This is a must-read book for anyone who wants to understand the reasons behind the current financial mess. Here's a long quote that on its own explains quite a bit:
"Suppose you own a portfolio of high-yield bonds with a below-investment-grade rating." [That is, junk with bad collateral, just like sub-prime mortgages with a high expectation of failure to pay.]
"To construct the CDO [collateralized debt obligation], you put the portfolio into a trust and create a family of bonds with different claims to the portfolio's cash flows. The top-tier bonds, which might by 80 percent of the total, get first dibs on all cash flows. Since those bonds are almost certain to be fully paid, they get a top credit rating, and conservative investors, like pension funds, are happy to take them off your hands."
"The rest of the bonds are queued up in the payments 'waterfall,' with each successive layer bearing greater risk, paying higher yields, and getting lower ratings."
