billion in 1995 to $769 billion in 2000, according to the report. Non-agency MBS issuance increased from $69 billion in 1995 to $170 billion in 2000.

Triggering a global crisis

Few economists or analysts predicted that performance in the nonprime mortgage market and the way that nonprime loans were converted into securities would cause a loss of investor confidence so profound that it would spark a severe global financial crisis, the report states. Not until August 2007 did the Federal Reserve decide that the eroding performance of subprime mortgage loans—and fizzling demand for the securities they backed—was enough of a threat to the broader economy to ease monetary policy.

But the Fed’s response, in lowering the discount rate for borrowing from the Federal Reserve, was too little, too late. Lehman Brothers collapsed, and the government felt forced to help rescue Bear Stearns, Merrill Lynch and insurance giant AIG. Credit markets froze in the fall of 2008, and the stock market tumbled as employers shed jobs and the problems spread internationally.

The asset-backed securities (ABS) market and the loans it backed became a critical part of the system that allowed the risk to the nation’s financial system to get out of hand. It played a key role in triggering turmoil in the global capital markets in mid-2007, the report says.

Among the short-sighted policies followed before the subprime crisis was one that allowed the leverage ratios of investment banks to be set by the banks themselves. Another failure was that no single regulator was responsible for gauging the level of systemic risk posed by practices in the financial markets or issuing regulations to contain the damage, also contributed to the catastrophic results.

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