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Give thanks for academic sleuths: Thomas J. Healey and Matthew A. Scogin on the intellectuals who sounded the alarm on Fannie, Freddie, the subprime mortgage market, and other dangers, and who are making financial markets safer and better for investors.

Article Excerpt
Academic researchers typically work in obscurity, but in a growing number of celebrated cases their relentless sleuthing is prying the lid off industry-wide financial fraud and improprieties that manage to elude the watchful eye of regulators.

By detecting and interpreting unusual statistical patterns or flawed practices, these researchers have set off early-warning alarms in such murky areas as subprime loans to risky borrowers, backdated securities options, improper trading procedures (a.k.a. late trading and market timing), and collusion among initial public offering underwriters. Their published studies have led to major government investigations and prosecutions and, ultimately, comprehensive new practices and safeguards in finance and regulation. Moreover, financial innovations such as tradable emissions permits and prediction markets--which provide the public and private sectors with strong market-based solutions to policy problems--are also products of aggressive academic probing.

The cases that follow describe how a new and determined breed of academic researchers is using its behind-the-scenes craft to turn the spotlight on fraudulent, deceptive, and questionable practices that populate the financial landscape.

Sounding the Alarm on Subprime Lending

The prime driver of the current crisis is irresponsible subprime lending that sent the residential mortgage market into a tailspin. While these challenges came as a surprise to many policymakers in Washington, the late Edward Gramlich, a Federal Reserve governor and professor at the University of Michigan, warned more than ten years ago of the dangers of subprime lending.

Subprime mortgage originations have grown from about $35 billion in 1994 to about $1 trillion last year. As Gramlich was quick to point out, that remarkable growth in subprime lending brought both good news and bad news. On the positive side, subprime mortgages--or mortgages made to individuals who do not qualify for prime mortgages--helped expand home ownership and made it easier for low-income borrowers and minorities to get mortgages. On the other hand, subprime products often involved loans with very low teaser rates that would reset to much higher rates after a few years. If house prices kept going up, borrowers...