It is important, for the argument that follows, to understand where the financial engineering came from and how it was supposed to work.
Suppose that a bank has a pool of business loans, which it is happy to hold, but it is
concerned about capping its exposure to default risk on those loans. In an efficient
market, the value of the risky loan portfolio should be equal to the value of a similarly sized riskfree loan portfolio plus the value of an insurance contract that guarantees the risky loan portfolio. If the bank buys the insurance, then its net position becomes completely riskfree. This insurance is a credit default swap (CDS).
On the other side of the swap contract, the seller of insurance now owns a risky asset. If he combines that risky asset with just the right amount of riskfree debt, he can recreate exactly the risk exposure of the original pool of business loans. If he funds this position by issuing pass-through notes, then whoever buys the notes will have exactly the risk exposure of the original pool of business loans. This combination of insurance plus riskfree debt is known as a