Financial bubbles breed accounting fraud. Those of us who warned of the stock bubble in the late nineties were not surprised by the Enrons and WorldComs that surfaced when the bubble deflated. Bubbles make it possible to paper over all sorts of questionable accounting or outright fraud. When the bubble deflates, these practices can no longer be hidden.
The analogous problem in the housing bubble is with appraisals. The basic story is simple. Mortgage issuers make their money by issuing mortgages. Once the mortgage is issued they sell it to someone else (in many cases, the key figure is actually a broker who never holds the mortgage), so they have little interest in accurately assessing the quality of the mortgage. To get a mortgage issued, it is necessary to have a house appraised at a value that justifies the mortgage.
The issuer generally chooses the appraiser. Okay, suppose an appraiser comes in with a low number and the mortgage can't then be issued? The issuer is very unhappy, no money here. The issuer then finds another appraiser, who will come in with a higher number for the value of the house. Appraisers, being intelligent people, come to realize that they don't get jobs if they give low appraisals, so appraisers come in with high appraisals so that the mortgages can get approved. Everyone is then happy, until the bubble bursts.
The Wall Street Journal has a good piece on this topic today. It would have been nice if they had run this piece three years ago, before the damage had been done. But, maybe this can help stop the next financial bubble driven train wreck:)