Structured Finance and the Financial Turmoil of 2007 2008

Double layered securitization process 3 chart 5 shows

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“double layered securitization” process. 3 Chart 5 shows that the issuance of structured CDOs increased very fast from the fourth quarter of 2005 to the second quarter of 2007, but when the financial turmoil hit in the third quarter of 2007, their issuance rather collapsed, a process that continued way into 2008. The process of creating structured CDOs is exemplified in Figure 6. As a first securitization, based on various pools of residential mortgage loans, a number of residential mortgage-backed securities (RMBS) are created. Then, on the basis of a pool of “mezzanine” 3 . This process has also been described as a broadening of securitization. See BIS (2008a), p. 5.
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BANCO DE ESPAÑA 25 DOCUMENTO OCASIONAL N.º 0808 tranches derived from these RMBS, a second securitization is conducted, which is the creation of a CDO based on the pool of “mezzanine” tranches. The interesting aspect is that the rating of the tranched CDO is for 87% “super-senior” and “senior” (i.e. 75% AAA and 12% AA), thus much higher than the BBB rating of the underlying “mezzanine” tranches from the RMBS. The new CDO has also a “mezzanine” tranche, which however is only 4% of the CDO. Thus, via “financial alchemy” of the rating agencies, a considerable part of the tranches of the CDO receives here much higher credit ratings (namely AAA and AA) than the original BBB tranche of the RMBS, linked to residential mortgages [on the inherent weaknesses of this process, see Mason and Rosner (2007a and 2007b); The Banker (2008)]. The main reason for this is that the correlation between the various “mezzanine” tranches is perceived to be lower than between the mortgages in the individual mortgage pools, because the “mezzanine” tranches are backed by different mortgage pools. For example, the correlation between the “mezzanine” tranche from a RMBS backed by a pool of mortgages from New York and the “mezzanine” tranche from a RMBS backed by a pool of mortgages from Alaska is perceived to be lower than the correlation between the mortgages in either the New York or Alaska mortgage pools. As a result, the debt issued by the SPE/SPV usually has a higher rating than that of the underlying or collateral debt. This has allowed institutional investors in certain countries to invest in such debt. In Table 3, it is shown how vulnerable in particular structured CDOs were to the US subprime mortgage crisis ¡ in fact, they played a key role in the 2007-2008 financial turmoil [see BIS (2008a), for an excellent exposition]. The table includes CDOs which are based on structured finance products, such as subprime and other residential mortgage-backed securities, CDOs and other underlying collateral. For example, 50% of the CDOs which were based on relatively highly rated “high grade” asset-backed securities (ABS) had in fact as collateral subprime residential mortgage-backed securities. For the CDOs based on lower rated “mezzanine” ABS this percentage was even 77%. Essentially what happened during
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