Structured Finance and the Financial Turmoil of 2007 2008

If a credit event occurs to the underlying debt the

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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 from the sale of this debt, the SPE/SPV also returns to the investors their principal-back payment. If the SPE/SPV lacks funds to fully repay all investors the principal amount that they invested in the tranched CDO, the order of payment follows the seniority of the tranches. “Synthetic” CDOs played a rather active role in the propagation of the financial turmoil. In the context of actual and feared further downgrades of various financial guarantors (or monolines) and of CDOs by the rating agencies, a rapid unwinding of “synthetic” CDO positions by in particular hedge funds resulted in a further widening of credit spreads, as demand for these products collapsed [ECB (2008b)]. This process spilled over to other structured finance products such as residential and commercial mortgage-backed securities (RMBS and CMBS) and other asset-backed securities.
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Figure 8: Creation of a “synthetic” collateralized debt obligation (CDO) based on “mezzanine” tranches of RMBS SOURCE: Adapted from: Chacko et al. (2006). Fees Creation and sale of “tranched” CDO in the form of tranched notes that pays coupons Sale of senior debt pays coupons CDS premium Sells CDS protection on reference debt Originator Protection buyer: Buys a pool of CDS over the debt acquired Special purpose vehicle (SPV): Sells CDS, buys senior debt and issues CDO tranches Investors: Buy (tranches of) CDO in the form of differently rated notes AAA assets Rating agencies Investors in “mezzanine” tranches (“B”) of various RMBS Cash Fees Fees Monolines Cash Credit enhancement Sale of “B” tranches RMBS BANCO DE ESPAÑA 38 DOCUMENTO OCASIONAL N.º 0808
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BANCO DE ESPAÑA 39 DOCUMENTO OCASIONAL N.º 0808 5 Conclusions: The specific channels of structured finance and the financial turmoil The financial turmoil of 2007-2008 has revealed substantial transparency and information shortcomings due to the increasing opaqueness and complexity of the global financial system. This has in particular been evidenced by uncertainty on the size and distribution of the losses resulting from the subprime crisis and on the valuation and related ratings of structured finance products. The aim of this Occasional Paper has been to present an overview of the fundamental characteristics of the main instruments of structured finance and their role in the financial turmoil. It has been shown that in particular various securitizations or asset-backed securities (in the broad sense), such as (subprime) mortgage- backed securities (MBS), asset-backed commercial paper (ABCP) and “cash-flow” collateralized debt obligations (CDOs), and one of the main types of “pure” credit derivatives, i.e. “synthetic” CDOs, played a crucial role in the development and propagation of the financial turmoil. It also has been shown that another credit derivative, i.e. credit default swaps
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