To be clear, the great majority of investment bank losses in 2008/2009 did not come from CDOs and even CDO^2s ("CDO squared"). It came from CDS on ABS/CDO. Roughly, you could get long/short on an ABS/CDO/whatever bond that you didn't own. It's like selling fire insurance on your neighbor's home. By itself, not as crazy as it sounds in the financial derivatives landscape, but the underlying collateral were a pile of garbage. There was (and still is) already a huge and healthy CDS on corporate names market, so it seemed reasonable at the time to expand the CDS product. Unfortunately, once the fraud with underlying loans started to unravel, the losses became so large that many CDS counterparties went bankrupt, so the whole thing backed up the investment banks themselves. (See: Fed/Treasury bailouts / bank firesales!) To me: CDOs and CDS on ABS/CDO is just the tip of the fraud iceberg.
