ADJUSTABLE RATE MORTGAGE (ARM) A mortgage with an interest rate that varies over time, usually with reference to some external rate.
ALT-A MORTGAGE Originally, a mortgage offered to a borrower with a good credit rating but without full documentation (an alien, for example). During the bubble, Alt-A mortgages were used to mask the borrower’s financial incapacity, becoming known in the trade as “liar loans.”
BANK HOLDING COMPANY A corporation that owns a regulated deposit-taking bank, usually along with other financial services entities that may or may not be regulated.
BROKER-DEALER A firm that is in the business of buying and selling securities for its customers. Broker-dealers are often subsidiaries of investment banks.
COLLATERALIZED DEBT OBLIGATION (CDO) A security that is backed by a range of other securities, often of multiple types, including mortgages, bank loans, bonds, and so forth. A CDO is almost always structured; that is, it will offer a hierarchy of bonds ranked by their payment priority. The cash flows from the securities supporting the CDO are directed first to the top-ranked bonds, then to the second-ranked, and so on down the “subordination” ladder. The bottom-ranked CDO bonds therefore absorb the first losses. CDOs played an important role in the financial crash, because their structure was inherently opaque and CDO creators loaded them up with very risky instruments, like subprime, often fraudulent, mortgages. A CDO SQUARED (CDO2) is a CDO constructed from risky pieces of other CDOs.
COMMODITY FUTURES TRADING COMMISSION (CFTC) An independent federal agency that regulates trading in futures and options.
COMMUNITY REINVESTMENT ACT (CRA) A 1977 federal law that required regulated lenders to make loans and provide services to their local communities.
CREDIT DEFAULT SWAP (CDS) A form of derivative that transfers the default risk of a debt security, like a bond or a loan. The protection buyer pays a stream of interest-like payments to the protection seller, who agrees to make the protection buyer whole if the instrument defaults. Neither the protection buyer nor the protection seller needs to own the underlying instrument. CDSs grew at an extraordinary rate during the bubble because they were a convenient way for traders to simulate bond portfolios with minimal cash outlays.
CREDIT RATING AGENCIES Private companies that evaluate the risk and credit quality of securities and provide ratings based on their analysis. The largest credit raters are Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s.
DEPOSITARY INSTITUTION A financial institution, which may be a bank, a thrift (savings and loan), or a credit union, that accepts deposits.
DERIVATIVE A financial contract with a value that is determined by the value of some other underlying asset, rate, or event.
FANNIE MAE Short for the Federal National Mortgage Association (FNMA), a government-sponsored enterprise that provides financing for the home mortgage market.
FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) An independent federal agency that insures the deposits of federally chartered banks and savings banks, as well as state-chartered institutions that elect to join the Federal Reserve System. It is financed entirely by the insured institutions. To prevent insurance losses it examines the books and safety of insured institutions; if an institution does fail it has the power to take over, reorganize, sell, or otherwise dispose of such institutions in order to recover its insurance payouts.
FORECLOSURE The legal process by which a mortgage lender takes ownership of a property securing a defaulted mortgage.
FREDDIE MAC Short for the Federal Home Loan Mortgage Corporation (FHLMC), a government-sponsored enterprise that provides financing for the home mortgage market.
GLASS-STEAGALL ACT The Banking Act of 1933 that, among other things, prohibited commercial banks from underwriting or dealing in most types of securities, and prohibited banks from affiliating with securities firms. In 1999 the Gramm-Leach-Bliley Act repealed the provisions of Glass-Steagall that prohibited affiliations between commercial banks and securities firms.
GRAMM-LEACH-BLILEY ACT The 1999 law repealing provisions of the Glass-Steagall Act prohibiting affiliations between banks and securities firms.
HEDGE FUND A privately owned investment vehicle exempted from most regulation and oversight; generally open only to high-net-worth investors. Hedge funds follow a great variety of investment strategies that may or may not involving hedging.
LEVERAGE A measure of the extent to which an asset is financed with borrowed money. A $100,000 home that is purchased with $10,000 cash and a $90,000 mortgage is leveraged at ten to one (the home value divided by the homeowner’s equity). The danger of leverage becomes clear when asset prices fall. If the value of the home dropped to $80,000, the homeowner would have lost his or her entire cash investment, and could not cover the mortgage even by selling the home. Investment banks like Lehman Brothers were typically leveraged at thirty to one before the crash ($3 billion in assets would be financed with $100 million of equity and $2.9 billion of borrowings). To make matters worse, the borrowing was often short-term, so it had to be paid back in full and refinanced several times throughout the year. When financial assets plummeted during the crash, many Wall Street firms were immediately insolvent.
LIQUIDITY The state of availability of cash or financial instruments that can be quickly converted to cash.
LIQUIDITY PUT A financial contract that requires one party to refinance or purchase an asset held by the other party under certain conditions.
LOAN-TO-VALUE RATIO (LTV) The ratio between the principal amount of a mortgage or mortgages and the market value of real property securing the mortgage(s), usually expressed as a percentage.
MARK-TO-MARKET An accounting convention by which the carrying values of securities are regularly adjusted to reflect their current market values.
MORTGAGE-BACKED SECURITY (MBS) A credit instrument supported by residential or commercial mortgages. An MBS may or may not be structured. (See entry for collateralized debt obligation.)
OFFICE OF THE COMPTROLLER OF THE CURRENCY An arm of the Treasury Department that charters, regulates, and supervises all national banks and certain branches and agencies of foreign banks in the United States.
OPTION-ARM An adjustable rate mortgage, usually with a “teaser,” or below-market initial interest rate, that allows borrowers, at their option, to make lower than scheduled payments during the early years of the loan. When the rate is reset to a market rate, the accumulated payment shortfalls are added to the loan principal.
PRIVATE-LABEL SECURITIES Mortgage-backed securities constructed and distributed by private investment banks and securities dealers (as opposed to MBSs distributed by Fannie Mae, Freddie Mac, or other federal mortgage agencies).
SECURITIES AND EXCHANGE COMMISSION (SEC) Independent federal agency responsible for protecting investors by enforcing federal securities laws, including regulating security and security options exchanges, broker-dealers, investment companies, and other securities professionals, and the issuance and sale of securities.
SECURITIZATION The process of pooling mortgages, credit card receivables, or other instruments in a separate legal entity to secure the issuance of new financial instruments to investors.
SHADOW BANKING SYSTEM Nonbank financial institutions, like hedge funds, private equity funds, mutual funds, and other investment vehicles, that often provide credit and perform other activities that parallel the formal banking system. The ballooning of the shadow banking system in the 2000s made it difficult for regulatory officials to track the volume of credit in the financial system.
SYNTHETIC CDO A collateralized debt obligation that is constructed of credit default swaps rather than of real securities. By using synthetic CDOs to reference very high-risk real CDOs, Wall Street greatly increased the volume of very risky assets in the market.
TRANCHE The French word for “slice,” used to refer to the various layers of securities making up a structured financial instrument.
UNDERWRITING The process of determining the risk and value of a security. Investment banks underwrite securities when they evaluate the creditworthiness of issuers and establish a price for distributing the securities to investors; mortgage lenders underwrite mortgages by evaluating the creditworthiness of the borrower and the market value of the underlying property.
WRITE-DOWN An accounting process by which the value of an asset is reduced from a previous accounting value. Frequently, when a company writes down an asset, the amount of the write-down must be deducted from reported profits.