The mortgage bubble was exclusively created by the very explicit government subsidy on mortgage interest. Regular people defaulting on homes is both allowed and

The mortgage bubble was exclusively created by the very explicit government subsidy on mortgage interest. Regular people defaulting on homes is both allowed and rational behavior. It's not illegal, and blaming people for it misses the point entirely. The aggregate effect of the mortgage interest tax credit, on the housing market however, is highly dependent on how much income tax can be written off with it, which is itself highly dependent on how much income middle america makes. This is a volatile figure. Banks have to have limited liability in order to function. They accomplish this limited liability through explicit hedges called insurance policies. Insurers, unfortunately, have no such requirements to limit their liability, and in this case were liable for VASTLY more than they were worth. The problem is that this is a rational strategy. As soon as your liability goes beyond what your company is actually worth, it no longer makes any sense to try to limit your liability on other investments. In fact you want to take on as much liability as possible. If someone gives you a loan which you could never repay, then rational behavior dictates that you go to vegas and put the entire sum of the loan on red. If you win, you pay your loan back, and if you lose, you declare bankruptcy. The only problem with this is that it is fraud. This is where the story gets interesting, because the only thing required for the insurers to maintain plausible deniability in the event of a default on their massively overleveraged positions was for an "independent third party" to call the investments that they intended to insure "triple A". Regardless of whether or not those agencies were truly independent, the fact is that they are an unacceptable point of failure.