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Structured Finance and the Financial Turmoil of 2007 2008

Their counterparties when defaults of the underlying

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their counterparties when defaults of the underlying reference entities occur, up to a maximum amount of 3% of the losses on the index contract. If the losses on the CDS index contract are larger than 3%, then the investors in the junior mezzanine tranche (3-7%) need to start paying their counterparties, etc. CDS index tranches are standardized and thus help fostering liquidity in the credit derivatives markets. Technically, CDS index tranches are basically synthetic CDOs, which will be discussed in section 4.2. Scheicher (2008) has conducted an empirical investigation of the determinants of the spreads of CDS index tranches during the financial turmoil, both for tranches of the main iTraxx and CDX index contracts. He finds that liquidity factors played a more important role since the start of the turmoil in the summer of 2007, indicating that the turmoil affected the pricing of these instruments. Thus, also here, the development and decomposition of CDS spreads (in their determinants) provides information on the development of the financial market tensions in 2007 and 2008.
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Chart 11: The 2007-2008 financial turmoil as shown by the spreads of CDS index contracts BANCO DE ESPAÑA 36 DOCUMENTO OCASIONAL N.º 0808 Bear Stearns hedge funds IKB Actions ECB, FED,CBs BoE bails out Nothern Rock Monolines Banks take SIV on B/S Action CBs (TAF) Hedge funds problems Actions FED (TSLF) Bail-out Bear Stearns GSE problems CDX NA IG iTraxx Europe 20 40 60 80 100 120 140 160 180 200 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 pb SOURCE: Datastream.
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BANCO DE ESPAÑA 37 DOCUMENTO OCASIONAL N.º 0808 4.2 “Synthetic” collateralized debt obligations (CDOs) Similar to securitizations, in addition to “cash flow” CDOs (which were discussed in section 3.3), there also exist “synthetic” CDOs, where the SPE/SPV does not buy physically the portfolio of underlying debt instruments, but sells credit default swaps over the same debt instruments underlying the “cash flow” CDO described above. Thus, the SPE/SPV acquires the same credit risk exposure to this underlying debt without owning it, and transfers this credit risk to investors. An example of a synthetic CDO is shown in Figure 8 (with in red the changes from the “cash flow” CDO). The originator only wants to get rid of the credit risk of the underlying pool of assets and not the physical assets themselves, in this case (similar as above) a pool of “mezzanine” tranches (rated “B”) of various RMBS. The originator buys protection through a CDS contract with the SPE/SPV, which is the seller of protection and gets a CDS premium for the acquired exposure to the credit risk of the reference debt. The SPE/SPV transfers the credit exposure by issuing CDO tranches and selling it to investors (through the same process as in the “cash” CDO). With the cash it receives from its investors, SPE/SPV buys senior low risk debt (rated AAA), receives the interest of that debt (coupons) and transfers a proportion of it to the investors. If a credit event occurs to the underlying debt, the SPE/SPV sells the senior debt in order to pay the CDS protection to the originator. With the profit
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