What does 'under-pricing of risk' mean, related to the financial crisis?

Interest rates on loans are supposed to be a measurement of the risk involved. If you have great credit, low rates. Bad credit, higher rates.



But instead, the government tried to intervene by forcing banks to make low cost loans to the underprivileged "sub-prime" borrowers.



As a result, the interest rate (the price of a loan) was not reflecting the risk, so the risk was under-priced.What does 'under-pricing of risk' mean, related to the financial crisis?
risk is traded. it imbues every single financial asset. when you purchase a risky asset of any kind you must determine the level of return you expect to get from it. financial traders get (sometimes explicit, sometimes implicit) risk budgets and must generate a level of return for the risk that they take on



underpricing risk means that you accept too low a return for the unit of risk that you are purchasing.



this is about more than interest rates on subprime mortgages, but appplies to



insurance (e.g. AIG went bust because it underpriced the risk on bond issuers defaulting)



share prices (the wider market underpriced the risk that AIG would underprice the risk on its Credit default swaps and hence take out too many, risky ones)



amongst others