The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.
...
One lesson of the current market chaos, then, is that it’s hard to get incentives right. Investors, after all, want fund managers and corporate executives to take reasonable risks—that’s the only way to make money—and many of them do just that. But, in trying to reward reasonable risks, we’ve encouraged unreasonable ones as well. And when you make it rational for people to bet the house, you may end up without a roof over your head.
