The people buying the bonds know exactly what is backing them. There are fairly extensive reporting requirements, and every bond holder knows both how much is required in defaults before they are hit, and has estimates from the rating agencies of the odds of that. (For investment grade bonds the odds are supposed to be 99.9% of paying off, for B-grade bonds they expect a 30-40% failure rate.) Everyone involved in the process is keenly aware that risk has not been reduced in any way, it has merely been reallocated from one bond to another. The purchaser gets to pick the risks - and returns - they feel comfortable with. ([link|http://www.criimimaeinc.com/corporate.asp|Sometimes] they feel comfortable with too much risk...)
When loans are made, the banks have cash on hand to make the loans. Again no dishonesty here.
And when the banks have deposits, those are backed by cash on hand, exactly as regulations require. Where financial institutions are supposed to also back up debts owed by cash, they generally do as well. (If they don't, that is a regulatory issue.)
No individual player is stepping outside of regulations or behaving unrealistically. The problem I see is an overall systemic one. Banking rules are designed to limit the amount of credit that can wind up extended total in the system. They no longer are performing that function as effectively as they used to. The result is an increase in leverage to levels that historically were regarded as unwise and unhealthy.
Let me give a specific example. Life insurance companies make loans on commercial real estate. If they hold those loans, they are legally obligated to hold at least 3% of the value of those loans in cash on hand. If they convert those loans into bonds, sell some, and keep others, regulations say that they have to back those bonds with 0.3% cash on hand.
In other words when a life company like John Hancock goes from holding loans on its books, to passing loans into bonds, 2 things happen. The first is that with a given amount of cash on hand, they can hold 10 times as much debt. The second thing is that the cycle from making a loan to getting their money back shortens from 10 years to a few months. So, subject to the availability of people willing to buy the bonds, they can issue loans over 20x as fast with the same cash on hand, hold 10x the debt long term, and they lose all limits on how many loans they can make in the long term.
The result? A staid financial institution turns into a mean, lean lending machine, a small minority of the market gets the vast majority of the risk (and return), while the total amount of money available to lend goes up. This is a process that has happened for a lot of kinds of loans. It has happened to a different extent for different kinds of loans, but the result is an ongoing fundamental restructuring in our economy of who ultimately issues credit and how much credit they can issue.
Cheers,
Ben