As the subprime mortgage industry loses its shirt, it's becoming clearer that over the last few years, it also lost its head.

Take for example, Joe Flipper (not his real name) in Irvington, New Jersey, and his lender, Infinity Home Mortgage Company. Last year, Mr Flipper owned three properties on the same street in Irvington, financed with four mortgages from Infinity totalling Dollars 838,000.

In March and April 2006, all four of Mr Flipper's home loans were sold to a unit of Credit Suisse. But by May, the bank claims that Mr Flipper was no longer making payments on three of the four mortgages. It appears that Infinity had allowed him to borrow more than he could possibly repay, leaving Credit Suisse holding the soured loans.

Such a situation would have been hard to imagine when mortgage lending was strictly the business of banks, who held mortgages on their balance sheets and had to live with the risk of what they underwrote.

Mr Flipper's bank manager would probably have been much more circumspect about lending him such a sum for three properties that he did not live in. (Mr Flipper lives in a fourth property on the same street.)

But over the years, the mortgage industry fell victim to what economists call the "agency problem": a conflict of interest that arises when participants in a business have different incentives.

In the subprime market, this came about because lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of default. During several years of strong capital markets and strong investor appetite for high-yielding securities, lenders became accustomed to selling easily the home loans they made to Wall Street banks.

The banks in turn packaged and sold them into securities to investors around the globe. Banks earned nearly Dollars 2.6bn in fees for underwriting mortgage-backed securities last year, according to Thomson Financial.

Meanwhile, lenders relaxed underwriting standards to boost volumes as the mortgage refinancing boom faded from its 2003 peak. This included lending 100 per cent of property values, accepting borrower's statements of income and qualifying them based on introductory "teaser" interest rates rather than on the full rates that later took effect.

However, loan originators typically hold mortgages only briefly, while the teaser rates are still in effect, before they are sold on to the likes of Credit Suisse, who have been left struggling to get poorly capitalised lenders to buy back soured loans.

Mortgage brokers, intermediaries who sell mortgages and collect commissions from lenders, also played an important role. According to the Mortgage Bankers' Association, brokers now originate more than 70 per cent of subprime loans.

They pushed the envelope even further, in some cases breaching the already loose requirements imposed by lenders.

Brokers have strong financial incentives to get borrowers to take out expensive loans. They are compensated with so-called "yield-spread premiums" - commissions paid to the broker for originating loans at higher rates.

As a result, some brokers were also responsible for encouraging borrowers to misstate their incomes to ensure that they qualified for the loans. In reviewing a sample of "no doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their income with almost 60 per cent inflating it by more than 50 per cent.

Harvard University's Joint Center for Housing Studies explained: "A broker's incentive is to close the loan while charging the highest combination of fees and mortgage interest rates the market will bear."

Studies have shown broker-originated loans are more likely to default than loans originated through traditional channels, even after controlling for other factors like credit scores.

The high cost of foreclosing on a home used to give mortgage lenders an incentive to avoid leaving borrowers like Mr Flipper with unaffordable loans.

The new lending regime worked the other way. It made mortgage lenders and brokers willing to make mistakes, because someone else was going to learn the painful lessons.