1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach  and Himmelberg, Mayer, and Sinai ). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff report by Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
in other words, they didn't know WTF they were doing. They were buying and selling real estate securities, with new, recently "invented" methods of speculation without understanding the method. they were taking risks without understanding what the risks were.
"incentives were misaligned", which can be restated as they all had serious conflicts of interest.
and - what wasn't stated, is that the regulators couldn't see the forest from the trees because they were connected to, or part of, the industry that caused the mess.
Imagine a world in which the cops and judges came from a rotating pool of people that included bank robbers, hit men, and the like. That's what our system of financial regulation and management it.