Although the majority of corporate bondholders still have no clue as to the embedded option they have purchased the same cannot be said for the investment banks. With the introduction of Interest Rate Swaps in the early 1980's and the development of the Asset Swap the seeds for the great crisis were already being sown.
If a corporate bond could be separated into an interest rate component and a credit component, then couldn't one just focus on the credit component and forget about funded or unfunded investments?
The investment banking community certainly thought so and went out and searched for investors for whom this would be interesting and found the Italian regional banks.
They had illiquid corporate credits on their books which was tying up their liquidity. The investment bankers came up with a strategy to monetise these investments-the CDO(or it's close cousin the CLO). The Italians were told that since they were already short the put to the issuers they should keep that piece of the structure which became known as the equity or first-loss piece. The investment bank would take the rest of the capital structure and sell it to investors under the "guise" of it being the "the risk-free component"-or at least as good as because as the top of the capital structure it could be rated AAA!
And that's what led to the Credit Crisis. More tomorrow.
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