Structured Finance and the Financial Turmoil of 2007 2008

After the implementation of major new policy measures

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After the implementation of major new policy measures in the course of March 2008, particularly in the United States, some sense of normalization returned to global financial markets, but uncertainty in various market segments ¡ in particular of the credit and structured finance markets ¡ remained at elevated levels. There is broad consensus that structured finance played an important role in the development and propagation of the financial turmoil. For example, the IMF has concluded that “… the proliferation of new complex structured finance products, markets, and business models exposed the financial system to a funding disruption and a breakdown in confidence” and that certain structured finance products “… likely exacerbated the depth and duration of the crisis by adding uncertainty relating to their valuation as the underlying fundamentals deteriorated” [IMF (2008a)]. The financial turmoil revealed a number of weaknesses related to the use of structured finance which can be summarized as follows. In numerous cases, banks underestimated their exposures to structured finance products and to specific 1 . More formally defined, according to Kiff and Mills (2007), p.3, subprime mortgages are residential loans that do not conform to the criteria for “prime” mortgages and so have a lower expected probability of full repayment, as they are made to more “risky” mortgage borrowers. This assessment is made according to objective criteria such as the borrower’s credit score and record and loan-to-value ratios. An elaborate discussion of the sub-prime mortgage market is beyond the scope of this paper. An excellent overview is presented in the aforementioned publication.
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BANCO DE ESPAÑA 10 DOCUMENTO OCASIONAL N.º 0808 “off-balance sheet” vehicles which play an important role in this type of finance. Moreover, certain banks invested heavily in structured finance products, with retaining large exposures to specific structured finance instruments such as collateralized debt obligations, but without understanding sufficiently their impact on the banks’ capital and liquidity positions. In addition, in recent years banks in general resorted to more volatile funding sources including structured finance products. When the financial turmoil hit and structured credit markets came to a virtual standstill, the funding capability of specific banks ¡ such as Northern Rock in the UK ¡ was impaired significantly. Furthermore, many of the globally operating banks had offered liquidity standby facilities to “off-balance sheet” vehicles engaged in structured finance, but generally underestimated the liquidity risk arising from off-balance sheet exposures. Finally, the financial turmoil has raised concerns that the process of securitization may have generated unwelcome incentive problems, in the sense that banks may not assess the credit risk of specific borrowers accurately as they put these loans off the balance sheet anyway through securitization techniques.
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  • Fall '12
  • Stefina
  • Economics, Collateralized debt obligation, mortgage-backed securities, CDO, Banco De Espana, DOCUMENTO OCASIONAL N.º

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