I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one's way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss. For example, a subprime loan extended in 2005 would earn the lender a higher yield in the event that house prices continued to rise, but perform quite badly when the housing market turned down. By taking a leveraged position in such assets, the slightly higher yield became an enormously higher yield, and while the game was on, the short-term performance looked wonderful. If the agent is compensated on the basis of current performance alone, and the principal lacks good information on the exact nature of the risks, the result is a tragically toxic incentive structure.
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