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Structured Finance and the Financial Turmoil of 2007 2008

Seller just pays the notional amount of the bond to

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seller just pays the notional amount of the bond to the buyer, while the buyer needs to deliver the actual reference asset to the seller (for example here the bond issued by Ford Motor Company) (see Figure 7B). The spreads of single-name CDS contracts related to specific banks are extremely useful indicators for both policymakers and market participants regarding market assessments of the soundness and risk-profile of these institutions. Both theoretical and empirical analysis have shown that the development of these spreads provides important information about various risks faced by banks, such as overall credit risk and more specific counterparty and liquidity risk, e v en h a v e p r ed i c t i v e pow e r [ s e e fo r e x amp l e : Di Cesare (2006); Düllmann and Sosinska (2007)]. Econometric techniques exist that can be used to calculate the probability of default of a specific bank as well as its counterparty risk from its CDS spread, such as perceived by financial markets. The actual movement of the spreads of banks’ single name CDS contracts is indicative of specific tensions related to these banks and may be used to monitor how they have been affected by the 2007-2008 financial turmoil. Chart 9 shows the development of the CDS spreads for a number of selected globally operating banks in two panels. Panel A provides information on a number of US investment banks (Merrill Lynch, Goldman Sachs, JP Morgan, Morgan Stanley and Lehman Brothers), whereas Panel B shows a mixture of European banks (BNP Paribas, Deutsche Bank, Barclays, UBS, Santander and BBVA). From the development of these CDS spreads, it is clear that the peak of the financial turmoil was reached in March-April 2008, after having started in August 2007. Furthermore, financial markets differentiated substantially in their assessment of individual banks, with the spreads of particularly affected banks such as Lehman Brothers, Merrill Lynch and UBS increasing to much higher levels than other banks. Chart 10 presents the development of the actual CDS spread of Bear Stearns (Panel A) and the one and five year default probabilities of Bear Stearns derived from this spread (Panel B), which indicate the probability such as perceived by the market that this investment bank would go bankrupt within one year and within five years. Bear Stearns has been the highest profile victim in the financial turmoil and had to be rescued from bankruptcy in March 2008 through a takeover by JP Morgan orchestrated by the Federal Reserve. Panel A shows that the CDS spread of Bear Stearns increased to levels significantly surpassing those of CDS spreads of other banks (see for example Chart 9), whereas Panel B indicates that the one and five year default probabilities of the bank spiked in March to respectively 12% and 45%, which are extremely high compared both with historical levels and those of comparable investment banks.
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