Structured Finance and the Financial Turmoil of 2007 2008

Originator and only the credit risk of the underlying

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originator, and only the credit risk of the underlying assets is transferred to the SPV by buying credit derivatives such as credit default swaps over this assets [ECB (2008a)].
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BANCO DE ESPAÑA 12 DOCUMENTO OCASIONAL N.º 0808 Securitization is closely linked to the so-called “originate-to-distribute” model. Under this model, the bank that originates the assets (basically loans) puts them off its balance sheet through securitization and thus “distributes” them to the SPV and the ultimate investors who buy the ABS issued by the SPV. This model and securitization have major advantages for the banks involved, as they can free up capital and liquidity by not holding the loans on their balance sheets. As the same time, since the bank knows that it is going to put loans off its balance sheet, it may not apply the same strict credit risk assessment as it would conduct otherwise (incentive or moral hazard problems). Figure 1 provides an overview of the main structured finance instruments. In essence, these instruments can be divided in securitizations and credit derivatives. Securitizations consist of short-term asset backed securities (short-term ABS, predominantly asset-backed commercial paper or ABCP) and longer-term asset-backed securities (term ABS), defined from a broad perspective. Broadly defined asset-backed securities include three main categories: Mortgage-backed securities (MBS), asset-backed securities in a narrow sense (ABS, which are basically collateralized by all kinds of assets except mortgages, such as car loans, student loans, etc.) and “cash flow” collateralized debt obligations (CDOs) [Jobst (2003 and 2006); Vink and Thibeault (2007)]. In market practice, often when the term asset-backed securities or the abbreviation ABS is used, the narrow interpretation is followed, thus implying asset-backed securities (ABS) with the important exception of mortgage- backed securities (MBS) and “cash flow” CDOs. CDOs are somewhat difficult to classify: In practice, they have been classified either as securitizations, credit derivatives or as a hybrid form incorporating elements of both [see also: IMF (2008a); Duffie (2007)]. In this Occasional Paper, “cash flow” CDOs are categorized as a hybrid form, but predominantly as securitizations, with only an indirect link to credit derivatives (see Figure 1). The reasons for this choice are twofold: First, their main characteristic is the explicit use of securitization techniques in transforming a pool of assets into new securities and second, various statistical sources include “cash flow” CDOs in asset-backed securities (and not in credit derivatives). At the same time, in this Occasional Paper, synthetic CDOs are included in “pure” credit derivatives (see Figure 1), which are not based particularly on securitization techniques, but are much more very specific instruments to transfer credit risk from one party to another. The classification of synthetic CDOs as “pure” credit derivatives is also done mainly in order to follow statistical market practices.
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