Inside the Meltdown
individual borrowing lesson: glossary of financial terms
Central Bank: The generic name given to a country's primary monetary authority, such as the Federal Reserve System in the U.S. Usually has responsibility for issuing currency, administering monetary policy, holding member banks' deposits, and facilitating the nation's banking industry.
Collateralized Debt Obligation (CDO): An investment-grade security backed by a pool of various other securities. CDOs can be made up of any type of debt, in the form of bonds or loans. CDOs are divided into slices. Each slice is made up of debt which has a unique amount of risk associated with it. CDOs are often sold to investors who want exposure to the income generated by the debt but who do not want to purchase the debt itself.
Credit Default Swap: A specific kind of agreement which allows the transfer of credit risk from one party to the other. One party in the swap is a lender and faces credit risk if loans are not paid back. Another party provides insurance to insure this risk in exchange for regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase the defaulted asset from the insured party. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal
Derivative: A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier. (For example, a bank takes a supply of mortgages it owns and creates a bond to sell to investors that makes money based on the interest paid by the mortgage borrowers.)
FDIC: The Federal Deposit Insurance Corp. preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $250,000.
Federal Reserve Bank (also known as the Fed): One of 12 regional banks established to maintain reserves, issue bank notes and lend money to member banks. The Federal Reserve Banks are also responsible for supervising member banks in their areas and are involved in the setting of national monetary policy.
Leverage: The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage, however, is not always bad; it can increase the shareholders' return on their investment, and often there are tax advantages associated with borrowing.
Member Bank: A bank that is part of the Federal Reserve System, or a bank that is part of a central clearing or central banking system. Such banks have to follow the rules and regulations put forward by the central bank or the clearing system.
Mortgage: A loan to finance the purchase of real estate, usually with specified payment periods and interest rates. The borrower (mortgagor) gives the lender (mortgagee) a lien on the property as collateral for the loan.
Shadow Banking System: System of nonfinancial institutions that borrow money in the short term and take that money to invest in long-term assets. Shadow banking systems are able to avoid standard banking regulations through the use of credit derivatives and are considered to be a major contributor to the subprime mortgage crisis around 2007-2008.
Subprime Borrower: Subprime refers to a borrower that is not "prime"; in other words, a borrower who might be less likely to repay a loan. Subprime borrowers may be classified as subprime because of bad credit or lack of history, low income or poor debt-to-income ratios, large loans relative to the securing property (high LTV ratio) and/or maxed-out credit cards.
Treasury Department: Its mission is to "serve the American people and strengthen national security by managing the U.S. Government's finances effectively, promoting economic growth and stability, and ensuring the safety, soundness, and security of the U.S. and international financial systems."
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