The first problem was that no one bothered to look at the underlying securities. When prospectuses were sought long after the market crashed, they were hard to find. But why bother, as the derivatives were repriced and could be rolled over in monthly auctions. They came with high ratings from S & P or Moody's or Fitch and they were apparently completely liquid but paid better than other short term securities.
Other problems were, according the New York Times:
"ÂThey were based on the assumption, endorsed by the bond rating agencies, that insurance regulators were requiring life insurers to retain too much capital.
ÂTherefore, investors could take on a large part of the risk of the insurance with complete safety. That would be only the "excess" part, as calculated by the insurance company
ÂThe securities were sold as virtually risk-free cash equivalents, enabling the investor to get out, at par, once a month. Supposedly sophisticated investors sank more than $30 billion into them.
ÂThe securities were explained in complex prospectuses that almost nobody even obtained, let alone read.
ÂThey were guaranteed by bond insurers, like Ambac, further persuading people there was nothing to worry about."
Read the article for all the ugly details on this colossal fraud, arising from no one paying attention and no one taking responsibility. It implicitly makes the case for tough regulation. But the news doesn't hold out great hope we will get it.