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In the Year 2010: Will CDOs Still Exist?

The main reason why the CDO market exists is because it provides a way to convert junk-rated assets into investment grade assets.

Financial firms have portfolios of junk corporate debt, B and equity tranches from securitizations that are not marketable. These can be pooled, structured and combined with credit enhancements like bond insurance, CDS, etc.

Voila, a pool of junk assets suddenly produces several tranches of investment-grade securities.

Due to restrictions on pensions and other institutional buyers ability to hold junk-rated debt, in a normal market, the market trades investment-grade debt at a premium higher than that warranted by the credit characteristics of these securities alone. The junk-rated debt trades at a similar discount for this same demand constraint.

Therefore restructuring the cash flows in a CDO pool generates a profit to the asset structurer.

This is basic finance.