Friday January 30, 2009
Financial Services Terms
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| Export-Import Bank |
| Action on Banking & Financial Services |
See also: As this nation faces the most severe financial services industry crisis in decades, it's useful for people to be able to understand the financial terms used in the debate and in the news, to the best of their ability. I've provided definitions for some terms, both simple and complex, that may help understand the discussion in which we all have a role to play.
Arbitrage: The simultaneous purchase and sale of two different, but closely related, securities to take advantage of a disparity in their prices. Alternatively, the purchase and sale of the same security in different markets.
Originally, most arbitrage occurred in the currency markets: arbitrageurs would buy in one market and sell in another. Nowadays, the practice applies equally to commodities, futures and stocks. For instance, if a company is dual-listed on two stock exchanges, and the prices are at variance, an arbitrageur has an opportunity to buy in one market and sell in another before the disparity is closed.
Asset: Any item of economic value owned by an individual or corporation, especially that which could be converted to cash. Examples are cash, securities, accounts receivable, inventory, office equipment, real estate, a car, and other property. On a balance sheet, assets are equal to the sum of liabilities, common stock, preferred stock, and retained earnings.
Capital: 1) Cash or goods used to generate income either by investing in a business or a different income property. 2) The net worth of a business; that is, the amount by which its assets exceed its liabilities. 3) The money, property, and other valuables which collectively represent the wealth of an individual or business.
Capital Markets: Any market where companies or governments raise money to fund themselves. The stock market and the bond market are the most widely used.
Commercial paper: The short-term borrowing that companies use to finance their day-to-day operations and cash needs. The corporate equivalent of a credit card.
Conservatorship: A legal status similar to bankruptcy, in which the government takes control of a company with the intention of restructuring and returning it to private ownership. Housing finance companies Fannie Mae and Freddie Mac are now under conservatorship.
Credit Default Swap: A contract that allows investors to make bets on the likelihood a company will be unable to pay its debts. More specifically, a counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.
Credit Derivative: A credit derivative is a financial instrument used to mitigate or to assume specific forms of credit risk, often to separate the credit risk of a borrower from overall market risk. The purchase of a credit derivative might be seen as insurance to cover the risk of bond issuer default, bankruptcy, insolvency, or a widening of the bond's yield against government securities.
Collateralized Debt Obligations (CDOs): A security that bundles together a number of bonds or loans and then slices them up into tranches, based on their risk.
Debt instruments: A written promise to repay a debt. Examples include bills, bonds, notes, CDs, GICs, commercial paper, and banker's acceptances.
Derivative: A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.
Distressed assets: Distressed assets include loans, mortgages or other types of financial assets that are nonperforming for a variety of reasons. Investing in such assets is a business that has grown in importance only recently in developing countries. Investors purchase these assets from commercial banks and other financial institutions-usually at a discount to face value. Investors obtain a return by working out the assets and reselling them at higher values.
Exotic home loans: Unconventional loans such as those allowing payment of interest only, those with balloon payments or those with an interest rate that may adjust steeply. Not all adjustable-rate mortgages (ARMs) are exotic; one-year ARMs have been used responsibly since the early 1980s.
Fannie Mae: A company created by the government in 1938 to expand the flow of mortgage money. Formally known as the Federal National Mortgage Association. It operates under a congressional charter that directs the company to channel its efforts into increasing the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. The firm buys mortgages that meet its standards, guarantees their credit and repackages them as bonds for sale to investors. The federal government put the company into conservatorship in early September 2008.
Federal funds rate: The interest rate at which banks make overnight loans to each other through the Federal Reserve. The Fed seets a target for this rate, then buys and sells government bonds to try to keep the rate banks, actually charge each other at the target. It is the primary tool that the Fed uses to expand or contract the supply of money in the economy.
Freddie Mac: A company created by the government in 1970 to expand the flow of mortgage money. Formally known as the Federal Home Loan Mortgage Corp. It operates under a congressional charger that directs the company to channel its efforts into increasing the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. The firm buys mortgages that meet its standards, guarantees their credit, and repackages them as bonds for sale to investors. The federal government put it into conservatorship in early September 2008.
Government Sponsored Enterprises (GSE): A group of financial services corporations created by the United States Congress. Their function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent.
Hedge Funds: A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).
Illiquid: That which cannot quickly and easily be converted into cash, such as real estate, collectibles, and thinly traded securities.
Jumbo loan: A mortgage that exceeds the limit at which Fannie Mae or Freddie Mac will buy it. Until earlier this year (2008), that limit was $417,000. It was raised to $729,750, creating a category of jumbo conforming loans. Because jumbo loans cannot normally be bought by Fannie Mae or Freddie Mac, the interest rates on them tend to be higher.
Leverage: The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing. Also called financial leverage.
Leverage ratios: 1) Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses. 2) A ratio used to measure a company's mix of operating costs, giving an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.
LIBOR: London Interbank Offered Rate is the rate at which banks lend to one another. Many other rates, such as those on corporate loans, are tied to this rate. Lately, it has been unusually high, suggesting that banks are hoarding cash and afraid to lend to each other.
Line of credit: An agreement in which a bank agrees to lend up to a certain limit of money for a specified period.
Liquid: Easily converted into cash
Liquidity: The free flow of money through the financial system.
Margin Requirements: The amount that an investor must deposit in a margin account before buying on margin or selling short, as required by the Federal Reserve Board's Regulation T.
Mark to Market accounting: Recording the price or value of a security, portfolio, or account on a daily basis, to calculate profits and losses or to confirm that margin requirements are being met.
Money-market mutual fund: A mutual fund that invests exclusively in short-term debt such as Treasury bills, certificates of deposits, or commercial paper. These funds are generally viewed as safe investments that yield more income than savings acounts.
Moral Hazard: The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.
Mortgage-backed securities: Security backed by a pool of mortgages, such as those issued by Ginnie Mae and Freddie Mac.
Mutual Funds: An open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. mutual funds raise money by selling shares of the fund to the public, much like any other type of company can sell stock in itself to the public. Mutual funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities.
Preferred Stock (Preferred Equity also): A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.
The precise details as to the structure of preferred stock is specific to each corporation. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares".
Private Equity Funds: A fund which invests its money in private equity, often in attempts to gain control over companies in order to restructure the company. When the fund gains control of a company, they will usually take the company off the market if it isn't private already, go through a multi-year restructuring process, and then relist the company on the stock market.
Reverse Auction: This usually occurs in industrial business-to-business procurement. It is a type of auction in which the role of the buyer and seller are reversed, with the primary objective to drive purchase prices downward. In an ordinary auction (also known as a forward auction), buyers compete to obtain a good or service. In a reverse auction, sellers compete to obtain business.
Securities: An investment instrument, other than an insurance policy or fixed annuity, issued by a corporation, government, or other organization which offers evidence of debt or equity.
Securitization: The process of that converts mortgage loans, credit card debt and other types oof assets into securities that can be traded on global markets. This allowes investors all over the world to indirectly make credit available to ordinary Americans, while protecting the lender from risk if any one borrower defaults.
Securitized Debt: A marketing technique that converts long-term loans to marketable securities.
Short selling: Borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. Short selling (or "selling short") is a technique used by investors who try to profit from the falling price of a stock.
Sovereign Wealth Funds: The term applies to government-owned funds set up by the world’s leading exporters, especially China and the major oil producers, that are being deployed more assertively for investment in banks, private companies, equity funds, real property and other assets.
Subprime loan: A loan made to a borrower who is considered risky. That can mean the borrower has a poor credit rating, unstable income or other factors that makes him or her more likely to default. Interest rates are higher than for prime loans to compensate the lender for the extra risk.
Swaps: An exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party.
Toxic paper: Term used to describe any financial instrument, represented by a document (piece of paper), that is not worth the dollar value denoted on that document.
Treasury bills: Short-term debt--effectively, loans that have a duration of less than a year--of the United States government.
Warrants: Warrants are securities issued by a company (often an investment trust) which give their owners the right to purchase shares in the company at a specific price at a future date. The warrants are tradable in their own right, and their value will go up and down as the price of the shares to which they relate goes up and down.
Write-down: Make a downward adjustment in the accounting value of an asset. opposite of write up.
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