So what did go wrong with the way CDOs were supposed to work and they did work in reality?
Counterparty risk.
Home loan CDO's were supposed to allow people to take a long position on housing. Assuming counterparties didn't go belly up, they would have done exactly that - the owners of various securities would have made money when housing went up and lost when housing went down.
When someone says "This is simply a mathematical identity." - how is all of this stuff grounded in reality - do people actually do controlled experiments to work out if any of this stuff is scientific?
It's just basic arithmetic. The borrowers are going to pay out a certain amount of money. The senior tranch gets paid first. If any money is left, the junior tranch gets paid. Short of politicians overriding the rule of law (e.g. the GM bankruptcy), there is no scenario where the junior tranch gets a payout and the senior tranch does not.
Counterparty risk.
Home loan CDO's were supposed to allow people to take a long position on housing. Assuming counterparties didn't go belly up, they would have done exactly that - the owners of various securities would have made money when housing went up and lost when housing went down.
When someone says "This is simply a mathematical identity." - how is all of this stuff grounded in reality - do people actually do controlled experiments to work out if any of this stuff is scientific?
It's just basic arithmetic. The borrowers are going to pay out a certain amount of money. The senior tranch gets paid first. If any money is left, the junior tranch gets paid. Short of politicians overriding the rule of law (e.g. the GM bankruptcy), there is no scenario where the junior tranch gets a payout and the senior tranch does not.