GFC crisis : Finance terminology

GLOBAL FINANCIAL CRISIS TERMINOLOGY

The following notes on Finance terminology arise out of discussion with Harry Greenwell and reference to Google:

Sub-Prime mortgage:

A sub-prime mortgage differs from a standard mortgage in that it is specifically designed for borrowers who have an adverse  or bad credit rating. Hence it is sub prime. A feature of sub-prime mortgages was that ordinarily they included a provision for adjustable interest rates. It is evident that if the borrowers are riskier the value of the security becomes correspondingly more important.

In the late 20th century there was a surge of money into the United States as it financed its trade deficit with China etc with Treasury Bonds*. House prices increased in value and  home owners on limited incomes were able to borrow sub-prime in the general expectation that house prices would continue to rise. They were additionally encouraged to borrow by the very low rates of interest maintained by the Federal Reserve during this period.

Agents ‘selling’ loans to home owners pressed them to borrow – ‘loan approval guaranteed in 15 minutes’.

House prices peaked in 2006. The ‘adjustable rates’ provision enabled interest rates to be increased and defaults in sub-prime mortgages mounted.

*Treasury Bonds are US Government debt, usually long-term, say, 30 years. Aggregate Treasury Bonds issued to China (889bn); Japan (765bn); Oil Exporters (218bn).

Mortgage – backed securities:

Mortgage loans are purchased from Banks, Mortgage companies and other originators. They were assembled into pools. The securities for these loans were usually sold by a process called securitisation. The securities were sold as Bonds but derived their ultimate value from the aggregate value of the securities in the mortgage pools.

Securitisation originated with Fanny Mae and Freddy Mac as a means of encouraging home ownership in the United States

Credit Derivatives:

Derivatives generally are designed to guarantee the party to an existing transaction against the risk of loss in the future resulting from that transaction. The ‘exchange traders derivatives’ are bought and sold on the Futures market. These derivatives  relate to relates to shares and stock. A share holder  can ‘insure’ against the risk of a fall in the market price by securing a promise to buy the shares  at an agreed price, should the shareholder exercise his/her option to sell .For this option the shareholder pays an option price.

The same principle operates in the case credit derivatives. These are bilateral contracts between buyer and seller under which the seller sells protection against credit risk. The seller receives as consideration a periodic fee and it agrees to buy the debt should the debtor default in the payment of it.

A credit default swap is a swap contract in which the protection buyer of the c.d.s makes a series of payments to the protection seller and, in exchange, receives a pay-off if the loan or bond goes into default.

The SEC case against Goldman Sachs:

The SEC has charged Goldman Sachs created a collateralised debt obligation called Abacus 2007-AC1 three years ago. The collateralised debt obligation comprised a bundle of sub-prime mortgages, which had been written in states that suffered the worst in the housing crash. Goldman told clients that an independent firm, ACA, selected the portfolio.In fact a hedge fund Paulson & Co  had paid Goldman Sachs about $15 m to put together an investment offering that was tied to mortgage-related securities the hedge fund viewed as likely to decline in value. Separately, Paulson took ut a form of insurance that allowed it to make a huge profit when those securities became nearly worthless. Within 9 months, 99% of the mortgages in the package had been downgraded and investors lost more than $1bn. Paulson, by contrast, made a profit of approximately the same amount.

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Published in: on April 10, 2010 at 2:19 pm  Comments (1)  
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One CommentLeave a comment

  1. Cripes, i think you got most of this from googling (not me) because it seems your understanding is much more advanced than mine (or, at least, more advanced than mine was prior to reading this post 🙂

    If I get time, I’ll see if I can do some of my own googling to supplement what you’ve found.


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