Oct 12, 2008
These days, you are going to need more than the usual financial vocabulary to get you through dinner conversations about the hottest topic of the day - the financial crisis. Can't tell Libor from Sibor? Confused by what a credit default swap is? These are the 10 terms you need to know.
1. Securitisation
This is the starting point to understanding today's financial crisis.
If a bank lends money to a company or an individual, it is simply called a loan. But the bank is at risk if the borrower defaults and cannot service the loan.
So the bank 'securitises' the loans it has, packaging them into investments (think of them as IOUs) and selling them to third- party investors.
The bank has now taken the risk of the loans off its books and no longer needs to set aside capital to protect against their default. So it is free to grant even more dodgy loans.
2. Mortgage-backed securities
These repackaged home loans are the 'IOUs' that third-party investors bought.
Investors are willing to buy mortgage-backed securities because each security is backed by thousands of loans, so the risk of default is much lower.
Besides, they get paid a healthy interest return and can even buy a 'credit default swap' (see point 3) to insure themselves against default. Crafty investment banks can even securitise the already securitised loans again and sell them off again.
When the property market slumped in the United States, homebuyers defaulted on their loans. This triggered the default of some mortgage-backed securities, which plummeted in value. Some banks were heavy investors in these securities, which is why they are in trouble today.
3. Credit default swaps
These are essentially 'insurance policies' that companies or investors buy to protect themselves from the default of something or someone.
The buyers of these swaps make regular payments (much like insurance premiums) to a swap seller, usually an insurer, in exchange for a payout when there is a default.
The CDS market plays a key starring role in the story of the current financial crisis. Banks in the US that granted dodgy mortgages securitised the loans and sold them to investment banks like Lehman Brothers to get the loans off their books.
The investment banks would then buy credit default swaps from an insurer like AIG to neutralise the risk of the homebuyers defaulting on their mortgages.
The CDS market was unregulated, so AIG didn't have to put up any capital to back the swaps. This is why AIG and other swap issuers continued to issue them freely until they became a US$60 trillion (S$89 trillion) market.
As housing prices collapsed in the US, sellers of swaps like AIG had to make big payouts they could not afford. This precipitated AIG's near-collapse.
4. Collateralised debt obligations
CDOs are like mortgage-backed securities, but instead of mortgages they are made up of different types of assets, including commercial property and bonds. CDOs and mortgage-backed securities are some of the instruments which people nowadays call 'toxic debt'.
5. Leveraging/Gearing
Leverage, or gearing, measures the degree to which a company or an investor is using borrowed money. Companies that are highly leveraged or highly geared borrow a lot of money compared to how much they actually have.
Leveraging plays an important role in the financial crisis because many investment banks borrowed heavily - using their shares as collateral - to invest in risky high-return securities.
This was highly profitable as long as the market was rising. Instead of stumping up $100 to buy something, they would put up $10 and borrow the money. If they made money on that $100, the return on the actual money waged ($10) would be much higher.
'Deleveraging' is an important term that describes what is happening now. As asset prices fall and confidence evaporates, banks and companies have to put up more collateral and reduce their debt levels by selling assets and raising capital.
6. Libor/Sibor
The London Interbank Overnight Rate and the Singapore Interbank Overnight Rate respectively, these terms refer to the rates that banks charge when they lend money to one another in London and Singapore.
The rates are set daily by banks themselves and are different from the rates at which banks lend money to individuals. In recent weeks, Libor and Sibor have soared as banks become more cautious about lending money to one another and want a premium for doing so. But Sibor has eased in recent weeks.
7. Treasuries
These are government bonds issued by the United States Treasury Department. They include treasury bills, treasury notes and treasury bonds, which have different maturity periods. Treasuries are seen as the ultimate safe-haven investment because they are denominated in US dollars - the reserve currency of the world - and also backed by the mighty US government. Therefore, demand for US Treasuries has skyrocketed of late.
8. Derivatives
These are a class of instruments that derive their value from another underlying asset, such as a company stock, allowing investors to profit from movements in the stock price without actually owning the stock.
Investors can also buy derivatives to take bets on anything from interest rates to the weather. US billionaire investor Warren Buffett has warned that these complex investments are a time bomb, calling them 'financial weapons of mass destruction'.
9. Short-selling
This is when an investor sells a financial instrument like a stock that he doesn't own, in the hope of buying it back later at a lower price and earning a profit. Short-sellers often borrow stock to make good their trades.
Short-sellers have exacerbated the financial crisis because their selling actions have pushed stock prices down very sharply. This has prompted many countries to temporarily ban the practice.
10. Hedge funds
These are private, barely regulated investment funds that manage assets using high-risk, high-return strategies. They typically borrow money ('leverage') to eke out bigger returns and are often blamed for indiscriminate short-selling.
Originally named after their tendency to hedge their investments to reduce risk, hedge funds now include funds that do not hedge, and those that use hedging methods to increase risk so as to get greater returns.
Fiona Chan
These days, you are going to need more than the usual financial vocabulary to get you through dinner conversations about the hottest topic of the day - the financial crisis. Can't tell Libor from Sibor? Confused by what a credit default swap is? These are the 10 terms you need to know.
1. Securitisation
This is the starting point to understanding today's financial crisis.
If a bank lends money to a company or an individual, it is simply called a loan. But the bank is at risk if the borrower defaults and cannot service the loan.
So the bank 'securitises' the loans it has, packaging them into investments (think of them as IOUs) and selling them to third- party investors.
The bank has now taken the risk of the loans off its books and no longer needs to set aside capital to protect against their default. So it is free to grant even more dodgy loans.
2. Mortgage-backed securities
These repackaged home loans are the 'IOUs' that third-party investors bought.
Investors are willing to buy mortgage-backed securities because each security is backed by thousands of loans, so the risk of default is much lower.
Besides, they get paid a healthy interest return and can even buy a 'credit default swap' (see point 3) to insure themselves against default. Crafty investment banks can even securitise the already securitised loans again and sell them off again.
When the property market slumped in the United States, homebuyers defaulted on their loans. This triggered the default of some mortgage-backed securities, which plummeted in value. Some banks were heavy investors in these securities, which is why they are in trouble today.
3. Credit default swaps
These are essentially 'insurance policies' that companies or investors buy to protect themselves from the default of something or someone.
The buyers of these swaps make regular payments (much like insurance premiums) to a swap seller, usually an insurer, in exchange for a payout when there is a default.
The CDS market plays a key starring role in the story of the current financial crisis. Banks in the US that granted dodgy mortgages securitised the loans and sold them to investment banks like Lehman Brothers to get the loans off their books.
The investment banks would then buy credit default swaps from an insurer like AIG to neutralise the risk of the homebuyers defaulting on their mortgages.
The CDS market was unregulated, so AIG didn't have to put up any capital to back the swaps. This is why AIG and other swap issuers continued to issue them freely until they became a US$60 trillion (S$89 trillion) market.
As housing prices collapsed in the US, sellers of swaps like AIG had to make big payouts they could not afford. This precipitated AIG's near-collapse.
4. Collateralised debt obligations
CDOs are like mortgage-backed securities, but instead of mortgages they are made up of different types of assets, including commercial property and bonds. CDOs and mortgage-backed securities are some of the instruments which people nowadays call 'toxic debt'.
5. Leveraging/Gearing
Leverage, or gearing, measures the degree to which a company or an investor is using borrowed money. Companies that are highly leveraged or highly geared borrow a lot of money compared to how much they actually have.
Leveraging plays an important role in the financial crisis because many investment banks borrowed heavily - using their shares as collateral - to invest in risky high-return securities.
This was highly profitable as long as the market was rising. Instead of stumping up $100 to buy something, they would put up $10 and borrow the money. If they made money on that $100, the return on the actual money waged ($10) would be much higher.
'Deleveraging' is an important term that describes what is happening now. As asset prices fall and confidence evaporates, banks and companies have to put up more collateral and reduce their debt levels by selling assets and raising capital.
6. Libor/Sibor
The London Interbank Overnight Rate and the Singapore Interbank Overnight Rate respectively, these terms refer to the rates that banks charge when they lend money to one another in London and Singapore.
The rates are set daily by banks themselves and are different from the rates at which banks lend money to individuals. In recent weeks, Libor and Sibor have soared as banks become more cautious about lending money to one another and want a premium for doing so. But Sibor has eased in recent weeks.
7. Treasuries
These are government bonds issued by the United States Treasury Department. They include treasury bills, treasury notes and treasury bonds, which have different maturity periods. Treasuries are seen as the ultimate safe-haven investment because they are denominated in US dollars - the reserve currency of the world - and also backed by the mighty US government. Therefore, demand for US Treasuries has skyrocketed of late.
8. Derivatives
These are a class of instruments that derive their value from another underlying asset, such as a company stock, allowing investors to profit from movements in the stock price without actually owning the stock.
Investors can also buy derivatives to take bets on anything from interest rates to the weather. US billionaire investor Warren Buffett has warned that these complex investments are a time bomb, calling them 'financial weapons of mass destruction'.
9. Short-selling
This is when an investor sells a financial instrument like a stock that he doesn't own, in the hope of buying it back later at a lower price and earning a profit. Short-sellers often borrow stock to make good their trades.
Short-sellers have exacerbated the financial crisis because their selling actions have pushed stock prices down very sharply. This has prompted many countries to temporarily ban the practice.
10. Hedge funds
These are private, barely regulated investment funds that manage assets using high-risk, high-return strategies. They typically borrow money ('leverage') to eke out bigger returns and are often blamed for indiscriminate short-selling.
Originally named after their tendency to hedge their investments to reduce risk, hedge funds now include funds that do not hedge, and those that use hedging methods to increase risk so as to get greater returns.
Fiona Chan
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