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The 2007-2008 financial crisis- causes,consequences and implications

by Senanayake, Nadia, MA

Abstract (Summary)
The fundamental motive of this thesis is to locate the main catalysts that caused the 2007/2008 financial crisis, and the rationale of their unique interaction. The three primary avenues used to layout the analysis are the Structured Finance Instruments involved, the parties concerned and the channels that exacerbated the rapidity of the spread that ultimately increased the severity of the crunch.
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Bibliographical Information:

Advisor:Prof Axel Hellmann

School:Fachhochschule für Wirtschaft Berlin

School Location:Germany

Source Type:Master's Thesis

Keywords:Structured finance, securitisation, credit derivatives, hybrid products, pro cyclicality, fair value accounting, Basel 2

ISBN:-

Date of Publication:07/27/2009

Document Text (Pages 1-10)

„Structured Finance and the 2007-2008 Financial Crisis -

Causes, Consequences and Implications”

Master of International Management -
Finance and Accounting”

Summer Term 2009

The 2007-2008 Financial Crisis
Causes, Consequences and Implications”

Master Thesis

by Nadia Senanayake


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„Structured Finance and the 2007-2008 Financial Crisis -

Causes, Consequences and Implications”

Berlin, 25 July 2009

Study program:

Master of International Management-
Finance and Accounting“

Master Thesis

The 2007-2008 Financial Crisis -
Causes, Consequences and Implications”

Name : Nadia Senanayake
Matrikel-No. : 248011
Email : nsenanayake@gmail.com
1st
2nd
Supervisor :
Supervisor :
Prof. Dr. Axel Hellmann
Felix Hulsch
Words : 19.984
Pages : 90


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TABLE OF CONTENT
„Structured Finance and the 2007-2008 Financial Crisis -

Causes, Consequences and Implications”

TABLE OF CONTENT ..............................................................................................................I
ABBREVIATIONS ..................................................................................................................III
LIST OF FIGURES ................................................................................................................. IV
GLOSSARY ............................................................................................................................. VI
INTRODUCTION AND CHANNELING OF THE RESEARCH.......................................... 10
1 CHARACTERISTICS OF CREDIT RISK TRANSFER INSTRUMENTS ....................... 11

1.1 Securitization ..................................................................................................................................... 13
1.1.1 Mortgage Backed Securities (MBS) ...................................................................................................16
1.1.2 Asset Backed Commercial Papers (ABCP).........................................................................................17
1.1.3 Cash Flow Collateralised Debt Obligations (CDOs) ..........................................................................19
1.2 Credit Derivatives and Hybrid Products .......................................................................................... 20

1.2.1 Single Name CDSs............................................................................................................................20
1.2.2 Synthetic CDOs ................................................................................................................................23
1.3 Re-Securitization ............................................................................................................................... 24

1.3.1 ABS CDOs........................................................................................................................................24
1.3.2 CDO² ...............................................................................................................................................26

2 THE PRECURSORS AND TRIGGERS OF THE CRISIS............................................ 29

2.1 Soft Macroeconomic Environment in the United States and the Vulnerability of Banks ............ 29
2.1.1 The Soft Macroeconomic Environment ....................................................................................................29
2.1.2 The Vulnerability of Banks ......................................................................................................................29
2.2 The Augmentation of Subprime Mortgages .................................................................................... 30
2.3 Increased Significance of the “Originate to Distribute” Model...................................................... 31
2.4 Surging Default Rates in the Subprime Mortgage Sector............................................................... 33
3 THE CHANNELLING OF STRUCTURED FINANCE & THE FINANCIAL CRISIS34

3.1 Step I: Reprising of Risk and Credit Market Spillovers (Feb July 2007)................................... 35
3.2 Step II: The Liquidity Squeeze (Aug 2007)..................................................................................... 38
3.3 Step III: The Rapid Deleveraging Process (Sep 2007- Dec 2007)................................................. 39
3.4 Step IV: Dysfunctional Credit Markets and Further Deleveraging (Jan - May 2008).................. 41
4 THE VITAL PLAYERS .................................................................................................. 44

4.1 The Role of Supervision by Regulatory Institutions....................................................................... 45
4.1.1 Greenspan and his failed motives ......................................................................................................45
4.1.2 The Dispersion of Financial Regulation among Multiple Institutions ..................................................46
4.1.3 The Gloomy Banking System .............................................................................................................48
4.2 The Role of Banks ............................................................................................................................. 49

4.2.1 Unforeseen Consequences of Basel II ................................................................................................49
4.2.2 The Short Term Horizons of Manager‟s Incentive Schemes ................................................................50
4.2.3 Failures Associated with Structured Finance .....................................................................................50
4.3 The Role of the Rating Agencies...................................................................................................... 52

4.3.1 Conflict of Interest between Rating Agencies and Issuers ...................................................................52
4.3.2 Absence in Cross-Checking the Origin of the Loans...........................................................................53
4.3.3 The Dependency on AAA Credit Ratings............................................................................................54
4.3.4 Misleading Risk Interpretations.........................................................................................................57

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Causes, Consequences and Implications”
5 PRO-CYCLICALITY & THE EXACERBATION OF THE CRUNCH ....................... 60

5.1 Issues of Capital Adequacy Requirements and Accounting Disclosure ........................................ 60
5.1.1 The Basel II Accord and the Curtailment in Lending Activity..............................................................61

5.1.1.1 The Concept of Basel II ..........................................................................................................61
5.1.1.2 The Drawbacks Associated with Basel II .................................................................................62
5.1.1.3 Pro-cyclicality and Basel II .....................................................................................................63

5.1.2 Fair value accounting and plummeting asset values...........................................................................66
5.1.2.1 The Concept of Fair Value Accounting....................................................................................66
5.1.2.2 Loopholes, Advances in Accounting Standards and their Consequences ...................................67
5.1.2.3 Pro-cyclicality and Fair Value Accounting...............................................................................69
5.1.2.4 Discussion..............................................................................................................................73

5.1.3 Summary ................................................................................................................................................74
5.2 Case Study: Northern Rock .............................................................................................................. 75

5.2.1 The Role of Securitization .................................................................................................................76
5.2.2 The Downfall....................................................................................................................................77
5.2.3 Pro-cyclicality and Leverage.............................................................................................................78
5.2.4 Summary ..........................................................................................................................................80

6 A POST-CRISIS OUTLOOK AND POLICY IMPLICATIONS................................... 81

6.1 Pro-active Monetary Policy .............................................................................................................. 81
6.2 Fair Value Accounting: Current Value Measurement Method....................................................... 82
6.3 An Alternative Approach to the Market Based Basel II Models.................................................... 84

6.3.1 Less Reliance on Risk Sensitive Market Based Models .......................................................................84
6.3.2 The Imposition of a Liquidity Regulation ...........................................................................................86

CONCLUSION ........................................................................................................................ 87
APPENDIX............................................................................................................................... 90
BIBLIOGRAPHY .................................................................................................................... 96

Methodology:

Words underlined in Italics are defined in the glossary
Illustrative practical examples are represented in blue boxes

Example Boxes:

Example 1: Consolidation of structured investment vehicles
Example 2: Credit ratings and the cash flow waterfall
Example 3: Effects of Minimum capital requirements on credit risk transfer instruments
Example 4: Manipulative techniques associated with fair value accounting
Example 5: Effects of mark to market fair value accounting coupled with Basel II

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Causes, Consequences and Implications”
Nadia Senanayake -III- 20.07.2009
ABBREVIATIONS
ABS Asset backed security
ABCP Asset backed commercial paper
AIG American international group
ARM Adjustable rate mortgages
BP Basis points
BIS Bank of international settlements
CE Credit enhancement
CDO Collateralized debt obligation
CMO Collateralized mortgage obligations
CLN Credit linked note
CP Commercial paper
EAD Exposure at default
FAS Financial accounting standards
FED Federal Reserve
FDIC Federal deposit insurance company
FSA Federal securities association
GAAP Generally accepted accounting principles
HPA Home price appreciation
IAS International accounting standards
IFRS International financial standard board
ISDA International swaps and derivatives association
LGD Loss given default
IFRS International financial reporting standards
M Effective maturity
NCUA National credit union administration
OCC Office of comptroller of the currency
OTS Office of thrift supervision
OTC Over the counter
PD Probability of default
ROE Return on equity
RBS Royal bank of Scotland
SEC Security and exchange commission
SIFMA Securities industry and financial market association
SIV Special investment vehicle
SPV Special purpose vehicle
SPE Special purpose entity
S & L Savings and loan crisis

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LIST OF FIGURES
„Structured Finance and the 2007-2008 Financial Crisis -

Causes, Consequences and Implications”

Figure 1: Overview of credit risk transfer instruments (Own illustration based on Jobst, 2003 and Rudolph
et.al 2007, p.14)..................................................................................................................................................... 12
Figure 2: Structured credit dispersion (IMF) ....................................................................................................... 13
Figure 3: European and US structured credit issuance (IMF) ............................................................................ 14
Figure 4: Global securitization by collateral (IMF) ............................................................................................. 15
Figure 5: Global securitization by currency (ECB & BIS)..................................................................................... 15
Figure 6: Creation of a true sale residential mortgage backed securities (Sarai & van Rixtel, 2008, p.18) ... 16
Figure 7: Creation of ABCP by conduits/structured investment vehicles (Sarai & van Rixtel, 2008, p.21)..... 18
Figure 8: Composition of the US ABCP market by collateral type: March 2007 (JP Morgan).......................... 18
Figure 9: US ABCP outstanding amounts (Federal Reserve).............................................................................. 19
Figure 10: CDO issuance by type (SIFMA) ........................................................................................................... 20
Figure 11: Single name CDS cash settlement (Sarai & van Rixtel, 2008, p.21) ................................................ 21
Figure 12: Single name CDS physical settlement (Sarai & van Rixtel, 2008, p.21)........................................... 21
Figure 13: Single name CDS spreads of US investment banks (DataStream)................................................... 22
Figure 14: Single name CDS spreads of European banks (DataStream)........................................................... 22
Figure 15: CDS notional outstanding amounts in $ trillion (ISDA) .................................................................... 23
Figure 16: Synthetic collateral debt obligation based on an RMBS (Sarai & van Rixtel, 2008, p.37)............. 23
Figure 17: Creation of a collateralized debt obligation (CDO) based on “mezzanine” tranches of residential
mortgage-backed securities (RMBS) (“Cash flow”, “true” sale CDO) ................................................................ 24
Figure 18: The relationship between structured CDOs and the subprime crisis (Bank for international
settlements) ........................................................................................................................................................... 25
Figure 19: CDO outstanding volume in July 2007 (IMF)..................................................................................... 25
Figure 20: Risk profile of subprime mortgage loans (UBS)................................................................................ 26
Figure 21: The channels of structured finance and the financial turmoil (Sarai & van Rixtel, 2008, p.41)..... 28
Figure 22: Mortgage debt outstanding in $billions (Financial shock, Mark Zandi p.44)................................. 30
Figure 23: S&P/Case-Shiller Home Price Index (Standard & Poor’s) ................................................................. 31
Figure 24: Global stability map 2007-2008 (IMF stability reports 2007-2008)
................................................. 34
Figure 25: Rising number of downgrades of mortgage related products (IMF stability reports)................... 35
Figure 26: Index spreads from CDS contracts on subprime mortgage bonds (JP morgan chase; Markit; BIS)
................................................................................................................................................................................ 36
Figure 27: Mark to market losses of credit risk transfer instruments (IMF stability reports) ......................... 37
Figure 28: Spreads of mezzanine ABS CDO tranches over LIBOR (BIS) ............................................................. 37
Figure 29: US commercial papers outstanding in 2007 (Federal Reserve)........................................................ 38
Figure 30: Asset backed commercial paper spreads (Federal Reserve Bank of New York; Bloomberg; BIS
calculations)........................................................................................................................................................... 39
Figure 31: Expected bank losses as of March 2008 (IMF stability reports) ....................................................... 40
Figure 32: Net income Ambac and MBIA (ECB) ................................................................................................... 41
Figure 33: Mark to market losses April 2008 (IMF stability reports) ................................................................. 43
Figure 34: Difference between 3 month LIBOR and Treasury bill yields (Bloomberg)..................................... 43
Figure 35: Mortgage lending regulators (Mark Zandi, p.146) .......................................................................... 47
Figure 36: The shadow banking system vs. the traditional banking system (Mark Zandi, p. 120)................. 49
Figure 37: The capital structure of a mortgage security (Mark Zandi, p.115) ................................................. 49
Figure 38: The absence of cross checking the origination of the loans (Own illustration)
.............................. 53
Figure 39: ABX price index spreads: Jan 2007- Jan 2009 (Brunnermeier 2008)................................................ 55
Figure 40: The cash flow waterfall (IMF stability report) .................................................................................. 55
Figure 41: Subprime residential MBS downgrades: 2007-2008 (IMF stability reports) ................................... 58
Figure 42: Corporate bond downgrades: 2001 (IMF stability reports) .............................................................. 58
Figure 43: Comparison of spreads of corporate bonds and MBSs (IMF stability reports)............................... 59
Figure 44: The relationship of business cycles to overall economic growth (SEMP 2009) .............................. 61
Figure 45: Timeline for implementation of Basel II framework (IMF April 2008, stability report) ................. 62
Figure 46: Accounting for securities held as financial assets (IMF April 2008, stability report, p.65)............ 66
Figure 47: Leading US based financial institutions (IMF April 2008, stability report) ..................................... 69
Figure 48: Total assets to leverage of US investment banks 1963-2006 (Shin & Adrian, 2009, p.9)............... 70
Figure 49: Write downs of selected financial institutions (IMF April 2008) ..................................................... 72
Figure 50: Mark to market write downs of structured finance instruments, Apr 2008.................................... 72
Figure 51: Mark to market write downs of structured finance instruments, Oct 2008 (IMF April 2008) ....... 72
Figure 52: Leverage in a downturn (Shin & Adrian, 2009, p.12)....................................................................... 73
Figure 53: The structured finance environment exacerbated by pro-cyclicality (own illustration) ................ 74

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Causes, Consequences and Implications”
Figure 54: A composition of Northern Rock’s liabilities (Northern Rock) ......................................................... 75
Figure 55: Northern Rock’s retail funding as a proportion of total liabilities (Northern Rock)....................... 76
Figure 56: Northern Rock’s securitization dispersion (Prospectus Northern rock, 2005)................................ 76
Figure 57: Composition of liabilities after the run (Northern Rock).................................................................. 77
Figure 58: Northern Rock’s leverage (Northern Rock) ....................................................................................... 79
Figure 59: Northern Rock vs. Their creditors (Northern Rock case study)........................................................ 79
Figure 60: Internal rating based approach (International Monetary Fund, April 2008c)................................ 90
Figure 61: Granite master issuer series 2005-2 (Prospectus Northern Rock, 2005) ......................................... 91
Figure 62: Leverage and total asset growth, asset weighted 1992-2008 (SEC)................................................ 92
Figure 63: Comparison of haircuts (Bloomberg) ................................................................................................ 92
Figure 64: Illustration of haircuts (Bloomberg) .................................................................................................. 93
Figure 65: Rating Changes in RMBS and Home Equity ABS, by Year (Ashcraft 2008.p 61 based on Moody’s
stability report October 27, 2007) ........................................................................................................................ 93
Figure 66: Third quarter bank losses in 2007 (Citigroup) ................................................................................... 94

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GLOSSARY














ABS: Security that represents an interest in non-mortgage financial assets (consumer loans, credit card
debt, etc.).
ABCP: A short-term investment vehicle with a maturity that is typically between 90 and 180 days. The
security itself is typically issued by a bank or other financial institution. The notes are backed by
physical assets such as trade receivables, and are generally used for short-term financing needs.
ABS CDO: ABS CDO is a CDO whose portfolio is comprised of ABS (asset backed securities). A
CDO is subject to credit risk, because some of the assets in the portfolio might not generate the
expected cash flows (when the underlying credits go into default).
ABX.HE: The Markit ABX.HE index is a synthetic tradable index referencing a basket of 20 subprime
mortgage-backed securities.
Arranger: In a CDO structure, the arranger is the entity (an investment bank or an asset management
firm) responsible for placing tranches with investors in return for a fee. In the case of “arbitrage CDO”
it may also be the originator of the transaction, or even the entity which actively manages the
underlying portfolio.
Alt A: A classification of mortgages where the risk profile falls between prime and subprime. The
borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will
generally have some issues that increase its risk profile. These issues include higher loan-to-value and
debt-to-income ratios or inadequate documentation of the borrower's income.
ARM: A type of mortgage in which the interest rate paid on the outstanding balance varies according
to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is
reset periodically, often every month. The interest rate paid by the borrower will be based on a
benchmark plus an additional spread, called an ARM margin
2/28 hybrid ARM: A type of adjustable-rate mortgage that has a two-year fixed interest rate period
after which the interest rate on the mortgage begins to float based on an index plus a margin. The index
plus the margin in known as the fully indexed interest rate. Often, a 2/28 ARM is designed as a shortterm
financing vehicle that provides borrowers with time to repair their credit before they refinance
into a mortgage with more favourable terms.
3/27 hybrid ARM: A type of adjustable-rate mortgage (ARM) frequently offered to subprime
borrowers. These mortgages are designed as short-term financing vehicles that give borrowers time to
repair their credit until they are able to refinance into a mortgage with more favourable terms.
Amortised cost: Amortised cost is the amount at which a financial asset or financial liability is
measured at initial recognition, less principal repayments and plus or minus any unamortized original
premium or discount.
Basel I: A set of international banking regulations put forth by the Basel Committee on Bank
Supervision, which set out the minimum capital requirements of financial institutions with the goal of
minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount
(8%) of capital based on a percent of risk-weighted assets.
Basel II: Capital reserve requirements: A set of banking regulations put forth by the Basel Committee
on Bank Supervision, which regulates finance and banking internationally. Basel II attempts to
integrate Basel capital standards with national regulations, by setting the minimum capital
requirements of financial institutions with the goal of ensuring institution liquidity.
Case Shiller home price index: A group of indexes that tracks changes in home prices throughout the
Untied States. The indexes are based on a constant level of data on properties that have undergone at
least two arm's length transactions. Case-Shiller produces indexes representing certain metropolitan
statistical areas (MSA) as well as a national index.
CBO: Type of CDO where the underlying portfolio comprises bonds.

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CDS: A financial contract between two parties in which a protection buyer pays a premium to a
protection seller in exchange for protection against the occurrence of a credit event on the reference
entity.
CDO squared: Type of CDO where the underlying portfolio is itself made up of CDO tranches.
CLO: Type of CDO where the underlying portfolio comprises bank loans.
CMO: A type of mortgage-backed security that creates separate pools of pass-through rates for
different classes of bondholders with varying maturities, called tranches. The repayments from the
pool of pass-through securities are used to retire the bonds in the order specified by the bonds'
prospectus.
Commercial papers: An unsecured, short-term debt instrument issued by a corporation, typically
for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on
commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount,
reflecting prevailing market interest rates.
CSO: Type of CDO where the underlying portfolio comprises credit derivatives.
CLN: A security with an embedded credit default swaps allowing the issuer to transfer a specific credit
risk to credit investors.
CDO: A security backed by a pool of bank loans and/or negotiable financial instruments (bonds, other
debt securities, etc.), and/or credit derivatives.
CMBS: A debt obligation that represents claims to the cash flows from pools of mortgage loans on
commercial property.
Conduit: An organization, usually a government agency, that issues municipal securities to raise
capital for revenue-generating projects where the funds generated are used by a third party (known as
the "conduit borrower") to make payments to investors. The conduit financing is typically backed by
either the conduit borrower's credit or funds pledged toward the project by outside investors. If a
project fails and the security goes into default, it falls to the conduit borrower's financial obligation, not
the conduit issuer.
Credit enhancement: A method whereby a company attempts to improve its debt or credit
worthiness.
Collateralization: The act where a borrower pledges an asset as recourse to the lender in the event that
the borrower defaults on the initial loan. Collateralization of assets gives lenders a sufficient level of
reassurance against default risk, which allows loans to be issued to individuals/companies with less
than optimal credit history/debt rating.
De leveraging: A company's attempt to decrease its financial leverage. The best way for a company to
de lever is to immediately pay off any existing debt on its balance sheet. If it is unable to do this, the
company will be in significant risk of defaulting.
Derivative Product Company: A special-purpose entity created to be counter-party to financial
derivate transactions. A derivative product company will often originate the derivative product to be
sold; as well, they may guarantee an existing derivative product or be an intermediary between two
other parties in a derivatives transaction
Discounted cash flows: A valuation method used to estimate the attractiveness of an investment
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts
them (most often using the weighted average cost of capital) to arrive at a present value, which is used
to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the
current cost of the investment, the opportunity may be a good one
Equity tranche: In a securitization structure, this tranche absorbs the first losses arising from defaults
on the underlying portfolio.

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Hair cuts: The difference between prices at which a market maker can buy and sell a security. The
percentage by which an asset's market value is reduced for the purpose of calculating capital
requirement, margin and collateral levels.
Jumbo ARMs: An initial rate on an adjustable-rate mortgage (ARM). This rate will typically be below
the going market rate, and is used by lenders to entice borrowers to choose ARMs over traditional
mortgages. The teaser rate will be in effect for only a few months, at which point the rate will
gradually climb until it reaches the full indexed rate, which will be a static margin rate plus the floating
rate index to which the mortgage is tied (usually the LIBOR index).
Loan to value ratio: A lending risk assessment ratio that financial institutions and others lenders
examine before approving a mortgage. Typically, assessments with high LTV ratios are generally seen
as higher risk and, therefore, if the mortgage is accepted, the loan will generally cost the borrower
more to borrow or he or she will need to purchase mortgage insurance.
Mark to market fair value accounting: Mark-to-market or fair value accounting refers to the
accounting standards of assigning a value to a position held in a financial instrument based on the
current fair market price for the instrument or similar instruments.
Mezzanine tranche: In a securitization structure, this tranche absorbs the losses arising from a default
on the underlying portfolio if they exceed the value of the equity tranche.
Mono-line: An insurer that provides financial guaranty insurance for bond issuance or securitization
transactions.
Originator: The entity setting up a securitization vehicle. Depending on the type of securitization, the
originator may be the arranger or the seller.
Over collateralisation: Situation where the asset pledged for a debt far exceeds the debt principal.
Prime borrower: A classification of borrowers, rates or holdings in the lending market that are
considered to be of high quality. This classification is placed on those borrowers that are deemed to be
the most credit-worthy and the prime rate is the rate that a lender will lend to its high quality
borrowers.
Principal-agent relationship: The arrangement that exists when one person or entity (called the
agent) acts on behalf of another (called the principal). For example, shareholders of a company
(principals) elect management (agents) to act on their behalf, and investors (principals) choose fund
managers (agents) to manage their assets. This arrangement works well when the agent is an expert at
making the necessary decisions, but doesn't work well when the interests of the principal and agent
differ substantially. In general, a contract is used to specify the terms of a principal-agent relationship.
Pro-cyclicality: A condition of positive correlation between the value of a good, a service or an
economic indicator and the overall state of the economy. In other words, the value of the good, service
or indicator tends to move in the same direction as the economy, growing when the economy grows
and declining when the economy declines.
Reserve account: In a securitization structure, a reserve account is used to provide credit
enhancement. Excess cash flows from the transaction are progressively deposited in this account.
Repurchase Agreements: A form of short-term borrowing for dealers in government securities. The
dealer sells the government securities to investors, usually on an overnight basis, and buys them back
the following day.
Return on equity: The amount of net income returned as a percentage of shareholders equity. Return
on equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.
Re-securitization: Re-securitization: The repackaging of securitised or structured products through a
CDO into securities once again, such that the securities created at the second stage represent a further
securitization of securities initially created as a result of securitization.

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