The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time.

False. They had calculated the probability of it happening to be a "six sigma event" or six orders of magnitude outside the standard deviation of probability. A two in a billion chance. It's in here somewhere, I think. Pretty sure Lehman actually ran the numbers.

Somewhere there's a hoary old list of "you might be an engineer if" that includes the line "you've ever modeled a horse as a sphere." Garbage In, Garbage Out - if your assumptions are crap, your model is crap. If your model is crap, your predictions are crap. It's worth noting that Credit Default Swaps were created by junior execs at Goldman Sachs while they were plastered on margaritas at a weekend retreat in Cabo San Lucas.

Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice.