Fallout: The Financial Crisis

Financial crisis glossary

Marketplace Staff Nov 10, 2008

Compiled by Sean Powers

Asset: Anything owned by an individual or a business that has commercial or exchange value.

Current assets: Used up, sold, or converted to cash within the normal operation of business. (Inventories, cash, office supplies, pre-paid insurance.)

Plant assets: Permanent or fixed assets, such as land, buildings, equipment.

Auction-rate security: An auction of a corporate or municipal bond, which finances items such as infrastructure, schools, general municipal expenditures or refunding of old debt. Investors (municipalities, colleges, or other institutions) who wish to acquire an ARS submit bids in an auction. During the auction, buyers identify the number of shares they want the lowest interest rate they are willing to accept. Depending on the outcome of the auction, the bond’s interest rate will be reset to match supply and demand. As credit problems escalated in this country, the ARS market began to freeze up, making it difficult for the interest rate of these securities to be repriced. This turned investors away from participating in the auctions. Citigroup, JPMorgan Chase, Merrill Lynch, Morgan Stanley, RBC Group and UBS bought back more than $50 billion of the securities from their investors to ease some of the economic strain from apprehensive investors who stepped away from the auctions.

Bond: A government- or company-issued certificate promising to pay back the principal and interest. An investor who buys a bond from a government or company is lending money to help finance current operations of a property or plant or equipment. The investor does not gain ownership rights like a stockholder.

Coupon bond: The bond gets paid over specified periods of time.

Discount bond: The bondholder gets paid at a specified date.

Collateralized Debt Obligation: A type of asset-backed security coming from a pool of fixed income assets (such as mortgage backed securities). CDOs represent different types of bonds with varying degrees of risk: senior (lower risk/lower yield), mezzanine (medium risk/medium yield), and junior/equity (higher risk/higher yield). The manufacturer of a CDO is usually an investment bank. The bank might pool together 5,000 different mortgages into a CDO. An investor who purchases the CDO would be paid the interest owed by the 5,000 borrowers whose mortgages make up the CDO, but the investor runs the risk that some borrowers won’t pay back their loans. CDOs are an important part of the mortgage market because they buy the riskier, more unpopular bonds of a mortgage-backed security. There is concern that those riskier bonds could suffer losses from the rising cost of delinquencies on subprime mortgages. If there are losses with the riskier bonds, CDOs could exit the residential housing market and leave behind bonds that can’t be sold. This could increase interest rates, and cut the availability of home loans for subprime borrowers.

Commercial paper: A common money market instrument like an IOU that’s issued by large banks and corporations. Companies all over the world rely on commercial paper for short-term borrowings, like paying salaries, purchasing inventory or capital, or buying raw materials. Defaults on commercial paper have happened only a couple of times in the last 30 years. The last time a bank defaulted on commercial paper was with Lehman Brothers. Lehman issued commercial paper to money market funds as an IOU to borrow money for a short period of time. One of these money markets was the Reserve Primary Fund, which held $785 million in Lehman commercial paper and medium-term notes. Lehman’s bankruptcy convinced the Fund’s board that the $785 million in commercial paper was worthless. As other money market funds pulled out, the Reserve’s net asset value dropped to 97 cents a share (net assets dropping less than $1 is known in economic terms as “breaking the buck”).

Credit-default swap: A contract or insurance policy between a seller (a bank) and a buyer (bondholder). The CDS maintains that the seller agrees to pay the buyer in the event of a bond default or bankruptcy. A CDS is essentially bond insurance. When one bond starts defaulting, it can create a ripple effect for other bonds to default because people lose confidence in the market. To protect bondholders from losses when there is a bankruptcy or a default, banks can agree to a CDS where they will replenish a bondholder’s losses. The American International Group was in the CDS business. When the federal government decided to bail out AIG, the Federal Reserve ultimately assumed responsibilities of providing bond insurance. An AIG bankruptcy without government intervention would have stalled this process of replenishing bond losses.

Liability: Amount owed by an individual or entity (such as taxes, salaries, mortgages).

LIBOR: The London Inter-Bank Offered Rate is what international banks charge each other for loans involving Eurodollars. LIBOR, which is set by 16 banks in a daily survey by the British Bankers’ Association, is similar to the United States’ prime rate. It is used to set rates on financial products worldwide, from home loans to derivatives. The index is commonly quoted for one-month, three-month, six-month and 12-month periods. Interest rates on adjustable rate mortgages (ARM) fluctuate in direct proportion to the LIBOR index. When the LIBOR goes up, then people who hold ARM loans tied to the index will experience increasing interest rates on their monthly payments. If the LIBOR decreases, interest rates may remain stable or decrease, which would be good for the economy.

Money market: The market for short-term (up to about a year) debt securities. The money market is where treasury bills, commercial paper and bankers’ acceptances are bought and sold. Historically, money market securities have been seen as safe investments with low interest rate returns, but the recent economic crisis has blown these perceptions out the window.

Money market fund: Money market funds are designed to be similar to bank accounts. When you put $1 in, you expect to get $1 out, including interest at your discretion. A money market fund is a mutual fund that invests in short-term money market instruments, such as certificates of deposit, treasury bills and commercial paper. The fund usually has a net asset value of $1.

Mortgage backed security: Fannie Mae and Freddie Mac are the country’s largest mortgage firms. They buy about half of all mortgages in the United States, and then organizations like banks and insurance companies invest in a pool of hundreds of thousands of these mortgages known as mortgage-backed securities. The investors issue home loans, and when people pay their mortgages a majority of the loan payments flow back to the investors. A big factor in what prompted the current financial crisis is too many investors were giving out loans to people who couldn’t pay them back, and then over a period of time these banks didn’t have any more loans to issue. The rising number of people who couldn’t pay back their mortgages is a reason for the growing number of foreclosures.

Note: A legal document that acknowledges a debt to be repaid.

Resolution Trust Corporation: The agency set up to absorb the assets and debts from failed financial institutions during the savings and loan crisis of the 1980s. Its responsibilities were later shifted to the Savings Association Insurance Fund (SAIF), a unit of the Federal Deposit Insurance Corporation (FDIC).

Security: A certificate of ownership, such as a share, stock, or bond.

Special Investment Vehicle: A pool of investment assets offered by banks to corporations for borrowing short-term money at short-term rates and lending long-term money or buying long-term securities at higher interest rates. Liquidity from highly rated, mainstream banks support SIVs. The risk for banks is being exposed to interest rate fluctuations and a run on liquidity if lenders demand money all at once. This is exactly what has happened during the subprime mortgage crisis. With so many lenders demanding SIV securities, some finance companies, like Cheyne Finance, defaulted on their obligations to businesses. The defaults had dire consequences for banks that invested in these failed SIVs. In the fall of 2007 the U.S. government announced it would initiate a Super SIV bailout fund, but this plan died in December 2007. Instead, some banks such as Citibank announced they would rescue the SIVs they had sponsored and would bring them onto the banks’ balance sheets.

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