Structured Finance and the Financial Turmoil of 2007 2008

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BANCO DE ESPAÑA 35 DOCUMENTO OCASIONAL N.º 0808 iTraxx families of corporate CDS indices (for an overview see Table 5 in Annex 1). The former includes reference entities in North America and emerging markets, while the latter includes reference entities in the European and Asian markets. The indices are based on active names in the single-name CDS market and a variety of indices is maintained. The two main and most actively traded CDS index contracts are based on a diversified investment grade portfolio of 125 names (the CDX.NA.IG for the United States and the iTraxx Europe index). For example, the CDX.NA.IG contract is essentially a portfolio of 125 five-year single-name credit default swaps, covering equal principal amounts of debt of each of 125 named North American investment-grade issuers [Duffie (2007)]. The development of the spreads of these two main index contracts is highly indicative of the development of the financial turmoil in 2007 and 2008, as they are representative for a broad category of financial and non-financial companies. Chart 11 shows the CDX.NA.IG and iTraxx Europe spreads, in re lat ion w ith a number of h igh ly pub l ished events which played key roles in the turmoil. These events are the collapse of two Bear Stearn’s hedge funds in June 2007, the collapse of the German bank IKB in July/August, the liquidity emergency operations by major central banks in August, the bail-out of the mortgage lender Northern Rock in the UK in September, the increasing problems with the financial guarantors or monoclines in October/November, the absorption of assets of problem SIVs by banks on their balance sheets in November/December, additional central bank actions in December, a widening of the financial market problems to hedge funds and specific credit market segments in February/March, the large scale market supporting actions by the Federal Reserve in March, including the bail-out of Bear Stearns and the uncertainties surrounding Fannie Mae and Freddie Mac (GSE problems) in July. The specific pattern of the two credit spread series shows that the developments in the US and Europe were highly correlated, indicating the truly global nature of the financial turmoil. It is also clear the problems culminated in March 2008 and that the interventions by the Federal Reserve in that month managed to mitigate the tensions. A CDS index contract is divided in tranches (CDS index tranches) , rather similar to other structured finance products (see for example Figure 3 in section 3.1). Each tranche refers to a different segment of the loss distribution of the underlying index. Most CDS index contracts are divided in five tranches. The specific tranches of the most traded (CDX.NA.IG) contract are as follows (within brackets the percentage loss on the index contract that the specific tranche absorbs): The equity tranche (0-3% ) , junior mezzanine tranche (3-7%), senior mezzanine tranche (7-10%), junior senior tranche (10-15%) and super senior tranche (15-30%). Thus, investors in the “equity” tranche (“0-3%”) are the first to pay
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