Thanks for the illuminating commentary. Of course, the "underlying debt" wasn't supposed to "go bad" any more so than accounted for in the models. Three things come to mind:
1. Fraud: A lot of the MBS used for the CDOs may have been created and marketed dishonestly by realtors, appraisers, LO's, bank officers and Wall Street bundlers.
2. Ratings: Even if S&P and Moodys and Fitch acted in good faith rating this stuff (not a sure bet given the incestuous relationship with the IBs, etc.) you can't model fraud.
3. Exchange: Maybe $60 trillion (notional value) of derivatives floating about, but an unregulated and opaque market at best. Getting these instruments on an exchange with rules and transparency might have discouraged excessive risk taking and would at least have kept bankers, Fed chairmen and Treasury officials from fumbling blindly in the dark.
You're correct. But now you see how Paulson will go out after the bailout plan is passed, holding his pail of money, and very likely could do more harm than good if he inadvertently triggers more loan and bond defaults. His mistake of spending a few million too little on a tranche of securities could cause devastating damage in the credit derivatives market.
I believe that a financial tsunami has been unleashed that will swallow up every bit of liquidity that Paulson wants to throw at it. He can buy up billions in loans and it still won't stop the wave.
The market (mainly controlled by investment banks) will be in complete euphoria for awhile this coming week. However, late in the week, or the following week, we will see the credit markets begin to tighten again as companies realize the severity of what was unleashed.