[drumdance]

It's also complicated by the legal framework. My (limited) understanding of the problems with CDOs in 2008 was that multiple buyers could purchase insurance on the same bond. It's like if I could buy fire insurance on your house. If a lot of us did that and your house burned down, the insurer would have been on the hook for many times the cost of the underlying asset. This is why we had to bail out AIG.

When it's spelled out like that, the idea seems preposterous. But the legal framework allowed it -- in certain contexts. AIG et al call them "CDOs" instead of just "insurance" so they could avoid the more-restrictive legal framework governing the insurance industry.

And given that a typical CDO is the size of a Manhattan phone book (remember those?), there obviously is a lot of nuance that a lot of people did not understand.

[flourpower]

You're thinking of CDS, not CDO. CDS stands for credit default swap(s) and CDO stands for collateralized debt obligation. You're right that a CDO would be really big if you printed out a formal specification, but that's because a CDO is special trust where the trustee buys and sells different securitized products and tranches out the payments to shareholders in the trust.

Also - AIG could have made the same mistake with conventional home insurance. Say they only keep 100 dollars of cash around and they decide to insure a million houses, each with a value of one dollar. If one ten thousandth of the houses burn down, AIG goes bankrupt. So it's not true that selling a dollar notional of home insurance is less risky than selling a dollar notional of CDS, because it could easily be the case that the expected payout on the CDS is higher. CDS are just harder to price. There are very robust statistics about houses burning down - the statistics on whether homeowners would default were a lot trickier to deal with.