I just saw this fascinating explanation of CDOs by Marketplace's senior editor, Paddy Hirsch. Until I saw this, I didn't realize that the poorly-rated elements of these instruments had become re-collateralized or maybe the better word is re-derivativized.
When a banker created the original security (S), s/he put together a package of mortgages and other debt that bear interest, and sold the package to investors, who purchased based on the risk they were seeking to undertake (let's call their choices: Saaa, Saa, Sbbb, Sbb, etc.). A second banker then created a derivative instrument (BS) based on (S), but instead of mortgages, this banker used the actual investments the first banker sold as the underlying asset. What's more banker#2 used the higher-risk bits of Sx, so (BS) is based on a bunch of Sbbb, Sbb-type investments vs. any debt instruments,and vs. Saaa or Saa.
With (S), people get paid in the following order (Saaa, Sss, Sbbb, etc.). The first people to get paid are (Saaa), but they get paid less as a percentage since they made a lower risk (and hence lower return) choice, but they get paid first. With (BS), the first people to get paid with (BS) are those that got paid last for (S).
Implication: people that bought BS got screwed.
How is it that the rating agencies have not been held accountable for this failure? Where is the Senate or House inquiry on these agencies' leaders?
It eludes me how simple accountability is abjectly ignored in our government.
When I wrote about this, I proposed a solution to the lending crisis. My idea was based on a purely market-economy-driven approach. I think if this approach were taken, while some of the Sx's and BSx's would have gotten a bit less money, most if not all of them would at least be paid for the simple reason that their interest payments would have resumed (albeit at a slightly lower level) very quickly. More critically, most homeowners would have been able to remain in their homes, continued to pay down their mortgages, and the banks and others in the financial system would have taken a bit of a hit but survived.
It's a simple idea, but it doesn't seem that simplicity is a preferred path.