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The secondary lender can charge less than 8%, becuase its cost of capital is much less than that of an investor (1/12th under Basel 1 rules - the Cooke ratio, and possibly less under the new Basel 2 rules).

So with a 1.5% interest rate, it can still get an 18% return on capital invested. Also, as a lender, you get first dips at being reimbursed so, as long as you don't lend the whole amount, you let the initial investor take the first hit (the whole thing about CDOs was to create more tranches between the traditional "debt" and "equity" tranches, to fine tune risk taking even better - exactly as ChrisCook suggests should be done).

But my point above is that the 5-10% default rate appears optimstic (see separate answer on that)
While the amount of capital at risk has not changed (ie the amount that can potentially be lost), the overall amount of money at risk (in a more diluted way, sure) has gone up.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Dec 17th, 2007 at 03:49:39 AM EST
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