Structured Finance and the Financial Turmoil of 2007 2008

The second category of structured finance instruments

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cash-flow and synthetic. The second category of structured finance instruments involves those that have been more instrumental in monitoring the crisis, both for market participants and policymakers. The main instruments here are credit default swaps (CDS), of which examples are presented for both single name and index contracts. Finally, the paper provides an overview of the specific contagion channels involving various structured finance instruments. This will be conducted on the basis of examples for hypothetical financial institutions that are nevertheless representative for real world developments such as they occurred in the course of 2007 and 2008. Keywords: financial turmoil, financial markets, financial institutions, structured finance, securitization, credit derivatives. JEL Classification: G10, G15, G21, G24.
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BANCO DE ESPAÑA 9 DOCUMENTO OCASIONAL N.º 0808 1 Introduction and motivation Global financial market conditions deteriorated sharply in the summer of 2007, triggered by concerns about exposures of financial institutions to the most risky segment of the US mortgage markets ¡ the so-called subprime mortgage market ¡ and related financial instruments. 1 As risk assessments were adjusted, the financial turmoil spilled over to other financial market segments and risky assets ¡ particularly those linked to structured finance ¡ were abandoned in favor of “safe haven” instruments such as government debt securities. Across the globe, stock prices fell, volatility levels jumped, credit spreads increased sharply and liquidity demand surged, prompting central banks to inject substantial amounts of additional liquidity into the markets. Uncertainly was particularly pronounced in the short-term money markets, as evidenced by a marked increase in risk aversion in the asset-backed commercial paper (ABCP) market and rather unprecedented rises in interbank money market interest rates. At the same time, the markets for the transfer of credit risk were affected as well, and the costs of credit protection increased markedly, particularly for specific sectors such as banks and other financial institutions. Although individual countries and specific market segments were affected to different extents, the scope of the financial market turmoil was truly global and discrimination by market participants among individual borrowers was uneven or nonexistent. The financial market turmoil continued to develop into 2008, partly driven by losses that were actually reported by various large international banks and which were generally either larger or much larger than had been anticipated, and partly by information indicating further deteriorating conditions in US housing and (subprime) mortgage markets. In this respect, the liquidity concerns that dominated the initial phase of the turmoil were accompanied increasingly by credit risk concerns and what had started as a liquidity crisis seemed to develop more into a crisis of solvency related to major financial institutions.
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