The Root of the Financial Crisis

In a compelling fictional narrative, there are villains, victims, and heroes. One can give a compelling account of the financial crisis of 2008 that contains such characters, but it would be fictional: A true villain has to be aware of his villainous deeds. Instead, the primary candidates for the role of villain in the 2008 emergency — the executives of banks, Wall Street firms, and insurance companies — made out too poorly in the end to suggest willfulness. If these companies had done nothing but deliberately foist risks on others, they themselves would have survived. The fact that Bear Stearns, Lehman Brothers, and other companies took such large losses is indicative of self-deception.

Executives had too much confidence in their risk management strategies. Regulators, too, had excessive confidence in the measures that they had in place to ensure safety and soundness of banks and other regulated institutions. The crisis was both a market failure and a government failure. In fact, some of the most important financial instruments implicated in the crisis, including mortgage-backed securities and credit default swaps, owed their existence to regulatory anomalies. In the way that they specified capital requirements, regulators gave their implicit blessing to risky mortgages laundered through securitization and to treating a broad portfolio of risky assets as if it were a safe asset.

Simply put, there was a widespread gap between what people thought they knew to be true and what was actually true.

Housing industrial policy

Housing and mortgage debt are heavily influenced by public policy. It might even be fair to say that housing is to the United States what manufacturing exports were to Japan in the decades following the World War II: a sector viewed by government as critical for the health of the economy. Like manufacturing exports in Japan, housing in the United States has been the focus of industrial policy, in which government and private firms worked together to try to maintain continuous expansion. Increased home ownership and cheap and accessible mortgage finance were major policy goals, regardless of which political party held Congress or the presidency.

This housing industrial policy can be traced back quite far, but we shall begin in 1968, when mortgage securitization made its debut. In that year, Lyndon Johnson was an unpopular president fighting an unpopular war in Vietnam. Under the circumstances, having to ask Congress to increase the limit on the national debt always caused friction and embarrassment for the administration. At the time, the national debt included the funds raised by government housing agencies, and in 1968, the government found two ways to get this debt off its books.

The Federal National Mortgage Association, which had been created in 1938 to fill the void left by bank failures, functioned by purchasing home loans from independent originators known as mortgage bankers. Fannie Mae, as it was later called, acted like a giant national bank, financing mortgages from all over the country. At that time, it did not issue any mortgage securities. Instead, it funded its holdings by issuing bonds, as an agency of the federal government. To get Fannie Mae debt off its books, the government privatized it by selling shares to investors. The government may have retained an implicit promise not to allow Fannie Mae to fail, but this implicit promise appeared nowhere on the government’s balance sheet.

Selling Fannie Mae, however, still left the government issuing debt to finance mortgages under loan programs of the Federal Housing Administration (fha) and the Veterans Administration (va). To take these mortgage loans off the books, Johnson created the Government National Mortgage Association (gnma), which pooled loans insured by fha-va into securities and sold them to investors. Thus, the government no longer had to issue its own bonds to finance these mortgages, but it continued to guarantee that fha-va mortgages would not default.

Mortgage securitization has always had two major advantages. One is that it permits accounting gimmicks, such as moving mortgages off the government books and thereby lowering the official national debt. Similar accounting tricks occur with every major surge in securitization.

The other major advantage of securitization is that it allows less-regulated firms to act more nimbly than depository institutions. When the regulated banking sector has been unable to satisfy mortgage demand, securitization has, for better or worse, stepped in to fill the gap. While the depository institutions (banks and savings and loan associations) have been restrained more firmly by state regulators or agencies in Washington, issuers of mortgage securities have been able to provide funds. Still, if the regulatory playing field had always been level, it is unlikely that securitization would have emerged.

Indirect costs

To understand the problems inherent in securitization, imagine that you are a bank executive faced with two alternative routes for obtaining mortgage loans — a direct route and an indirect route. In the direct route, your loans are originated by your own staff. You establish standards, policies, and procedures for loan origination. You choose the markets in which you would like to originate loans, and you will probably focus on communities where you know the local economy. You hire and train personnel to follow internal guidelines. Your compensation policies incorporate incentives for them to accept or reject applicants in accordance with company policy. Once the loan has been made, if the borrower misses a payment, your staff follows company procedures for contacting the borrower and resolving the problem.

In the indirect route, loans are originated by persons unknown to you, following guidelines established by someone else. The loans may come from communities with which you are totally unfamiliar. The originators may very well be paid on commission, which they can receive only if they close a loan — never if they reject an applicant. If the loan gets into trouble, you will have no control over how the delinquency is handled.

No sane bank executive would choose the indirect route over the direct route. In economic jargon, the “agency costs” of the indirect route are prohibitive. The originators of mortgages in the indirect route are operating under incentives that are contrary to the bank’s interest. The misalignment of incentives between the bank and those acting as its agents in the indirect route will force banks to incur additional costs to monitor and review the work of the originators. Even with most diligent efforts, the bank is likely to incur higher losses from defaults as originators squeeze bad loans through the cracks of its monitoring systems.

It is surprising, then, that as of 2008, nearly three-fourths of mortgage debt in the United States originated by use of the indirect method. To reach this point required a combination of Wall Street ingenuity and regulatory anomalies.

Some of the ingenuity involved finding an intermediary to bear the risk of mortgage loan defaults. For example, gnma securities are guaranteed by the government, with the default risk on the mortgages ultimately borne by fha. As we will see, the concept of guaranteed securities spread to other types of mortgages, although the quality of the guarantees became suspect during the crisis period in 2008. Without the guarantees — or the apparent guarantees — indirect lending would not have been possible. Even with guarantees, there was nothing cost-effective about indirect lending. The main cost advantages of securitization came from accounting and regulatory anomalies.

Securitization’s growth

In 1970, there were many regulatory constraints hampering savings and loans (aka s&ls or “thrifts”), the dominant mortgage lenders at the time. Their deposit interest rates were limited by government-set ceilings, under what was known as Regulation q. Because of ever-rising inflation, market interest rates were much higher than Regulation q ceilings, and the thrifts were soon to be starved for funds. Nimbler, less regulated competitors — money market funds — siphoned money away from retail deposits.

Thrifts in California were particularly frustrated by a shortage of funds. At the time, depository institutions could not operate across state lines, and the relatively abundant savings in the Eastern United States could not reach the West.

To address the mismatch between savings in the East and mortgage demand in the West, Congress established Freddie Mac, with a goal of creating a national “secondary market” in mortgages. Freddie Mac was placed under the Federal Home Loan Bank Board, the agency that had oversight of the savings and loans. Unlike the thrifts themselves, Freddie Mac could move funds from one coast to the other. For example, Freddie Mac could bundle mortgage loans originated by a thrift in California into securities that Freddie Mac could sell to a thrift in New York.

Freddie Mac was able to do what the thrifts themselves were not able to do because of regulation. Had Regulation q not been in effect, California thrifts could have increased interest rates on deposits to attract sufficient funds to allow them to meet mortgage demand using the direct method of lending. Alternatively, if restrictions on interstate banking had been lifted, a multi-state holding company could have channeled excess savings from its banks in the East to be used for mortgage loans by its banks in the West — and it could have done so without resorting to indirect mortgage origination.

To make the secondary mortgage market efficient, Freddie Mac stepped in to guarantee security holders against mortgage defaults. If a mortgage in a Freddie Mac security stopped making payments, Freddie Mac stepped in, pulled the mortgage out of the pool, and paid investors the full principal due on that mortgage. At that point, Freddie Mac would attempt to recover as much as it could through the foreclosure process.

The 1970s were not kind to the savings and loan industry. With inflation out of control, market interest rates steadily rose. Relaxation of Regulation q interest-rate ceilings proved to be a mixed blessing, to say the least. Although it enabled thrifts to raise interest rates to stem the loss of deposits, it raised their cost of funds above the rates they were earning on mortgage loans from prior years, when inflation and interest rates had been lower. In the late 1970s, Lew Ranieri and Robert Dall, two executives at the bond trading firm Salomon Brothers, created a vision of a U.S. mortgage market dominated by securitization, which would enable investment banks to participate in the largest credit market in the world. With the thrift industry on the ropes, their timing was good. However, it took a combination of luck and intentional lobbying to shape the playing field in order to fulfill their vision.

Starting in 1980, newly appointed Federal Reserve Chairman Paul Volcker decided to break the back of inflation with contractionary monetary policy — i.e., higher interest rates to lower the rate of money growth and slow the economy. Interest rates soared to double-digits, and many thrifts became insolvent. Before they were shut down by their regulators, though, not a few of them made one last desperate effort to borrow money to stay in business.

The s&ls wanted to use their mortgage assets to raise cash, but they did not want to sell those mortgage assets. Under accounting rules that prevailed at the time, the thrifts were allowed to record their mortgage assets as if they had not declined in value. In fact, in an environment where new mortgages were being originated with interest rates of 12 percent, an old mortgage that carried a 6 percent interest rate and a $100,000 outstanding balance was worth approximately $50,000. Selling such loans would mean recognizing the losses, which would expose the negative net worth of the institution, which in turn would force regulators to shut it down.¹

Thus, without selling mortgage loans, the thrifts could not raise cash to operate. On the other hand, if they sold the loans, they would have had to recognize losses on the assets. The thrifts appeared to be in a trap.

Wall Street proposed a solution: a new security program at Freddie Mac, called Guarantor. Under this program, a thrift would exchange a package of its old mortgages to Freddie Mac for a security backed by those mortgages. The security could then be used as collateral by the thrift to borrow against. Freddie Mac earned a fee (as high as 2 percent) for engaging in this purely paper transaction. Wall Street firms earned fees by finding institutional investors to lend to thrifts, with the securities as collateral. The losers, ultimately, were the taxpayers, since most of the thrifts ultimately still went bankrupt, having been bled by the fees and having made further unsound investments.

The key to the Guarantor program was a regulatory accounting ruling, much sought after by all parties, that the exchange of mortgages for a security backed by those mortgages did not require the thrift to mark the value of the security down to market value. Even though the loans that the thrifts received from institutions were based on market values, rather than book values, the thrifts were allowed to keep the securities on their books at fictional book values. Without this peculiar accounting treatment, Guarantor would not have gotten off the ground. Instead, thanks to regulators’ tolerance of an accounting fiction, Guarantor became a large program at Freddie Mac. Fannie Mae, seeing the profit opportunity, entered the mortgage security business with its own version of Guarantor, called Swap.

Until this point, Fannie Mae and Freddie Mac had operated differently from one another. Freddie Mac primarily bought loans from thrifts, packaged the mortgages into securities, and sold the securities to investors. Fannie Mae primarily bought loans from mortgage bankers and held them in its portfolio, financed by debt. Therefore, Fannie Mae took interest-rate risk as well as mortgage-credit risk. In 1988, Freddie Mac stock was divided among thrifts. In 1989, the stock was made available to the public on the New York Stock Exchange, thus privatizing the agency just as Fannie Mae had been privatized 20 years earlier. In its new form, Freddie Mac adopted and increasingly implemented Fannie Mae’s strategy of buying loans for its portfolio, funded with debt.

Perverse capital requirements

By 2003, freddie mac and Fannie Mae together held 50 percent of the mortgage debt outstanding in the United States. Depository institutions could no longer compete effectively with the two companies, known as Government-Sponsored Enterprises, or gses.

The key competitive advantage of the gses involved capital requirements. Banks are required to hold 8 percent capital against risk-weighted assets. In 1989, the United States adopted requirements developed by the Bank for International Settlements; these are called the Basel I agreements. Under Basel I, mortgage loans have a risk weight of 50 percent so that the capital requirement for a mortgage loan would be 4 percent. More-refined capital requirements, known as Basel II, allow low-risk mortgages, with down payments of more than 40 percent, to receive a risk weight of 20 percent, while loans with down payments of 20 to 40 percent have a risk weight of 35 percent. For mortgage loans with a down payment of 20 percent or more, bank capital requirements are much higher than they are for Freddie Mac and Fannie Mae. Freddie Mac and Fannie Mae are subject to different regulations. In practice, their ratio of capital to assets was less then 3 percent, which was well below that of banks.

The gses capital requirements were based in part on a stress test. They were supposed to hold sufficient capital to be able to withstand a decline of housing prices comparable to a severe historical recession. Whether this stress test was calculated properly for the portfolio of high-risk loans that the firms acquired starting in around 2004 is questionable. Yet, for loans with substantial down payments made to credit-worthy borrowers, the capital requirements for the gses were more accurate than the crude requirements given to banks.

As of 2003, the capital requirements were an anomaly that artificially restrained depository institutions from competing effectively with the gses. But capital requirements were not yet a source of instability in the banking system. Problems in the banking system developed only when securitized sub-prime mortgage lending took off.

Private securitization

By 2004, a number of market developments caused the emergence of a significant segment of mortgage loans with low down payments, originated by mortgage brokers and securitized by Wall Street firms. These mortgage securities are called private securities, to distinguish them from securities issued by the gses. Private securitization reached for a segment of the market that was considered too high-risk by the gses. That segment included borrowers with impaired credit or with income levels that historically would have been considered too low to qualify for the housing expenses being incurred. This so-called sub-prime market was dominated by private securitization.

One of the developments that promoted private securitization was credit scoring. In the late 1990s, credit scoring had replaced human underwriting at the gses. In addition to being inexpensive and reasonably accurate, credit scoring helped to reduce the agency costs associated with indirect lending. A credit score is objectively calculated by an independent specialty firm (Fair Isaac is the most well known), which removes the concern that a third-party underwriter could be hiding flaws in the borrower’s credit history.

Another development was the concept of risk tranches. The cash flows from a pool of mortgages could be divided in such a way that all of the first, say, 5 percent of mortgage defaults would be borne by the subordinate security, with senior securities insulated from that portion of default risk. Insulated in this way, senior securities were able to earn aa or aaa ratings from agencies, which in turn made those securities eligible to be held in institutional portfolios. For example, a bank could hold a aa security and have it receive a 20 percent risk weight.

In reality, a senior security backed by sub-prime mortgages with down payments of less than 5 percent was much more likely to suffer losses than a prime mortgage with a 20 percent down payment made by the bank. But even under Basel II, capital regulations gave a 20 percent risk weight to the security and a 35 percent risk weight to the safe mortgage loan. The regulators were telling the banks to prefer securities backed by someone else’s junk loans over safe loans originated directly by the bank.

The aaa and aa ratings of mortgage securities have come under fire. Relative to those ratings, the actual performance of the securities has been dismal, and a congressional hearing in October uncovered internal memos in the agencies warning that the ratings were inaccurate. The problems with the ratings are discussed extensively in a paper, “The Economics of Structured Finance,” by Joshua Coval, Jakob Jurek, and Erik Stafford.² They cite evidence that at least one of the rating agencies, Fitch, did not even consider the possibility of house-price declines when it rated mortgage securities.³

Economists report that large Wall Street firms had internal models of mortgage default risk that showed that a aaa-rated mortgage security was far riskier than a aaa-rated corporate bond. These risk models were used by sophisticated investors to value mortgage-backed securities. On the other hand, the ratings made a difference to less-sophisticated investors, particularly banks, given the incentives created for the latter by capital requirements.

Innovation inflates a bubble

The financial innovations of credit scoring, senior-subordinated private mortgage securities, and loans with low down payments served to broaden the mortgage market. As more households became able to borrow, the demand for homes expanded and prices rose. This had the effect of reducing mortgage defaults. A homeowner’s equity consists of the down payment plus any price appreciation that has taken place since the home was purchased. When that equity is positive, a borrower who finds it difficult to make the payments on a home will either sell the house or refinance it with a larger mortgage rather than default.

As long as house prices were appreciating, the performance of mortgage securities was excellent. This encouraged more lending, which encouraged more home ownership, which in turn fed into faster house-price appreciation. Much of the new home buying was speculative. Over 15 percent of home loans in 2005 and 2006 went for non-owner occupants, meaning that they were bought for investment purposes. This was more than triple the rate of investor loans that were made a decade earlier. Economist William Wheaton estimates that the housing stock grew by 6 percentage points more than the number of households, as the speculative demand for housing boosted production.

Policymakers encouraged this burst of housing speculation. Enforcement of the Community Reinvestment Act for banks and the “affordable housing goals” for the gses meant that these companies had to make sure that a sizable percentage of mortgage loans went to low-income borrowers, even as the run-up in house prices was increasing the ratio of median home prices to median incomes. While traditional rules of thumb suggested that a house price should be no more than three times the borrower’s income, in some California counties the ratio of price to income approached ten.

Pressed to meet their “affordable housing” goals, the gses for the first time began to back sub-prime loans and other mortgages with low down payments. Despite internal warnings that these purchases threatened the safety and soundness of Freddie Mac and Fannie Mae, the two companies took on unprecedented exposure to credit risk. Under the stress-test methodology, the mortgages that the gses were now guaranteeing would have required much higher levels of capital than traditional mortgage loans. However, concerned with not diluting earnings, the companies postponed raising the capital needed to restore compliance with the stress tests.

Suits and geeks

The conflict between executive decisions and internal warnings at Freddie Mac and Fannie Mae was an example of what I call the “suits vs. geeks” divide. The geeks were staff who used statistical models to predict mortgage defaults under alternative scenarios and to translate those simulations into values of various mortgage securities. The suits were executives with decision-making authority. Often, the geeks saw lower values and higher risk in the securities than the suits, but the suits were in charge of setting corporate portfolio policy.

Innovative financial instruments, such as senior-subordinated structures for private mortgage securities, were understood by financial engineers (the geeks). They were understood less well by executives and major policymakers (the suits). The geeks regarded the aa and aaa designations by the rating agencies as faulty. The suits took the ratings as reliable. Geeks watched suits develop ever-increasing confidence in quantitative risk management, including credit scoring and bond default modeling, which was used to create the market for credit default swaps. Once their initial skepticism was overcome, suits became excessively confident in quantitative risk modeling. Then, when the crisis broke, the suits became excessively wary, driving down security prices and creating a liquidity panic.

The geeks treated mortgage securities as having embedded put options that were very close to being in the money — i.e., the security-holder has effectively sold mortgage borrowers an option to default. Borrowers are more likely to exercise that option if their equity in the home is negative, in which case the option is in the money. When initial down payments are low, it only takes a small decline in home prices to make the default option in the money. This option to default will be exercised particularly aggressively by non-owner-occupants (recall that the rate of investor loans had tripled by 2005 and 2006 to over 15 percent of all mortgages).

The suits, on the other hand, treated mortgage securities as bonds, ignoring the power of the embedded options. In August and September, when policymakers began to perceive the severity of the crisis, the suits thought that mortgage securities could not possibly have lost as much value as their market prices indicated. Federal Reserve Board Chairman Ben Bernanke insisted that if the securities were “held to maturity” that they would have higher values. Treasury Secretary Henry Paulson proposed to have the government buy and hold these securities in order to “unclog” the financial system. However, this thesis, which in effect argued that the geeks had wrongly priced mortgage securities, proved to be incorrect. The banks that had invested heavily in these securities were truly under-capitalized. The mistakes had been made by the suits, not the geeks.

A complex phenomenon

Overall, one can describe the housing and mortgage credit bubble as a complex phenomenon that emerged for a number of reasons. Much of the blame should be allocated to the growth of securitization, which in turn was affected by a number of regulatory anomalies, notably capital requirements that favored securities backed by risky mortgages over ordinary direct mortgage lending, even when the latter included loans with sizable down payments.

Another large share of the blame can be assigned to the emergence of a large volume of mortgage loans with low down payments. This created a situation in which housing equity consisted largely of price appreciation. That accentuated the housing cycle, because with no money down almost everyone can buy a home when prices are rising and almost no one can buy a home when prices are not.

Finally, some blame goes to the “suits vs. geeks” divide. Knowledge of mortgage credit risk and the behavior of mortgage securities was separate from power over portfolio decisions. The executives who took on mortgage credit risk at banks, insurance companies, and the gses did not fully appreciate the chances they were taking. The financial engineers responsible for the creation and pricing of complex mortgage securities did not educate key executives or heads of regulatory agencies about the true nature of the new products. It was tempting to believe that securitization reflected the “genius” of Wall Street rather than a dubious process artificially sustained by regulatory anomalies.

Other narratives

Other narratives, however, do exist. Some pundits wish to blame the financial crisis on a “general atmosphere of deregulation” and “free-market ideology.” But they usually avoid citing specific policies. The fact is that securitization, house price inflation, and the lack of understanding of risk-taking on the part of executives were little influenced by specific relaxation of financial regulation. The most powerful regulatory impetus — the anomaly in risk-based capital standards — was subtle and cannot be attributed to any particular regulatory ideology.

Another narrative is that the Community Reinvestment Act and the promotion of lending to racial minorities and borrowers with bad credit histories was a critical factor. But it was the nature of the mortgage loans — in particular, the relaxation of requirements concerning making a significant down payment — that caused the housing cycle to get out of control. The problem with the loans made in 2003–07 was not the color of the borrower’s skin or the content of his credit report. It was the fact that public policy so heavily favored mortgage indebtedness and, hence, housing speculation rather than true home ownership. Had the subsidies and mandates instead been geared toward encouraging new homebuyers to save for down payments, the impact would have been less destabilizing and better for all concerned.⁴

Still another narrative is that new derivative instruments made the system fragile because of counterparty risk. Credit default swaps are often cited as an example of a market that might have been better regulated by an exchange.

With a credit default swap, the buyer of a swap pays a regular fee equal to a percent of the bond’s principal value. The seller of a swap agrees that in the event of a default, the seller will purchase bond from the swap buyer for its full principal amount. Thus, the credit default swap acts like an insurance policy on the bond. Credit default swaps were traded privately, with investment banks acting as brokers. That meant that there was counterparty risk—i.e., when one party to a contract could default on that contract. In particular, the buyer of a credit default swap has to worry about whether the seller will truly make good in the event that the bond default occurs.

The problem with credit default swaps is not counterparty risk, though. The problem is that there is no natural seller of default swaps. With corn futures, say, there is a natural buyer (the food processor) and a natural seller (the farmer). With credit default swaps, there is a natural buyer (the holder of a risky corporate bond), but there is no natural seller. Without a natural seller, it’s doubtful that an organized exchange can work. In practice, the sellers of credit default swaps are relying on two strategies, neither of which is really sound. One strategy is diversification. That means that a large seller, such as an insurance company, will have many swaps outstanding, but only a few defaults will occur at a time. The analogy would be with a large life insurance company, which can presume that only a small fraction of policyholders will die at any one time. However, the crisis of 2008 made a mockery of diversification, as the threat of defaults became widespread.

Apart from diversification, another strategy for selling credit default swaps is dynamic hedging. Suppose that the seller of a default swap on a bond issued by xyz Corporation starts to suspect that the probability of a default on that bond is increasing. The seller can hedge its risk by selling short either xyz Corporation stock or other xyz Corporation bonds. In the event of a default, the loss that the seller will take by having to purchase the defaulted bond at par will be offset by the gains on the short-selling. The problem with dynamic hedging is that it only works in a relatively stable market, in which few others are attempting similar strategies. When everyone is trying dynamic hedging at once, the result is a wave of short-selling that overwhelms markets. If dynamic hedging is used by sellers of credit default swaps, they generate systemic risk. Furthermore, credit default swaps are also subject to liquidity risk, even if the fundamental calculations of default risk are correct. Even without a single default, an increase in the likelihood of defaults can undermine the seller of default swaps. The seller may lose liquidity due to margin calls or lose solvency due to the change in the value of the swaps.

There are many ways for financial institutions to get caught up in processes that amount to selling put options that are far out of the money. The gses, by providing guarantees of mortgages, were selling put options that were out of the money as long as house prices were not falling sharply. Holders of senior tranches in mortgage securities were in the same position. A lesson of this crisis is that sellers of out-of-the-money options can become too complacent about the risks that are being taken to earn the option premium. As the probability increases that the options will be exercised, the seller’s institutional viability can be undermined long before the options actually are in the money.

A deeper narrative of the financial crisis is that risk-taking tends to be cyclical, and that the housing bubble reflected a boom in risk taking. In the period when the bubble was inflating, Federal Reserve Chairman Ben Bernanke himself spoke of the “global savings glut” that was helping to feed U.S. credit markets. Rapidly growing economies, particularly in Asia, produced incomes that grew faster than consumption. Having experienced currency crises in the 1990s, Asian investors, including central governments, sought dollar-denominated investments. This large increase in savings found its way into the U.S. housing market. As noted earlier, one could argue that if housing finance had been better regulated, the global savings glut would simply have found its way into another risky arena, leading to a different bubble and a different locus for the crisis.

Knowledge and power

In hindsight, it seems that the regulators had the tools but lacked the knowledge to prevent the 2008 financial crisis. Had policymakers determined that the housing bubble posed risk, they could have warned banks and the gses to limit their risk exposure starting in, say, 2005. Had policymakers understood the way that bank capital requirements were distorting the mortgage market away from direct lending and toward securitization, they could have adjusted those capital requirements. Had regulators understood the extent to which the gses were trading off safety and soundness in order to meet affordable housing goals, they could have required the gses to change behavior, either by buying fewer risky loans or by raising more capital. Had regulators understood the way that rating agencies were mislabeling mortgage securities, they could have issued rules to banks requiring them to treat mortgage securities as riskier than their ratings signified.

The failure to regulate in time was not due to lack of tools. Nor was it due to lack of will. The failure to prevent the crisis was due to the lack of knowledge among key policymakers: There was a discrepancy between knowledge and power.