Short definitions of financial terms that have become part of the daily conversation as the worst financial crisis in decades has deepened.
The Associated Press
NEW YORK — A number of financial terms have become a part of the daily conversation as the worst financial crisis in decades has deepened, affecting companies, industries and ordinary people. A slowdown that began in the real estate market has led to bank failures, plunging stock prices and an economy that may be hurtling toward a deep recession. The glossary below lists short definitions for these terms.
One one-hundredth of 1 percentage point. Changes in interest rates are measured in basis points. So if the target Federal funds rate was at 2 percent and it was cut by 50 basis points, the new target rate would be 1.5 percent.
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Collateralized debt obligations:
A security backed by underlying bonds or other fixed-income assets. CDOs are made up of different sections that are rated according to risk; the riskier sections pay higher interest rates to investors. Credit rating agencies have been accused of failing to account for the risks that many CDOs posed and mistakenly gave them AAA ratings, the highest classification. Many CDOs failed and contributed to the credit crisis.
Short-term promissory notes, or IOUs, that companies sell to money-market mutual funds and other investors to raise cash to pay for daily needs, such as making payroll. It typically carries interest rates higher than risk-free Treasury bills, but lower than what banks charge for short-term loans. Commercial paper with maturities ranging from overnight to up to 270 days are exempt from Securities and Exchange Commission registration requirements. Maturities had averaged about 30 days before the credit crisis intensified, according to the Federal Reserve. But as demand for commercial paper dried up in September as investors pulled money out of money-market investments, many companies have had trouble selling commercial paper. That led to a new program announced by the Federal Reserve on Tuesday to buy top-rated commercial paper directly from companies.
Credit default swap:
A contract that is a form of insurance that a debt security will be repaid in case of default. Banks and others have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold. But the credit default swap market, estimated at more than $62 trillion, is unregulated and prone to poor documentation. That lack of transparency has helped fan the credit crisis. Many credit default swaps have sunk in value as the mortgage-backed securities they support have imploded. Fear of what would happen if investors had to unwind swaps led the government to lend $85 billion to insurer American International Group in September.
The money that a company or individual owes a creditor through the use of loans or bonds. Companies, banks and agencies depend on debt to finance their operations. As the credit markets have frozen up, companies have had trouble operating. Their inability to borrow money has contributed to the economic slowdown.
A financial instrument whose value depends on its underlying assets, such as mortgages, stock or any tradable commodities. Derivatives can be used to hedge risks but can also produce steep losses if the value of their underlying assets fall. Credit default swaps are one form of derivative. So are stock futures.
A share of ownership in a company, home or other asset. Companies issue shares of ownership through stock. With a home, equity equals its current market value minus the amount the borrower owes on the mortgage. As home values have sunk, many homeowners have lost equity. Some are even “upside down” on their mortgages: They owe more than their homes are worth. Many of these homeowners have fallen into foreclosure.
The Federal Deposit Insurance Corp., the government agency that insures deposits in banks and thrifts. The FDIC has temporarily raised the maximum amount it will repay depositors from $100,000 to $250,000 in cases where banks or savings and loans fail. If a customer has accounts at more than one bank, each account is now insured up to $250,000. For joint accounts in which both people have equal rights of withdrawal, the insured limit is $500,000. The higher limits are set to expire at the end of 2009.
Lightly regulated private investment funds that gather investments from wealthy private investors, pension funds, state retirement funds and others and use sophisticated techniques to try to produce high returns, usually with high levels of debt to increase leverage. These tools, including investing in derivatives and short selling, are supposed to reduce risk. But when certain investment classes collapse, hedge funds can suffer devastating losses. The most famous was Long-Term Capital Management, a hedge fund whose failure required a $3.6 billion bailout from Wall Street banks in 1998. Successful hedge fund managers tend to command outsized yearly fees: 2 percent of all money under management and 20 percent of all profits.
Home equity line of credit (HELOC):
A line of credit secured by a home that borrowers can use to pay for big purchases, such as home additions. Borrowers can draw on the line of credit, up to a limit set by the lender, for a fixed period, usually five to 10 years. Over that time, borrowers typically are required to only pay interest. During the repayment period, often 10 to 20 years, the borrower must repay the principal with interest.
The use of borrowed money to invest or finance operations. The more leveraged a company or investor is, the more risk they take on. Investment banks have traditionally used high levels of leverage. By contrast, federal regulations have limited the use of leverage by commercial banks. Highly leveraged institutions ran into trouble when mortgage-backed investments collapsed, leaving them unable to make their loan payments.
The rate that international banks charge for short-term loans to each other. Libor, an acronym for the London Interbank Offered Rate, is calculated every business day in 10 currencies and 15 terms, ranging from overnight to one year. In normal times, Libor is usually about one half of a percentage point above comparable yields on U.S. Treasury bills, whose yields tended to be influenced primarily by the benchmark rate set by the Federal Reserve for overnight loans between banks, known as the Fed funds rate. Recently, though, as banks have grown fearful of lending to each other, Libor has surged. Recently, the three-month U.S. dollar Libor rate was 4.32 percent, while the yield on three-month Treasury bills was only 0.89 percent.
The more quickly or easily an asset or an investment can be sold or redeemed, the more liquid it is. Liquid investments are often traded on exchanges such as the stock market. Banks were able to turn formerly illiquid investments, such as mortgages, into liquid ones by packaging them into securities.
Mark to market:
A form of accounting in which companies must value assets at their current price, reflective of what similar assets have been sold, rather than a higher price they might fetch later. Also called “fair value.” As markets for investments such as mortgage-backed securities have evaporated, their market value has plummeted. Some bankers have argued that mark-to-market accounting is to blame for their write-downs and for falling confidence. As part of the $700 billion bailout legislation, Congress has authorized the SEC to suspend the mark-to-market accounting rule. Those who want to drop mark-to-market accounting say it created an insolvency crisis for banks. But those who favor this accounting approach say it reflects reality: If a company has made a rotten investment and no one wants to buy it, its fair value should be low.
A loan secured by property. The contract between the borrower and the lender gives the lender the right to take possession of the property and resell it to repay the debt in case of default. Mortgages are categorized in terms of their riskiness:
— Prime mortgage: A mortgage with the benchmark interest rate that banks charge their most creditworthy borrowers. The rate can be fixed or adjustable after a certain period.
— Alternative-A mortgage (Alt-A): A mortgage considered riskier than a prime loan but not as risky as a subprime loan. Alt-A covers a variety of mortgages, including those for borrowers with only small down payments or unstable incomes. Also included are mortgages that let borrowers pay only interest on the debt for a fixed period. Included, too, are mortgages in which borrowers can pay less than the full interest due, thereby boosting the principal balance they owe.
— Subprime mortgage: Mortgages used by borrowers with tarnished credit histories. These borrowers typically pose greater risk for lenders, so they are charged a higher interest rate. Those rates can be fixed or adjustable after a certain period.
A bond or security backed by a pool of mortgages. These securities, which provide a cash flow based on the principal and interest payments of the underlying mortgages, were long seen as a relatively safe way to earn returns higher than Treasury rates. But mortgage defaults and foreclosures sharply raised their risk. As more investors refused to buy the securities, banks that had been selling them were stuck holding them. The plunge in the value of mortgage-backed securities has contributed to more than $300 billion in write downs by global banks and brokerages. Historically, most residential mortgage-backed securities were guaranteed by government-sponsored entities, such as Fannie Mae and Freddie Mac, and had to meet certain standards. But the share of mortgage-backed securities issued by private companies without such standards grew from about 20 percent of all mortgage-backed securities in 2001 to 56 percent in 2006, according to the Office of Federal Housing Enterprise Oversight, a regulator.
A technique the government may use to buy illiquid mortgage-related and other assets from financial institutions. Because a reverse auction involves a single buyer, it is the opposite of a traditional auction in which one seller weighs bids from numerous would-be buyers. In a reverse auction for subprime mortgage loans, a bank that offers to sell a bundle of bad loans for 50 cents on the dollar would outbid a bank offering to sell its loans for 60 cents on the dollar. By creating a market for distressed debt, proponents say such auctions allow more uniform and transparent pricing. But critics say banks might sell the government only their weakest assets, which could lead to huge taxpayer losses. Or, if the government pushes to buy securities for the lowest possible price, it could compound the losses at the selling institutions, further weakening them.
The practice of bundling hundreds or thousands of individual mortgages or other assets together and then selling ownership stakes to investors. The pools typically included sections called tranches, which varied by level of perceived risk and represented various streams of income from the underlying assets, such as interest payments and principal repayments.
A technique in which investors borrow shares in a company from a broker and sell them, hoping to buy them back later at a lower price. Short selling is a bet that a stock’s price will fall. But short sellers lose money if they have to buy back the shares after the stock has risen. The SEC recently banned short-selling in nearly 1,000 financial companies, saying sharp declines in those stocks had eroded confidence in the companies. The order is set to expire today. The SEC is also investigating whether some investors shorted shares of financial stocks while spreading false rumors about the companies.
The ability to pay expenses and debt obligations on time and continue operating. An insolvent company will typically have to seek bankruptcy protection from its creditors. Besides companies, individuals, agencies and governments can be solvent or insolvent.
Securities sold by the federal government to investors to fund its operations and to cover the interest costs of existing U.S. debt and pay off maturing securities. Because they carry the full backing of the government, Treasurys are viewed as the safest investment for those seeking income and preservation of capital. While Treasurys pay lower rates than most other debt securities of similar maturity, they have been the safe-haven choice for investors fearful that their other holdings could decrease in value. And since yields move inversely to prices, this increased demand has pushed up prices and pushed down yields in recent weeks. Securities that mature in one year or less are known as Treasury bills. The Treasury currently sells three-month, six-month and one-year T-bills. Treasury notes have maturities of more than one year and up to 10 years, with two-year, five-year and 10-year T-notes now sold. Treasury bonds have maturities of 10 years or longer. The 30-year bond is the only T-bond now sold.
Write-down (n., adj.), write down (v):
An accounting step a company makes when an asset or class of assets it holds falls in value. The decline in value is reflected in a reduction on the asset side of a company’s balance sheet. As mortgage defaults and foreclosures have surged and the market for mortgage-backed securities has vanished, global banks and brokerages have written down more than $300 billion in assets.