A major component of the current financial crisis involves the "toxic assets" on the balance sheets of many banks. These assets include derivatives that were manufactured to reduce and spread risk. There is an interesting article in the newest Journal of Economic Perspectives entitled, "The Economics of Structured Finance" and was written by Joshua Coval, Jakub Jurek, and Erik Stafford. They illustrate how the collatorized debt obligations (CDOs) could be created such that a lower level of risk is attached to one of the obligations. I illustrate with an example they use in their article.
Suppose there are two identical bonds and each has a probablitity of default equal to 10%. Let the bonds each pay $1 if there is no default and $0 if there is a default. Combine the two securities into a portfolio and create two tranches, each of which pays $1. But one of the tranches--the junior tranche--bears the first $1 of losses to the porfolio while the other--the senior trance--bears a loss only if the capital of the junior tranche has been wiped out. To determine the expected cash flow for the senior tranche, we need to know the likelihood of observing both bonds defaulting. That depends on whether the probabilities of default for the two bonds are correlated. If they are uncorrelated, then the probability of default for the senior tranche is 1%. The senior tranche will sell for a higher price than the junior tranche. If the probabilities of default are correlated, then the risk associated with the senior tranch will be greater than 1%.
The authors then develop a simulation study involving more complex securities with different assumptions about the correlation of risks associated with the underlying assets. They show two things in their simulations. First, they find that small errors in assessing the riskiness of an asset are magnified by the collateralized debt obligations structure. Second, structured securities experience more exposure to systmatic risk. They state, "Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole." (p. 23).
As housing prices fell and defaults increased, the system-wide problems became obvious and the prices of CDOs fell. In the extreme, no one is willing to buy some of these assets because they do not know the actual risk associated with them.