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In a way, what you say doesn’t surprise me (Gillian Tett at the Financial Times has been quoting traders who have said, in less detail that you, that a lot of the buyers are unsophisticated) but it is still pretty horrifying.

I haven’t had direct experience in this market, but I worked actively with some derivatives players in the early days and witnessed the same phenomenon you saw: investors buying products they didn’t, and couldn’t possibly, understand. If you don’t have the higher math skills, you are certain to be taken.

It reminds me of that old saying, “If you are playing poker, and you don’t know who the mark is, it must be you.”

There is now an active market on Subprime Correlation risk (TABX), and I am more interested in seeing how much and how well people are engaging in this product. How do you determine the default correlation of a New Century pool of loans with a Countrywide pool of loans…And yes it’s the same cash bond traders that are now using gaussian copula to trade these instruments.

The big fixed income investors (until hedge funds joined in the game) were pension funds and insurance companies (they are still big, mind you). They have projected liabilities and they buy various assets to make sure they have the cash flow to meet their obligations. This isn’t supposed to be a rock n’ roll, swing for the fences, bunch. Historically, fixed income investors are a skeptical and dour lot.

Now in fairness, it is apparently the public pension funds that have bought this stuff, and they are more herdlike in their behavior.

Investors and lenders DID read documents, including indenture (those specify the terms of the covenants), and I guarantee you at at places like Pimco they still do. You know what sections are boilerplate and hone in on the ones that count. And Moody’s and Standard & Poors publish detailed summaries of the key terms of all public debt deals.

In this case (see post http://www.nakedcapitalism.com/2007/06/bear-stearns-and-vagaries-of-models.html) many investors seemed to have derived false comfort from credit agency models (meant to measure credit quality ONLY) and used them as pricing models.

Your comment does apply to what is called “active” or “managed” CDOs, where a manager can and does trade assets within the CDO vehicle during the life of the deal. It bears some resemblance to a mutual fund, except it lacks liquidity and transparency. It’s complete “trust me” paper. Why anyone would buy this stuff is still beyond me.

So in the case of CDOs and MBSs, the pension funds and other buyers bought believing the sales person and the fact that these instruments had been sold for some time without any real problems. This trust gave way over the years to egregious behavior. Human nature. Now that there is a problem everyone goes around looking for a villain and claiming to be victims.

I’m sure there are both. Where the real problem lies in the lack of regulatory supervision. This is what government is suppose to do IMO is to keep the playing field even and the rules transparent and eliminate those who morf the system to be a one sided win lose game.