> It's not simply that there was ready money, but that at the bottom of
> it, in both the US and Europe, there was free money, i.e., AAA rated
> bonds -- risk free assets -- that paid more than AAA bonds were
> supposed to. In the US, these fake AAA assets were created by the CDOs.
First of all, nobody believes a AAA rating makes something risk-free. According to this paper from Moody's, within any given 20-year window in the 1920-1999 era, about 2% of AAA-rated corporate bonds defaulted. http://www.moodyskmv.com/research/whitepaper/52453.pdf
During the bubble, nobody actually believed that CDOs and Treasuries had the same risk level just because they had the same rating. A rating is not a recommendation about what precise interest rate investors should demand - within a rating class, there is always a spectrum of interest rates. And even if ratings were meant that way, it's clear that investors *don't* take rating agencies at their word. Just look at what happened when S&P downgraded Treasuries the other day. What did investors do the next day? They bought! (And they've been doing the same with Japanese bonds for years, despite Japan losing its AAA years ago.)
So investors don't just outsource their brain to the rating agencies -- or at least the more sophisticated ones don't. There were all sorts of outside sources of expert information on the credit quality of specific CDOs other than from the ratings agencies: analyst reports from banks, brokerages, boutique firms, etc. All this info made clear that CDOs would become worthless if house prices fell, but would pay off if they didn't. Investors made their decisions accordingly.
> In the US, the desire to mint more CDOs, after all conceivable normal
> housing had been securitized, led necessarily to a huge fall-off in
> loan standards and loan quality to meet the accelerating volume
> requirements of demand.
I strongly disagree. The only reason anyone ever bought a CDO is because they believed it would pay off. A triple-A rating won't help you if the security ends up defaulting anyway. And they all understood that CDOs would not pay off if national house prices fell. They bought the CDOs because - just like everyone else - they believed house prices wouldn't fall.
SA