Structured Finance and the Financial Turmoil of 2007 2008

The recent financial turmoil is that as problems in

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the recent financial turmoil is that as problems in the subprime mortgage markets in the US mounted during the second and third quarters of 2007, CDOs based on tranches of mortgage-backed securities linked to the subprime market eventually were negatively affected as well, and their credit spreads widened drastically, inflicting huge valuation losses on investors (as prices went down sharply). Markets for these products completely dried up and as a result prices could not be established. Consequently, investors were not able to calculate their losses, which added to the growing uncertainty in global financial markets and led to a spill-over of the financial turmoil to other financial market segments. In the process, global CDO issuance completely collapsed, as is shown in Charts 4 (by type of CDO), 5 (by type of collateral) and 6 (by currency). This development intensified even more in the course of 2008. The description of “cash flow” CDOs above shows their similarity to standard securitizations, with the use of a pool of underlying debt instruments and their transformation into new securities backed by this pool of collateral assets. However, CDOs in general are in some important ways different from conventional securitizations. In essence, CDOs are based on pools of relatively few numbers of relatively heterogeneous assets (for example on small numbers of specific tranches from various mortgage-backed securities), whereas securitizations or the creation of asset-backed securities (in the narrow sense) are based on pools of relatively large numbers of relatively homogeneous assets (for example many residential mortgages of a few cities) [Cousseran and Rahmouni (2005); ECB (2008a)]. Consequently, generally it is much more complicated to assess the risk of CDOs than that of standard securitizations such as residential mortgage-backed securities.
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BANCO DE ESPAÑA 26 DOCUMENTO OCASIONAL N.º 0808 Chart 4. Global CDO issuance by type Chart 5. Global CDO issuance by underlying collateral Chart 6. Global CDO issuance by currency 0 20 40 60 80 100 120 140 160 180 200 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 8 0 0 2 7 0 0 2 6 0 0 2 5 0 0 2 US Euro Yen Sterling Other bln USD SOURCE: SIFMA. 0 20 40 60 80 100 120 140 160 180 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 7 0 0 2 6 0 0 2 5 0 0 2 4 0 0 2 2008 bln USD bln USD SOURCE : SIFMA (a) Funded tranches require the deposit of cash to an SPV at the inception of the deal to collateralize portions of the SPV’s potential swap obligations in the transaction; losses result in principal writedowns of the issued notes. The unfunded are supposed to be the same amount at least as the funded ones. Cash Flow and Hybrid Synthetic Funded (a) 0 20 40 60 80 100 120 140 160 180 200 q1 q2 q3 q4 q1 q2 q3 q4 q1 q2 q3 q4 q1 8 0 0 2 7 0 0 2 6 0 0 2 SOURCE: SIFMA. Structured Finance HY Loans HY Bonds IG Bonds Other swaps Other
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Figure 5: Creation of a collateralized debt obligation (CDO) based on “mezzanine” tranches of residential mortgage-backed securities (RMBS) (“Cash flow”, “true” sale CDO) SOURCE: Adapted from: ECB (2008a), Criado and Van Rixtel (2007), Renault (2007), IMF (2006), Cousseran and Rahmouni (2005) and Tavakoli (2003).
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