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I'm gonna have to weigh in here with the writers who point out how misleading this article is. The betting-on-football analogy is totally wrong: it doesn't explain anything about CMO's or derivatives that can't honestly be said about any other form of investment security. The problem here isn't fatcat Wall Street investment bankers, from New York City no less, writing opaque disclosure documents (to be honest: in my youth I helped write disclosure for mortgage-backed securities). The problem is more that dishonest salesmen were writing loans to equally dishonest borrowers. There's no amount of disclosure on earth that can compensate for the fact that a borrower who claimed an income of $175k actually only earns $50K. What makes these securities worthless is the fact that people were encouraged to fib just a little to qualify for the loan -- and they went along with it. If enough people do that, the little fibs add up to one giant fraud.
The difference between investing in derivatives and outright betting is the same as the difference between taking medicine and doing recreational drugs. A derivative is no more a "bet" than any investment in any company. If you know that in any given geographical area there is a five percent chance that a $100,000 mortgage will default, you probably won't buy that mortgage off the bank, because most of us aren't willing to risk $100,000 that has a 1-in-20 chance of being lost. But, if you pool that mortgage with a hundred other identical mortgages, you suddenly have something that a hundred different investors can afford to buy in for $100,000 apiece -- because even with that 5% default rate, the accumulated mortgages are generating, say, 12% (interest, late fees, points, blah blah blah) which means a net return of 7% per year, plus whatever gets paid down from proceeds of foreclosure, maybe another 2-3%, and that's easier to stomach. The risk is no longer all-or-nothing; it's something you can quantify. It makes it easier for people who are honest to get access to lenders who are honest.
Selling in tranches doesn't diffuse anything. The high-risk tranches are always sold to institutional investors who are well able to bear the loss and fend for themselves.
The problem came in because some astonishingly high percentage of these borrowers apparently falsified their incomes -- in collusion with agents working on commission.
