Electrical engineers who design analog circuits learn an important rule of thumb: closed loop systems that provide only positive feedback to their inputs can become unstable. In the diagram at right, when A and B are relatively good amplifiers, the multiplication of their amplifying effect at the input Vin can cause the system to blow up.
The closed loop oscillator with only positive feedback is actually also a useful way to understand what caused the subprime mortgage market bubble, and what could have been done to prevent it.
According to the newspaper accounts, something like this was happening: home buyers were bidding for price (Vin), which was being approved by assessors. Banks were then offering loans based on the assessments to the buyers, and selling the loans to loan-buyers. Loan-buyers were then bundling the loans into CDOs (amplifier A), and then selling them to bigger loan-buyers, who were then bundling CDOs into CDO^2s (amplifier B). The bundling permitted for larger-scale buyers of loans to get into the market, which has a multiplying effect on demand for loans, which in turn gave the banks and assessors an incentive to offer loans at higher assessed values regardless of the underlying value of the property. There was no mechanism for negative feedback on price to enter the closed loop that buyers, assessors, banks, and institutional investors formed. And when A*B approaches 1, as it will eventually in a system with powerful amplifiers and no negative feedback, the system blows up.
Electrical engineers avoid these kinds of instabilities (usually!) by building negative feedback into the loop -- i.e., by introducing some circuit element that inverts or phase shifts the signal fed back into the input of the circuit so that the signal doesn't just keep growing and growing until it blows up the circuit.
Lee Fennell at the University of Chicago law school has a great suggestion for how we could have built negative feedback into the system: bifurcate on-site and off-site risks associated with homeownership, and make buyers pay separately for these two types of risk. So for example, a home buyer might be required to buy an insurance contract at the same time they purchase their home, the premium for which is large enough to permit the insurer to pay the home buyer off for a loss in home value should the value of her home later decrease precipitously because of off-site problems in her community (such as factory closings, pollution, or crime).
Now imagine how the same cycle would have worked: the home buyer makes a bid on both the home and the insurance for off-site risk -- the law has to require her to buy both, otherwise this doesn't work. The home assessor approves an inflated price. That's still the assessor's incentive because of the demand for mortgages. But the insurer then raises insurance prices in response to the assessment to offset the larger risk associated with the inflated price. If the home buyer can pay the increased premium, it's a deal. If not, the deal falls through, and prices tend to fall back to a level that more accurately reflects the underlying value of the property.
UPDATE: Upon reflection, I realize that the government actually does not have to require homebuyers to buy both the home and the insurance. In fact, only the insurance-provider and mortgage-provider would have to agree. This raises other complications (what happens when they're owned by the same entity, e.g.?), but it's useful to see at least that new legislation might not be required.