Oh yes. It’s fair to say that the mortgagors, structurers, insurers, and (most of the) tranche buyers all thought that they were doing 2 – 3 year credit. Smart money and dumb money were in agreement about that (with a few exceptions on the smart end), and a lot of very sharp guys have gotten blown up. I don’t know, but I suspect that few on the short side expected their bets to work out as well as they did.

I’m not doing this thread justice (good comments, BTW) but happened to see you comment and wanted to confirm it.

Right when this subprime mess was in its early days, a hedgie I know (very very smart guy, been through multiple cycles, knows more than a thing or two about risk) blithely asserted that subprimes weren’t a big deal because anyone who could pay on time for two years could refinance into a prime loan. There were clearly a lot of otherwise smart people who were of that view once.

Since the 1970s, largely due to issuer demand for ratings as a way to increase investor confidence, the rating agencies revenues have increasingly been generated by issuers of securities. 8 In the past few years, these revenues have been increasingly driven by ratings for relatively newer structured finance products. As a result rating definitions have undergone significant changes to their meaning as well as the manner in which they are employed. These changes and their implications to the integrity of the rating process are significant.

In an effort to meet market demands for investment grade assets with higher yields, the rating agencies created new models and approaches to rating these assets. Given the limited number of Nationally Recognized Statistical Rating Agencies (NRSROs) and requirements directing certain investors to purchase only “investment grade” rated assets, their move to rate newer asset classes strengthened their market power, 9 or in the words of one rating industry executive, their “partner monopoly”.

The concentration of rating agency power is not limited to the structured finance market and extends into traditional credit rating business. However, unlike other debt markets where the number of issuers allows for the broad diversification of operational and model risk, 11 there is a significant concentration in structured finance. For example, a recent report by the French securities regulator pointed out that “12 banks account for more than 70 percent of European deals, and three rating agencies cover the entire market (two of them accounting for 80 percent). According to 2005 figures for the French market, three legal firms account for more than 60 percent of the legal structuring work in the CDO market, and three others account for more than 50 percent of volume in the MBS market.” 12 This concentration could have the effect of amplifying rating model risks, the risks to legal structures, other legal risks, counterparty risks, and the risks of misapplications of accounting rules (particularly FAS-140). Moreover, traditional corporate bond ratings have long a long history of application and have been empirically tested through various economic cycles. Many structured products – notably CDOs – have not.

11. Bank for International Settlements, Committee on the Global Financial System, The Role of Ratings in Structured Finance: Issues and Implications 24 (Jan. 2005) (“Model risk is … not confined to structured finance. However, given the lack of historical default data and the analytical challenges in assessing credit risk exposures (e.g. treatment of correlation, recoveries and time variation), it is likely to be a more important issue in the credit risk than in the market risk world. This applies, in particular, for structured finance instruments, as in the case of correlation assumptions discussed above. As a result, model-based risk assessments can be a long way from ‘true’ values and, to the extent that investors rely on ratings for their structured finance investments, the model risk linked to the agencies’ rating methodologies will be among the principal risks these investors are exposed to.”)

…

Bank for International Settlements, Committee on the Global Financial System, Incentive Structures in Institutional Asset Management and their Implications for Financial Markets 7 (Mar. 2003) [hereinafter BIS Study]. (“Similarly, with consensus on “best practice” regarding the modelling of portfolio credit risk still lacking, “model risk” in instruments such as collateralised debt obligations (CDOs) is an issue for even the most sophisticated market participants. Use of structured finance instruments, together with the occurrence of worst case scenarios relating to mispriced or mismanaged exposures, might thus lead to situations in which extreme market events could have unanticipated systemic consequences. Given these issues and the fact that structured finance markets are still largely untested, continued growth in structured finance activity warrants ongoing central bank awareness.”).

Deal Structure
Dexia is selling the credit risk related to the AAA ABS portfolio to external parties by means of two credit default swaps: a non-funded super senior credit default swap with an undisclosed party and a junior credit default swap with Dublin Oak Ltd, a special purpose company registered in Ireland.

By using outdated models, all the rating agencies came up with loss curves resulting in bogus values.

Its a hunch at why they all screwed up, its either model distortion or the other theory that they all were paid off and failed in fiduciary roles; take your pick!