To make matters even more complicated, there was not just one bond issued against a package of mortgages. The mortgage-backed securities were sliced into different “tranches,” each tranche with different claim priority against payments from the underlying mortgages and each with a different bond rating. It was called “financial engineering.” Even if the underlying mortgage loans were of low quality, the bond-rating agencies were happy to bestow an AAA rating on the bond tranches with the first claims on the payments of interest and principal from the underlying mortgages. The system should more accurately be called “financial alchemy,” and the alchemy was employed not only with mortgages but with all sorts of underlying instruments, such as credit card loans and automobile loans. These derivative securities were in turn sold all over the world.
It gets even murkier. Second-order derivatives were sold on the derivative mortgage-backed bonds. Credit-default swaps were issued as insurance policies on the mortgage-backed bonds. Briefly, the swap market allowed two parties—called counterparties—to bet for or against the performance of the mortgage bonds, or the bonds of any other issuer. For example, suppose I hold bonds issued by General Electric and I begin to worry about GE’s creditworthiness. I could buy and hold an insurance policy from a company like AIG (the biggest issuer of credit default swaps) that would pay me if GE defaulted. The problems with this market lay in the fact that the issuers of the insurance such as AIG had inadequate reserves to pay the claims if trouble occurred. And anyone from any country could buy the insurance, even without owning the underlying bonds. [I bolded.] Eventually, the credit-default swaps trading in the market grew to as much as ten times the value of the underlying bonds, pushed by demand from institutions around the world. This change, where the derivative markets grew to a large multiple of the underlying markets, was a crucial feature of the new finance system. It made the world’s financial system very much riskier and much more interconnected.
Please see the bolded sentence and the titled question. I believe that personal life insurance requires the beneficiary to be related to the insured. Why not for credit-default swaps?