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Structured Finance and the Financial Turmoil of 2007 2008

The aim of this occasional paper is to provide an

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The aim of this Occasional Paper is to provide an introductory overview of structured finance, so that the reader may better understand its role and importance in the financial turmoil of 2007-2008, such as briefly described above. Thus, this publication serves as a background document which may be useful in providing rather specialized knowledge that is required to be able to comprehend recent developments in global financial markets, in particular the financial turmoil. Structured finance has developed very fast in recent years and often involves highly complex financial instruments and techniques, which may not be understood completely beyond a small circle of financial market experts. In this sense, the overview pays attention to the most relevant instruments of structured finance such as asset-backed securities and collateralized debt obligations and techniques such as securitization. In addition, the Occasional Paper provides a concise analysis of the most important channels linking specific structured finance instruments to the financial turmoil. At the same time, the aim of this paper is not to provide an in-depth analysis of the financial turmoil, of which excellent studies exist [for example: IMF (2008a and 2008b); ECB (2008b); BIS (2008c); Borio (2008)]. The paper is organized as follows. Section 2 provides an overview of structured finance and discusses its specific characteristics. It also presents a detailed classification of structured finance instruments that serves as a basis for the rest of the Occasional Paper. Furthermore, it is explained that a number of structured finance instruments such as mortgage-backed securities (MBS), asset-backed commercial paper (ABCP) and collateralized debt obligations (CDOs) have been at the centre of the financial turmoil, whereas other instruments such as credit default swaps (CDS) have been more monitoring devices to assess the development of the financial turmoil. Section 3 pays attention to securitization and to the aforementioned specific structured finance instruments that played an important role in the financial turmoil: MBS (section 3.1), ABCP (section 3.2) and (cash-flow) CDOs (section 3.3). Section 4 sets out the main characteristics of credit derivatives, in particular credit default swaps (CDS) (section 4.1) and synthetic CDOs (section 4.2). Section 5 concludes and analyses the main channels through which structured finance instruments contributed to the initiation and propagation of the financial turmoil.
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BANCO DE ESPAÑA 11 DOCUMENTO OCASIONAL N.º 0808 2 Structured finance Structured finance relates to a group of complex financial instruments and mechanisms that defers a simple universal definition, but broadly defined it could be described as referring to the repackaging of cash flows that can transform the risk, return and liquidity characteristics of financial portfolios [Issing (2005); Fabozzi et al. (2006)]. A more straightforward interpretation is provided in BIS (2005a), where structured finance is defined as a form of financial intermediation which is based on securitization technology:
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