The crisis was caused by government policies. Just go check out the Wikipedia article — stop listening to the blasted media. The NYTimes reported that the crisis was coming …. in 1999, because the government literally forced lenders to give loans to people who –couldn’t– afford them. You can’t get around this.

Short Answer: Due to the ‘winner take all’ mentality. You see this on game shows, the lottery, court battles, Wall Street.

Sadly, your simple explantion of VaR modelling was lost on the “experts” who became so impressed with the sophistication of their models that they forgot about what happens in a more than 99% event.

That the banks take these risks is due to the fact that, as you say, there is big money to make on all the other days. Any since pay is driven by annual performance, and since performance is measured in comparison with peers over the same period, there is a major penalty for not taking risks that others took successfully. That is, the relative performance risk is extremely high for the individual banker. Besides, most individual bankers/traders do not expect to make a 30 year career of the business. The objective is to make a pile quickly and find some other line of work – ideally managing your assets from your boat. So, if a “Black Swan” occurs every 10 years or so and your time horizon is 1 year, most of the time you are going to be up. Furthermore, when you lose, you get to keep the profits (i.e. bonuses) you earned in previous years. Clearly a heads I win, tails you lose proposition.

Of course, this doesn’t explain the stupidity of bank CEOs who had massive amounts of their personal fortunes at risk in the stock of the bank they managed. Unlike many of the rank and file, they did not have an option that paid off if they were right and simply left them with zero if they lost (which encourages risk taking). They had real prospect of loss. It goes to show that armed with massive incentives for “outperformance” are not a way out of the agency problem.