Structured Finance and the Financial Turmoil of 2007 2008

Cds played a much more indirect role and has been of

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(CDS), played a much more indirect role and has been of particular use in monitoring the spreading of the financial turmoil. As a summary overview, Figure 9 presents in a stylized format the main channels through which structured finance instruments played a role in the financial turmoil. Although not all possible channels are shown, the figure depicts the essential interaction between the use of structured finance, the banking sector and the development of the financial turmoil. The specific instruments are chosen as examples and are representative of the underlying mechanisms. Not all structured finance instruments that have been of significance in the turmoil are included; for example, “synthetic” CDOs are not shown here. Furthermore, by far not all players involved are taken into account, such as hedge funds, other highly leveraged financial intermediaries and other investors [for this, see for example ECB (2008b), pp.32-33]. Channel 1 involves the creation of subprime mortgage-backed securities by a US commercial bank, which are bought by ABCP conduits, for example a SIV belonging to a German bank. The example of a German bank has been chosen as a number of German banks, such as IKB and Sachsen Landesbank, were particularly affected by the turmoil in this way. When due to the subprime crisis the value of these assets declined substantially, the collateral values of the SIV eroded, resulting in major refinancing difficulties. In a similar fashion, Channel 2 shows the creation of “cash flow” CDOs by a US investment bank which are collateralized by residential mortgage loans that also are bought by the SIV of the German bank. Also here, the collapse of the price of these instruments created major problems and losses for the SIV. Channel 3 involves the creation of the same CDOs as in Channel 2, but now the US investment bank needs to absorb these instruments on its balance sheet. Namely, the financial turmoil eroded completely investor confidence in CDOs and banks were no longer able to sell these instruments to investors. As a result, some SPVs of banks became saddled with CDOs as they could not get rid of them, forcing their sponsoring banks to absorb these instruments. Merrill Lynch has been one of the (investment) banks hit in particular through this channel [see for example The New Yorker (2008)].
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BANCO DE ESPAÑA 40 DOCUMENTO OCASIONAL N.º 0808 Channel 4 is a channel more directly linked to the banks and their ABCP conduits. Numerous banks used these conduits ¡ here the SIV belonging to a German bank ¡ to put specific assets off their balance sheet and/or to absorb debt securities that they issued. Some of these assets proved to be relatively risky when the financial turmoil evolved, generating losses for the SIV. Moreover, when the crisis of confidence in financial markets hit the banking sector, also the debt securities issued by the sponsoring bank that the SIV purchased dropped in value.
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