Krugman is right that this alphabet soup of securitization is complex and virtually impossible to value. During a market in which asset prices rise rapidly due to the easy flow of credit, such complexity does not worry investors. It's only when participants lose faith in the system that the complexity matters.

The aspect of the system in which they're losing faith is their ability to get paid. The participants in the securitization system I mentioned earlier get paid based on revenue, not profit. Why does this matter? A mortgage originator gets paid based on how big a pile of mortgages he or she can sell to borrowers, e.g., in proportion to the revenue he or she generates.

Mortgages, however, also have costs associated with them, in particular the cost of writing off mortgages on which the borrowers can't make the payments. The profit is what's left over after these costs have been subtracted from the revenue. If participants were paid based on the profit rather than the revenue, then they'd be careful about borrowers' ability to repay the loan in order to minimize costs and maximize profit.

The current revenue-based compensation system rewards participants for originating loans that borrowers could not pay back. 47% of subprime mortgages, for example, were made without documentation of the borrower's income ("liar loans"). So if the borrower signed the mortgage contract and a few months later stopped paying back the mortgage, the loan originator's compensation was not affected.

In his call for more regulation, Krugman misses this important point that if participants in the credit market are compensated in the right way -- i.e., based on profit rather than revenue -- then the system will regulate itself. How so? As I posted in October, if participants' bonuses were based on profit, then they would only make loans that they thought had a high probability of being paid back.

The result of such a shift in compensation would be a far smaller loan market -- for example, originators would not have pushed most of those 47% worth of liar loans. But we're now beginning to see just how high the costs can be of a market where society pays the price for a skewed system of rewarding credit decision-makers. The current system allocates the revenues to those who originate, package and sell the ABSs and shifts the costs to buyers of those packages while dropping enormous collateral damage on society.

To restore belief to the credit system, we don't need regulation as Krugman suggests. We just need to pay those decision-makers based on the profit they generate. If they need to consider the profit -- the revenues and the costs -- of their decisions, self-interest will lead them to do the right thing.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.