As I've read the ever-growing torrent of articles on the meltdown in the subprime mortgage market, my gut reaction is, how did this happen?

Cognitively, I know how it happened. Every player in the mortgage business has incentives to lend, lend, lend! The appraisers, mortgage brokers and lenders all stand to profit from more mortgages and have little downside if the mortgages aren't repaid. The lender bundles the mortgages together and sells them to large investment banks (who resell them to investors). This sale of mortgages allows the banks to lend again immediately - no need to wait for 30 years to be repaid.

This sale also represents an enormous moral hazard. The lender, who should be in the best position to know whether the borrower can repay the loan, doesn't care because they don't bear the risk of default. If increased regulation of the mortgage market is where we're headed - this looks like a great place to start.

For those of you with an abiding interest in finance, here's the rest of the story.

Investment banks take the bundled mortgages, known as mortgage backed securities or MBSs, and splice them into different tiers based on which tier gets repaid first (from payments made by borrowers). The last several tiers of securities are the riskiest because no money will be paid on these until the other tiers have been paid off. The benefit of these latter tiers is that they generally carry a very high interest rate. Subprime mortgages and the MBSs created from them are even riskier and carry higher interest rates.

Investment banks sell off these securities to investors - often large institutional investors - recouping their capital and allowing them to buy more mortgages from lenders.

Here's the last piece:

Over the last several years there has been a glut of capital chasing investments. Investors have poured money in MBSs, foreign stocks, etc. searching for higher returns. This deluge of money drove prices up, and interest rates/rates of return down. As a result, until recently, there was very little difference between the return on government bonds and the return on MBSs (shocking since one is backed by the US government and the other is backed by a homeowner paying double digit interest on a mortgage).

All of this was made possible by a period of global economic stability making investors forget that the assets they were buying were very risky. As the default rates in the US mortgage market have skyrocketed, investors' temporary amensia has evaporated.