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Structured Finance and the Financial Turmoil of 2007 2008

Channel 5 is related to the previous channels and

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Channel 5 is related to the previous channels and essentially involves the absorption of the impaired assets from the ABCP conduits by the sponsoring banks, again here by the German bank that owns the SIV. Ultimately, the problems spilled over to the banks arising from the fact that they had to bail out their SIVs, for example by taking over the impaired assets which had declined significantly in value, a process that resulted in major write-downs and losses for the banks involved. Some banks that have been hit via this channel are HSBC, Citigroup and WestLB. Finally, Channel 6 is also related to the first four channels and consists of the process that the liquidity facilitating banks actually needed to provide liquidity support to the ABCP conduits. As the ABCP issued by the conduits is of very short maturity, they almost constantly are in need of new funding. Thus, when a crisis hits and no investor wants to buy ABCP, almost immediately conduits face major funding problems and need to sell their assets and/or need to obtain liquidity support from the liquidity facilitating banks. Of course, in a collapsing market, it is very difficult to sell assets or only at a substantial loss, so in fact many SIVs had no choice than to recourse primarily to liquidity support when the subprime crisis hit the market. This resulted in major liquidity strains for the banks involved, as they had not anticipated that they would have to provide such large amounts of liquidity and consequently the process resulted in considerable disarray in interbank markets. We want to conclude this Occasional Paper with a short discussion of the role of the rating agencies in structured finance and the financial turmoil. Although this aspect can only be touched upon briefly, it is highly important to understand some of the mechanisms underlying the problems with structured finance during most of 2007 and 2008. Essentially, the financial turmoil highlighted strong doubts on the ratings methodologies for structured finance products in general and their robustness in particular. These doubts further increased by substantial ratings’ downgrades both in number and severity in the course of 2007 and 2008m which resulted in major valuation losses of the structured finance instruments involved. All in all, the turmoil revealed intrinsic problems with the valuation of structured finance products and various incentive problems involving the rating agencies [see: Mason and Rosner (2007a and 2007b); BIS (2008d)].
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Figure 9: The channels of contagion involving structured finance in the financial turmoil BANCO DE ESPAÑA 41 DOCUMENTO OCASIONAL N.º 0808 US commercial bank Special Purpose Vehicle A Households in the US which have taken sub- prime mortgages Cash Subprime mort- gages Subprime mort- gages Cash Households in the US which have taken mortgages Cash Special Purpose Vehicle B of US investment bank Mort- gages Cash Collateralized Debt Obligations (CDOs) Structured Investment Vehicle (SIV) that belongs to a German bank Cash Mortgage-backed securities (MBS)
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