Structured Finance and the Financial Turmoil of 2007 2008

Structured finance involves the pooling of assets and

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Structured finance “… involves the pooling of assets and the subsequent sale to investors of claims on the cash flows backed by these pools. Typically, several classes (or “tranches”) of securities are issued, each with distinct risk-return profiles”. This definition clearly involves the elements of a) pooling of assets (either cash-based or synthetically created by using credit default swaps) and b) the tranching of liabilities that are backed by the asset pool. In addition, c) the credit risk of the collateral asset pool is separated from the credit risk of the originator, through the involvement of a Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) [Gorton and Souleles (2005)]. These specific characteristics will be explained in the subsequent sections. In structured finance, rating agencies play a crucial role. These agencies, such as Standard & Poor’s , Moody’s Investors Service and Fitch’s Investors Service, provide ratings to structured finance products which are vital in the valuation process of these instruments. The ratings are indicative for the credit risk (and other risks) of the instruments and depend on the creditworthiness of the issuing bodies such as SPVs/SPEs. A common differentiation between ratings is investment grade and below-investment grade ratings . Following the ratings that are commonly used in the financial markets, investment grade structured finance instruments are those rated BBB or above by Standard & Poor’s and Fitch’s Investors Service, and Baa or better by Moody’s Investors Service, whereas below-investment grade instruments have lower ratings. As has become clear from the introduction above, structured finance is strongly interrelated with securitization. According to Fabozzi and Kothari (2007), structured finance, in a narrow sense, is used almost interchangeably with securitization [see also: The Economist (2008); Blundell-Wignall (2007a and 2007b); Citigroup (2007)]. Traditionally, securitization can be defined as the pooling of financial assets, such as for example residential mortgages, and their subsequent sale (of either the assets themselves or only their credit risk) by the originator to a SPV, which then issues debt securities ¡ known as asset-backed securities (ABS) ¡ for sale to investors. The principal and the interest of the ABS issued by the SPV depend on the cash-flows produced by the pool of underlying financial assets (such as residential mortgages) [ECB (2008a)]. In different words, securitization can also be interpreted as a financing mechanism, or a process in which assets are refinanced in the capital markets by issuing securities sold to investors by a SPV [Vink and Thibeault (2007)]. Securitizations can be conducted basically in two ways. First, in a so-called true sale securitization, the underlying assets are indeed actually sold by the originator to the SPV and thus removed from the balance sheet of the originator (for example a bank). Second, in a so- called synthetic securitization, the underlying assets remain on the balance sheet of the
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