This is one of the better simple explanations of both the appeal and hidden risk of CDO's. The example, which is short and is worth working through, ends this way:
Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06. In terms of our original mortgages the true default rate is 20 percent higher than we thought--not good but not deadly either. However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase. Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!
The dark magic of structured finance conjured many low-risk securities out of many risky securities. Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined.
As an ex-engineer who used to do a lot of operations analysis as well as post-disaster failure analysis, this shares a central theme that I have found in many such failures -- people tend to overestimate their own knowledge.
Coming in to a class at HBS, the professor had us all do a 20 question survey. It asked us questions like "what is the population of Argentina" and then asked us to give the lowest and highest number we thought it would be such that the answer had a 95% chance of being in that range. Based on this, only one of our 20 answers should have been out of my limits. About eight of the answers were out of my ranges. It was a really good lesson in overestimating one's knowledge.
Which leaves me with a thought -- if we define a large part of the problem as overestimating our understanding of a certain phenomenon, from your observation of the Obama administration and its personalities, what gives you any confidence that a new lager of government regulators will solve this problem?