Structured Finance and the Financial Turmoil of 2007 2008

600 700 800 900 1000 1100 1200 jan 07 apr 07 jul 07

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600 700 800 900 1000 1100 1200 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 bn USD SOURCE: Federal Reserve.
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BANCO DE ESPAÑA 24 DOCUMENTO OCASIONAL N.º 0808 Furthermore, structured CDOs exist, which are CDOs that are based on collateral that exists of structured finance instruments and which will be discussed below. Finally, CDOs can also be classified according to the aim of the transaction [Cousseran and Rahmouni (2005)]. Balance sheet CDOs allow the originator to place certain assets off their balance sheet, allowing assets and/or credit risk to be transferred to an off-balance sheet legal entity. Arbitrage CDOs allow the originator to take advantage of spread differences between the average yields on the underlying portfolio and on the tranches issued. These CDOs will not be discussed here further in detail. Taking into account that the classification of “cash flow” and “synthetic” CDOs is the main one, this Occasional Paper specifically will discuss them. As the former CDOs can be regarded as a form of securitization and since they are often included in statistics on asset-backed securities (see section 2), they are discussed in this section. The latter CDOs have been included explicitly as “pure” credit derivatives and therefore are presented in section 4 on credit derivatives. Turning now to “cash flow” CDOs in detail, these instruments allow the SPE/SPV to obtain the credit risk exposure by purchasing outstanding debt instruments and to transfer the credit risk by issuing its own collateralized financial instruments, primarily debt but could also be equity. Credit rating agencies rate the various tranches of debt issued by the SPE/SPV, depending on differences in seniority, similar to the asset-backed securities described in Figure 3 in section 3.1. An example of a “cash flow”, “true sale” CDO is presented in Figure 5. This is a CDO based on an underlying pool of “mezzanine” tranches of residential mortgage-backed securities (RMBS). The “mezzanine” tranches of RMBs are usually rated BBB (see Figure 3 for an example), thus are relatively low rated. In the example, the originator creates a pool of “mezzanine” tranches from various RMBS and sells this pool to the SPV. The SPV finances its purchase of the pool by issuing a CDO in the form of “tranched” notes, which are bought by various investors. According to their risk preference, these investors buy either lower or higher-rated tranches, with corresponding higher or lower yields. The explanation in Figure 5 of a CDO based on RMBS tranches is an example of a so-called structured CDO (ABS CDO), such as included in Figure 1. These structured CDOs are based on the securitization of another securitization, for example a CDO based on mortgage-backed securities (i.e. CDO of MBS, which is called a collateralized mortgage obligation or CMO). Another example of a structured CDO is a CDO based on other CDOs, which is called a CDO 2 [Citigroup (2005 and 2006a)]. Thus, structured CDOs constitute an element of re-securitization, in other words consist of a
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