So the cross-trading was the issue? As in Company A had 20$ collateral into Company B's CDO, and Company B only had 5$. When Company A goes bankrupt and defaults on Company B's over-leveraged CDO, then Company B subsequently goes under. Is this accurate?
No, I think the first layer of mortgages and CDOs could have crashed without taking the global financial market down with it. Oh, and see "The Big Short" - very entertaining and some really good insight. So my take:
First layer, CDOs that only own mortgages. Some overlap, so leveraged damage, but survivable.
Second layer, synthetic CDOs contain other CDOs. Now the leverage is out of control, and could bring down a company. Lots of confusion is possible as well.
Third layer, "credit default swaps". It's like getting 0.00001% interest (I made up this number) on a bond that only pays out if company A goes under. These swaps are leveraged, and are very dangerous for the very rare event of a solid company going under. Say company A is a $25 billion company, but out in the market is $1 trillion in credit default swaps against company A going under - because it's unthinkable.
So the mortgages default, nobody is that concerned. Rating agencies don't have the real picture.
The first layer of CDOs stop paying - they default, and the damage begins spreading...
The synthetic CDOs, which contain other CDOs, follow next and now the damage is reaching billions. It's enough to tilt company A into bankruptcy when it can't make good on it's obligations.
Now the market realizes that the credit default swaps for company A, which are guaranteed by company B, C, and D... are a multiple of company A's value. If every credit default contract is honored, many big financial companies will go under trying to honor their contracts.
I would say the multiplied leverage of CDOs, synthetic CDOs and credit default swaps brought down the market. That's also why you heard the Fed say it had to intervene. If any company failed, the whole credit default swap market comes tumbling down.