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rewards, but cap the downside losses, encourage traders to take on excessive risk. one unintended consequence of financial innovation was that it enabled clever traders to create positions with considerable embedded leverage – that is, portfolios requiring little payment up front, but whose returns amplified changes in the value of the underlying assets. traders then had a natural incentive to gravitate towards these types of highly risky instruments. a related problem is that it is extremely difficult for management to observe the risk being taken on by their traders, particularly when innovative financial instruments have unusual return distributions. take, for example, a deeply out of the money option. this pays a steady income premium and has little variation in value when the underlying instrument is a long way from the strike price, but generates rapidly escalating losses in bad states of the world. in good times this looks like a high return, low risk instrument. only in very bad states of the world do the true risks taken on become apparent. information problems information problems have also been central to the crisis. most of the asset - backed securities that have proved toxic are far from simple. a plain vanilla residential mortgage backed security ( rmbs ) typically contains tens or hundreds of thousands of underlying mortgages and even the documentation on them can run to a couple of hundred pages. these instruments provide diversification, but unless the mortgages are fairly homogenous in nature, it will be difficult for an individual investor to monitor the evolution of the underlying risk exposures at all precisely. the problem is compounded when the pool of mortgages is continually topped up to replace maturing mortgages, as is the case with master trusts, as the characteristics of newer cohorts may differ from those of older cohorts. in addition, us rmbs contain embedded options that further complicates the evaluation of their worth. ordinary us mortgage loans are usually non - recourse and offer the borrower the option of both early repayment and of default if the price of the house falls below the value of the loan, leaving the lender to recover what they can from re - sale of the house at what will be an uncertain price. us sub - prime mortgages also embed an option for the lender. essentially sub - prime mortgages are structured as a rolling sequence of short - term loans, with the lender sharing in some of the increase in housing equity when house prices rise and having discretion over whether to offer a new and affordable loan depending on