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Structured Finance and the Financial Turmoil of 2007 2008

1 typical composition of underlying assets of cdos

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1 Typical composition of underlying assets of CDOs which invest in asset-backed securities (ABS) (so-called “ABS CDOs”). Thus, this example coincides with the example shown in Figure 5, where the creation of a CDO was shown based on residential mortgage-backed securities (RMBS).
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BANCO DE ESPAÑA 30 DOCUMENTO OCASIONAL N.º 0808 4C r e d i t d e r i v a t i v e s Generally, credit derivatives can be defined as private financial contracts under which an financial market participant buys or sells risk protection in a OTC market against the credit risk associated with a specific reference entity (or specific entities) [IMF (2007)]. The main credit derivatives (which have been typified as “pure” credit derivatives in Figure 1 in section 2) are credit default swaps (CDS) and synthetic collateralized debt obligations (CDOs), with other instruments existing as well such credit-linked notes, total return swaps and credit spread options [BIS (2004); Mengle (2007); Partnoy and Skeel, Jr. (2007); Morgan Stanley (2008)]. The main types of credit default swaps are single name CDS CDS index contracts, whereas an important category of synthetic CDOs are so-called index tranches-based CDOs. An overview of the development of these main credit derivatives is presented in Table 4, which shows that CDS index contracts expanded their market share rather significantly in recent years. Table 4: Composition of credit derivatives market 1 2 0 0 0 2 0 0 2 2 0 0 4 2 0 0 6 Single name CDS 38% 45% 51% 33% CDS index contracts 2 -- 1 1 % 3 8 % Synthetic CDO 3 1 6 % 1 7 % Others 4 62% 55% 22% 12% 1 0 0 % 1 0 0 % 1 0 0 % 1 0 0 % SOURCE: BBA (2006). 1 This overview does not include “cash flow” CDOs, which do not use credit default swaps to actually transfer credit risk (contrary to synthetic CDOs). 2 CDS index contracts consist of CDS linked to indices and CDS linked to tranches of indices. 3 Include fully funded and partially funded synthetic CDOs. 4 Include basket products, credit-linked notes, credit spread options, equity-linked credit products, swaptions and others. Chart 7 shows the evolution of the total amount outstanding of credit derivatives, which is based on a comparison of different sources. Moreover, it includes for comparative purposes the development of the total underlying debt instruments and the size of the credit derivatives markets as a percentage of total bank assets. Chart 8 provides a breakdown of the main players in the credit derivatives market (buyers and sellers) as mentioned in the most recent market survey available (BBA).
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BANCO DE ESPAÑA 31 DOCUMENTO OCASIONAL N.º 0808 % share of each side of the market (5%). SOURCE: BBA (2006). Various credit derivatives have played rather different roles in the 2007-2008 [email protected]@K turmoil. Whereas “synthetic” CDOs were much more actively involved in the propagation of the subprime mortgage market shock [see ECB (2008b)], credit default swaps played a more indirect role. Nevertheless, these latter credit derivatives are included in this Occasional Paper because they have been instrumental in monitoring and assessing the development of the turmoil. Some examples of this function will be shown in this section, for both the
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