Basically, I don't think anyone was minding the store. Theoretically, the model should work: if lenders adequately diligence their borrowers and make loans only to qualified people, historical default rates had a good chance of being accurate. You dump a whole lot of mortgages into a pool, and have an idea of what percentage of them will default. Based on that, you can divide interests the pool into different pieces, or tranches: a lower-quality piece (the B piece) that will pay interest at a higher rate, but will be affected first by any losses, and one or more higher-quality pieces that pay interest at the lower rates paid by good corporate credits.
What may be an apt analogy is the concept of "allowable filth" adopted by US food regulators:
Food Defect Action Levels: Levels of natural or unavoidable defects in foods that present no health hazards for humans. The fact that a certain level of filth may be unavoidable, and harmless to health, however, does not mean that you knowingly allow it into the food chain (from
this Training Manual:
Quote:
In looking for insect or rodent activity, inspect areas most likely to produce results.
It is general opinion of enforcement agencies that a plant will be clean and free of contaminants regardless of what must be done to prevent them. No system is permitted to be insect infested, even a raw grain handling system. While a court case may not evolve from such an infestation, this will appear on an “I Observe” form (Form FDA 483, Inspectional
Observations) for which the operation can be held accountable.
Concepts in the amount of allowable filth in any food operation have changed drastically in the past few years. This had diminished from a shovelful to a teaspoonful, and now even a potential contaminated situation must be looked upon with alarm.
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In the subprime market, too many people were looking at a contaminated situation and failing to take alarm.