https://en.wikipedia.org/wiki/Collateralized_debt_obligation...
EDIT: and what that diagram misses is that, because the originators couldn't manufacture mortgages fast enough to satisfy the demands of investors/speculators, banks started manufacturing CDOs directly (synthetic CDOs), meaning investors' total notional exposure to mortgage performance could exceed the total value of outstanding mortgages.
It's a helpful diagram! What it doesn't say is each of those AAA tranches actually [erfpr,ed. When you look back at how the AAA tranches of CDO-squareds circa 2005 to 2008 paid out, they pretty much all behaved like AAA securities.
Those tranches were solvent. In many cases, their junior tranches were solvent. What none of those tranches were was liquid. I can hold a security that will pay me $1,000 indefinitely, but if nobody will buy it for more than a penny, it isn't useful if my trading group is busy diving into a liquidity crisis. (Granted, ratings don't say anything about the liquidity of a thing. Just its solvency.)
I don't know the answer. A quick Google search suggests bucket shops were made illegal in the US, but I don't know the details, or why this doesn't make derivatives illegal.
One rationale for regulation I could imagine is to protect 'investors' from counterparty risk in case the bucket shop is inadequately hedged. Presumably synthetic CDOs were manufactured from derivatives whose counterparties were big banks, which are subject to capital adequacy requirements which in theory provide some protection.
AAA doesn't mean that the security will pay out. It means they have the lowest risk and it means that it's the most expensive. Even AAA-rated debt can fail.
What happened was that large financial institutions were paying top dollar for AAA mortgage-backed securities, but after it was revealed that all of these mortgage-backed securities were poisoned with subprime loans, the value of those securities plummeted. The value of those assets dropped, which put the holders of those assets in a bad financial situation because they didn't have as much money as they thought and they also couldn't sell them. Some companies or funds are legally required to hold only AAA securities. This caused reverberations throughout the financial industry.
My point is there was no “poisoning of AAA securities with subprime.” Subprime mortgages can be legitimately assembled to produce AAA securities. This happened, and those securities ultimately paid out like AAA securities. They just didn’t perform, liquidity-wise, like Treasuries. (Neither did other corporate AAA securities, for that matter. OTR Treasuries are OTR Treasuries.)
Not quite. Suppose I take a million subprime mortgages and say “I’ll pay you the first dollar any of these mortgages pay”. The probability that all of those mortgages default is slim. So this particular top-of-the-stack claim is, indeed, a quality one.
This is what people mean when they say “top tranche” of a CDO. The CDO is the pile. The tranche is the priority. The top tranches were rated AAA. Looking back, they pretty much all paid as expected.
The problem is a AAA rating means the security will pay out. Not that it will be able to be sold like a Treasury. So due to a confluence of things, many institutions needed liquidity, and when they tried to sell these instruments found there weren’t enough buyers. The desperate fire sold, thereby requiring others to mark down their holdings, and behold: crisis.
There was also fraud in origination. And fraud elsewhere largely unrelated to the proximate causes of the crisis. But the proximate element was a classic one: a liquidity crisis. (The root element was over-leveraging.)