AFP |
The 2008 financial crisis brought financial terminology into wider public usage.
Here is a glossary of some of the key terms:
Too Big to Fail
When a financial institution is of sufficient importance for its collapse or failure to generate shock waves that destabilise others, or even the wider economy as a whole, it is known as “too big to fail”.
Categorised as “systemic”, these institutions are crucial by virtue of the cross-border nature of their business, their interconnectedness, and the highly complex financial instruments they trade in.
In 2008, the United States had to bail out a number of them, including insurer AIG, in view of the risks that would arise if they were allowed to collapse.
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Subprime
Subprime mortgages are loans awarded to households that are not always financially sound. Such loans enabled a great many Americans to acquire their own property. The loans were often awarded at low interest rates, fixed for the first few years, but variable after that.
As the US Federal Reserve raised its key interest rates, market rates followed, and borrowers found their mortgage repayments became more expensive. Many borrowers that found themselves unable to make the repayments lost their homes, but as house prices fell and lending became more strict, many banks found themselves in difficulty as they couldn’t sell the properties.
Securitisation and CDOs
Securitisation enables banks to pool illiquid assets — such as subprime mortgages — and turn them into more readily tradeable securities. So as to be tradeable on the market, the assets are pooled into a portfolio of CDOs (collateralised debt obligations). In theory, the investors are guaranteed their initial investment, as well being paid interest — at least if the loans are repaid.
Securitisation is a way for banks to spread the risk should a borrower default on their repayments. But it also brings with it the risk of wider contagion across the financial sector should a problem arise.
When American households found themselves unable to repay their “subprime” mortgages, these securitised CDOs, very popular among speculative investors, collapsed, triggering a chain reaction.
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Hedge Funds
Hedge funds are highly speculative funds geared around making quick profits. They are not subject to the same disclosure requirements as other funds. And that lack of transparency made it more difficult to evaluate the extent of the subprime crisis.
They are considered to have played a major role in the crisis, which began with the collapse of two of them, managed by the investment bank Bear Stearns, which in turned failed itself and was sold off.
Credit Default Swaps or CDS
A credit default swap is a type of insurance a lender can take out against a possible default by the borrower. The lender’s insuring party takes on the risk in return for regular income payments. In the crisis, insurer AIG, which sold CDSs, found itself in difficulty when a number of companies went bankrupt and it had to pay off CDS holders.
Rating Agencies
The three top rating agencies are S&P (Standard & Poor’s), Moody’s and Fitch. They rate a company’s or country’s perceived ability — from highly reliable to so-called “junk” issuers — to repay its debt as a guide for investors looking to buy bonds.
The agencies came under heavy criticism in the wake of the crisis, because they had given top ratings to securitised bonds or CDOs, helping to bolster the market for such instruments, without taking into account the real risks they represented.
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Interbank Market
The interbank market is the global network used by financial institutions to lend money to each other in order to manage liquidity and meet the reserve requirements placed on them by regulators. They do so at interest rates that depend on maturity, market conditions and credit ratings.
The so-called “benchmark”, or most widely used of these rates are the LIBOR or London Interbank Offered Rate, the Fed Funds rate in the US and the Euribor in Europe. If the rates rise suddenly, it is a sign of a contraction of credit. And central banks intervene using various tools to supply liquidity to banks.
© Agence France-Presse