Structured Finance and the Financial Turmoil of 2007 2008

Bank that originates the mortgage loans the spv that

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bank that originates the mortgage loans, the SPV that creates the RMBS and the specific tranches of the RMBS. Furthermore, in order to raise the credit quality of the RMBS tranches issued, the SPV may use credit enhancement techniques. This implies the use of certain mechanisms that elevate the credit quality of the financial instruments involved and consequently protect investors from losses incurred on the underlying assets [Standard & Poor’s (2007)]. This is attractive for the SPV, because if it can raise the rating of some part of the RMBS issued, it can lower its financing costs on this debt. For example, by using credit enhancement techniques, it may be able to issue a greater part of the RMBS tranches at investment grade level. Credit enhancement can take many forms but some common credit enhancements are over-collateralization and third-party guarantees
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BANCO DE ESPAÑA 16 DOCUMENTO OCASIONAL N.º 0808 by [email protected]@K [email protected]@MSNQR or m NMNKHMDR (see Figure 2). In the case of over-collateralization, the amount of RMBS issued is less than the amount of the underlying assets or collateral. In the case of monolines, they may guarantee that interest and principal of the RMBS issued will be paid on time and in full in the event of a default by the SPV issuing the paper. They can do this by either issuing j nancial guaranties (or “wraps”) or by selling protection via credit default swaps (CDSs) [Moody’s (2008c)]. The mortgages underlying the RMBS issues may be either of “prime” or “subprime” quality, depending on the creditworthiness of the respective borrowers, or combinations of both. The [email protected]@K turmoil that started in the summer of 2007 originated in the subprime mortgage markets and affected particular those structured [email protected] instruments that were collateralized by these assets [see Ashcraft and Schuerman (2007)]. In order to grasp the importance of securitization at a global level, Chart 1 and Chart 2 depict the breakdown of securitization by region respectively by collateral. The jFTQ es on securitization presented in these charts include the amounts of [email protected]±kNVt CDOs issued. The charts show the very rapid growth of securitization over the past 15 years and its collapse in the wake of the [email protected]@K turmoil that started in the third quarter of 2007, which proceeded well into the second quarter of 2008. The main reason behind this was the crisis of BNMj dence that hit structured jM ance and securitization, as the jM ancial turmoil revealed important shortcomings in the valuation and disclosure of these [email protected] cial instruments [see: IMF (2008a and 2008b); ECB (2008b); BIS (2008c)]. Chart 1 shows that global securitization is clearly dominated by US originators, but that the relative importance of European originators has been growing. Chart 2 exemp KHjDR that mortgages are by far the most important underlying asset of global securitization, with residential mortgages being the most important single asset class. The chart also shows that “c @RG±kNVt CDOs have increasingly become important in recent years.
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