What this chart is telling us is that the various Asset Backed and Credit Default Obligation structures have been repackaged into other ABS and CDO structures. Based on historical loss rates in the 1-2% range, the rating agencies were able to assign a AAA rating to the top portion of the repackaged BBB tranche. Based on actual losses experienced of 10-15% (much higher than anticipated and consistent with a major economic downturn, not seen in many years), the bottom three tranches of the leftmost structure were wiped out, along with much of the AA tranche. That means that all the tranches on the right two columns were completely wiped out! Banks and investors that thought they had quality assets (AAA) on their books (from the right hand columns) suddenly found them worthless, triggering massive write-downs and general suspicion of rating agencies’ ratings. It doesn’t take a genius to figure out this could have happened. Indeed asking the question, “what happens if actual losses are larger than historical losses?” would have raised this issue. The problem is that most investors didn’t have the chance to even ask these questions. When presented with a AAA product, investors would assume that the quality was AAA, and one couldn’t distinguish between the left column, middle column, and the right column. This is an oversimplification of course, and in some cases there were guarantees in place to help ensure a AAA rating.
