QuoteOriginally posted by: syaekHi,Why is it that a CDO structure creates additional [return] when compared to the components that are used to build it? The answer, of course, is leverage. It creates additional return to the equity tranche when things go well and additional losses when things go badly.From an article by Douglas Lucas, "The Evolving CDO market", (2006):/quotebuyers ofCDO equity receive nonrecourse term financing with leveraged exposure to CDOassets. CDO equity provides nonrecourse financing because CDO equityholdersown stock in a remote entitythe CDOand are not liable for the losses ofthat entity. Asset financing is in place for up to 15 years, during which time itcannot be withdrawn, the rate cannot change, and under the cash flow creditstructure, a forced liquidation of collateral will not occur. CDO debtholdersprovide the financing for the equityholders, and the equityholders sustain therisk of collateral asset payment delays and credit losses. Equityholders own aleveraged position in the assets of the CDO and receive all cash flows in excessof the debt tranche requirements and thus collect all the upside on the CDOsassets./end-quotehttp://
www.cfapubs.org/doi/pdf/10.2469/op.v2006.n1.4392