It has been hard to get my head wrapped around the financial crisis. I console myself that this is true even for geniuses and Wall Street veterans. One thing is sure, though, the financial crisis has elevated new words into common parlance, and has changed the definitions of rather technical terms. Looking ahead to 2009, there are 10 words that popped up a lot in the past year, and the meanings of these words will remain important as we collectively figure out a way out of the quagmire.
10. Credit. We have seen the post-Lehman world become one where no one gives anyone any credit. Credit facilities are nullified, credit lines are dried up. The impact on trade is currently immeasurable, but the forecasts are dim. So much of trade is reliant on the money market (short term loans for the purposes of buying inventory), but that whole industry is now a Fed facility. There Wall Street, and then there’s the street, the neighborhoods in which real people live. In the neighborhood, credit also has meaning. It means money sent from a lender to you. This is not your money. This is money you don’t have. So, spend it wisely if it’s offered to you.
9. Derivative. A derivative is an instrument that has a value. Okay. And that value is dependent on the value of other things. Got it? So, for example, I think oil will go through the roof in several years. So, I make a contract to buy oil in ten years at low price (someone else thinks oil will be even cheaper, and is willing to supply it to me at the buying price as agreed in the contract). The contract itself has a value because it allows the holder to buy oil at a certain price, regardless of what the actual market value will be. Now, as time goes by and we get closer to the ten year point of the contract, the value of the contract itself will go up or down. If, for example, oil is super, super cheap, then my contract will have less value, because it allows the holder of the contract to buy oil at a price higher than market value. Who wants that? But, if the price of oil skyrockets, then the contract is worth more because the holder of the contract gets to buy oil at less than market value. Similarly, the bonds that bundled mortgages are derivatives because the value of the bond (the bundle of mortgages) is determined by whether the home buyers continue to pay their mortgages. If there are a lot of defaults, then the bond’s value goes down. If everyone pays, then the bond retains its value (and may even go up if investors are eager for a safe place to put their money).
There is no street equivalent, strictly speaking, because we have more common sense in the neighborhood.
8. On/Off Balance Sheet. As lenders piled up stacks of risky mortgages and related derivatives, there was a need to place these volatile assets some place where they couldn’t do damage to the lenders’ balance sheets. Neighborhood equivalent: buying a car you can’t afford and putting it in your mom’s name. When you stop making payments, the dealer comes and takes away the Escalade, crippling your mother’s credit and possibly putting her in legal trouble. You don’t escape, though, because your mother may forgive, but she won’t forget. Plus, your siblings will all know you suck, thus ensuring that you will always have to double check your turkey sandwich for special sauce courtesy of your older brother.
7. Transparency. This means both operations and products are open for inspection. In the derivative buying madness, we had a de facto lack of transparency as there was literally no time to unravel the mortgage bundles prior to the sale of the bonds. Simply, there were too many risk-dumb investors who wanted a piece of the action and were willing to shell out hundreds of millions to buy something they didn’t inspect. Of course, the mortgage originators and other securitizors willfully created this environment, giving short notice prior to auctions.
The neighborhood equivalent is buying dope advertised as chronic, but sold in an opaque, airtight bag. “No, don’t look at it. I’ve got other buyers lined up with cash in hand. You want the good stuff or not?” Take it home, light it up, cough on the mortgage shwag.
6. Leverage/Overleveraged. Bank regulations require a certain ratio between assets and outstanding loans and deposits. This means banks have to have a certain level of money on hand in case depositors pull out. For a bank, a customer’s deposit is an obligation. They are borrowing money from the depositor. So, if there is a bank run, the banks need to be able to pay depositors as well as any loans they owe to other banks. A bank or other entity becomes overleveraged when its obligations to pay others far exceed the cash on hand.
In the neighborhood, college loans are increasingly the cause of people being overleveraged. You enter college without many assets, yet are given credit lines up to infinity. Doctors, lawyers, and other professional degree holding persons are saddled with immense debt upon graduation. The credit given to them is predicated on the idea that they will make a lot of money. Basically, the lender is looking at (future) cash flows rather than assets when determining how much money to lend. Plus, the law gives these lenders a great deal of security – college debt cannot be discharged in bankruptcy.
5. Liquidity/Illiquidity. Liquidity and leverage go hand in hand. If you are liquid, then you have enough cash to pay for your obligations. These days, with the credit markets frozen, liquidity equates to solvency. Basically, if you can’t pay your bills today, you’re out of business.
In the neighborhood, we know this all too well. That’s why we have credit cards.
4. Collateral. If you take out a loan, you should pledge something of value in return. That’s what makes credit cards so scary. Visa doesn’t ask you to put anything up of value, it doesn’t even take an interest in the thing you purchased. If you buy a house, the bank can take the house away if you don’t pay your monthly mortgage payments. If you don’t pay your credit cards, however, Visa doesn’t come and take away your Coldplay CD. Stock tip: don’t buy credit card companies. The business model is just too sketchy in the post-credit bubble world.
3. Subprime. People who meet certain financial criteria are given loans at a rate near the prime rate (mortgage jargon for something that will exceed inflation). Those with shaky credit histories are riskier, so the banks will lend to you with a risk-adjusted premium. This can mean a percentage point or two above the average. That’s no big deal. But, mortgage lenders developed all these terribly stupid mortgages that entice people to take out a loan that they can only pay for a year or two before the rates reset to the risk-adjusted levels.
It’s like dating someone with a checkered history of infidelity. Once the infatuation period wears off, he or she is going to be looking elsewhere. You can count on it. Just like you can count on people defaulting on loans they couldn’t really afford to pay. The introductory rate was the infatuation period. The rest is just what you deserve.
2. Bailout. I have two definitions for this one. The first is: the social cost of poor regulation. The second one is: a tax for believing U Chi ideology.
The neighborhood equivalent is believing that the preacher with the Cadillac is putting God first, then when he goes to jail for embezzlement, the congregation has to pitch in to keep the soup kitchen running.
1. Accountability. This is as hard to define as “spirit” or “mind”. We know it exists, but it has never been observed in replicable conditions.
10. Credit. We have seen the post-Lehman world become one where no one gives anyone any credit. Credit facilities are nullified, credit lines are dried up. The impact on trade is currently immeasurable, but the forecasts are dim. So much of trade is reliant on the money market (short term loans for the purposes of buying inventory), but that whole industry is now a Fed facility. There Wall Street, and then there’s the street, the neighborhoods in which real people live. In the neighborhood, credit also has meaning. It means money sent from a lender to you. This is not your money. This is money you don’t have. So, spend it wisely if it’s offered to you.
9. Derivative. A derivative is an instrument that has a value. Okay. And that value is dependent on the value of other things. Got it? So, for example, I think oil will go through the roof in several years. So, I make a contract to buy oil in ten years at low price (someone else thinks oil will be even cheaper, and is willing to supply it to me at the buying price as agreed in the contract). The contract itself has a value because it allows the holder to buy oil at a certain price, regardless of what the actual market value will be. Now, as time goes by and we get closer to the ten year point of the contract, the value of the contract itself will go up or down. If, for example, oil is super, super cheap, then my contract will have less value, because it allows the holder of the contract to buy oil at a price higher than market value. Who wants that? But, if the price of oil skyrockets, then the contract is worth more because the holder of the contract gets to buy oil at less than market value. Similarly, the bonds that bundled mortgages are derivatives because the value of the bond (the bundle of mortgages) is determined by whether the home buyers continue to pay their mortgages. If there are a lot of defaults, then the bond’s value goes down. If everyone pays, then the bond retains its value (and may even go up if investors are eager for a safe place to put their money).
There is no street equivalent, strictly speaking, because we have more common sense in the neighborhood.
8. On/Off Balance Sheet. As lenders piled up stacks of risky mortgages and related derivatives, there was a need to place these volatile assets some place where they couldn’t do damage to the lenders’ balance sheets. Neighborhood equivalent: buying a car you can’t afford and putting it in your mom’s name. When you stop making payments, the dealer comes and takes away the Escalade, crippling your mother’s credit and possibly putting her in legal trouble. You don’t escape, though, because your mother may forgive, but she won’t forget. Plus, your siblings will all know you suck, thus ensuring that you will always have to double check your turkey sandwich for special sauce courtesy of your older brother.
7. Transparency. This means both operations and products are open for inspection. In the derivative buying madness, we had a de facto lack of transparency as there was literally no time to unravel the mortgage bundles prior to the sale of the bonds. Simply, there were too many risk-dumb investors who wanted a piece of the action and were willing to shell out hundreds of millions to buy something they didn’t inspect. Of course, the mortgage originators and other securitizors willfully created this environment, giving short notice prior to auctions.
The neighborhood equivalent is buying dope advertised as chronic, but sold in an opaque, airtight bag. “No, don’t look at it. I’ve got other buyers lined up with cash in hand. You want the good stuff or not?” Take it home, light it up, cough on the mortgage shwag.
6. Leverage/Overleveraged. Bank regulations require a certain ratio between assets and outstanding loans and deposits. This means banks have to have a certain level of money on hand in case depositors pull out. For a bank, a customer’s deposit is an obligation. They are borrowing money from the depositor. So, if there is a bank run, the banks need to be able to pay depositors as well as any loans they owe to other banks. A bank or other entity becomes overleveraged when its obligations to pay others far exceed the cash on hand.
In the neighborhood, college loans are increasingly the cause of people being overleveraged. You enter college without many assets, yet are given credit lines up to infinity. Doctors, lawyers, and other professional degree holding persons are saddled with immense debt upon graduation. The credit given to them is predicated on the idea that they will make a lot of money. Basically, the lender is looking at (future) cash flows rather than assets when determining how much money to lend. Plus, the law gives these lenders a great deal of security – college debt cannot be discharged in bankruptcy.
5. Liquidity/Illiquidity. Liquidity and leverage go hand in hand. If you are liquid, then you have enough cash to pay for your obligations. These days, with the credit markets frozen, liquidity equates to solvency. Basically, if you can’t pay your bills today, you’re out of business.
In the neighborhood, we know this all too well. That’s why we have credit cards.
4. Collateral. If you take out a loan, you should pledge something of value in return. That’s what makes credit cards so scary. Visa doesn’t ask you to put anything up of value, it doesn’t even take an interest in the thing you purchased. If you buy a house, the bank can take the house away if you don’t pay your monthly mortgage payments. If you don’t pay your credit cards, however, Visa doesn’t come and take away your Coldplay CD. Stock tip: don’t buy credit card companies. The business model is just too sketchy in the post-credit bubble world.
3. Subprime. People who meet certain financial criteria are given loans at a rate near the prime rate (mortgage jargon for something that will exceed inflation). Those with shaky credit histories are riskier, so the banks will lend to you with a risk-adjusted premium. This can mean a percentage point or two above the average. That’s no big deal. But, mortgage lenders developed all these terribly stupid mortgages that entice people to take out a loan that they can only pay for a year or two before the rates reset to the risk-adjusted levels.
It’s like dating someone with a checkered history of infidelity. Once the infatuation period wears off, he or she is going to be looking elsewhere. You can count on it. Just like you can count on people defaulting on loans they couldn’t really afford to pay. The introductory rate was the infatuation period. The rest is just what you deserve.
2. Bailout. I have two definitions for this one. The first is: the social cost of poor regulation. The second one is: a tax for believing U Chi ideology.
The neighborhood equivalent is believing that the preacher with the Cadillac is putting God first, then when he goes to jail for embezzlement, the congregation has to pitch in to keep the soup kitchen running.
1. Accountability. This is as hard to define as “spirit” or “mind”. We know it exists, but it has never been observed in replicable conditions.
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