A Glossary Of Financial Terms
MICHELE NORRIS, host:
If some of the language thrown out in today's Senate hearing left you wondering, what exactly is a synthetic instrument or a short position, well, help is here. We're joined by Adam Davidson of NPR's Planet Money team. He's going to explain some of the financial terms being battered about. Hey, Adam.
ADAM DAVIDSON: Hi, Michele.
NORRIS: Let's start with synthetic, collateralized debt obligations. In her opening statement, Senator Claire McCaskill offered this definition of synthetic CDOs. Let's listen.
Senator CLAIRE MCCASKILL (Democrat, Missouri): They are instruments that are created so that people can bet on them. It's the la la land of ledger entries. It's not investment in a business that has a good idea. It's not assisting local governments in building infrastructure. It's gambling, pure and simple, raw gambling.
NORRIS: That's Senator Claire McCaskill's definition. What's the actual definition or description of a synthetic CDO?
DAVIDSON: Let me start with a regular CDO and then we'll get to synthetic CDOs. So, let's say you and me, Michele, we're standing on a corner somewhere and each of us wants to buy a house. You might think it's worth 340,000, say, and I think it's only worth 300,000. We can have a difference of opinion, but it's based on real information.
Then there's something called a mortgage-backed security. That's where they take, say, a thousand houses, wrap them up and sell shares in the market just of those thousand houses. You can actually get a pretty reasonable guess on how much those thousand houses are going to be worth over the next, say, 10 or 20 years or whatever.
When you get into a CDO, that's taking, like, 150 of those pools of a thousand homes. So now you're talking about having a share in something like 150,000 homes all over the country. But a synthetic CDO is something else all together. That's people standing on the sidelines and making bets about the bets that the people buying the regular CDOs are making. So, you and I are in a room saying, I think this CDO of 100,000 homes is worth 80 cents on the dollar and you're saying it's worth 87 cents on the dollar.
Well, there's a bunch of other people in the synthetic CDO world saying, I think Michele's going to lose all her money. No, I think Adam's going to lose all his money. So, it's placing bets on something that has very abstract connection to any actual value in the real world.
NORRIS: One of the other things we heard today was a lot of talk about a position called a short.
DAVIDSON: A short position is not in and of itself a bad thing. I'm allowed in Wall Street to say I think this particularly company is going to do well, so I can buy their stock. That means I'm going long. Long is just fancy Wall Street language for I have a positive view about something. Or I can go short, I can have a negative view.
We definitely want there to be short positions on Wall Street. We want negative views about the stock market or the housing market or the bond market allowed into Wall Street. In fact, a lot of people think if there more shorts shorting the subprime housing market earlier, this crisis never would've gotten so big.
NORRIS: There's one word I heard today that left me flummoxed. Traunch?
DAVIDSON: Yeah, a traunch is just a fancy way of saying a slice. So these big mortgage-backed securities or CDOs or synthetic CDOs have different slices. And each slice has a risk level. What makes these things so crazy is that all the traunches lost almost all their value.
NORRIS: And traunch is derivative of what?
DAVIDSON: It's French for slice.
NORRIS: Oh, okay.
(Soundbite of laughter)
NORRIS: Adam, thank you very much.
DAVIDSON: Thank you, Michele.
NORRIS: That's Adam Davidson at NPR's Planet Money team.
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