A number of you have asked for a glossary of economic and financial terms. We hear you. And we're going to start building that glossary right now, in this very blog entry. It will live over in the right column, in the list of Categories as "Glossary" -- right between "Fun With Economics" and "Inside Planet Money."
After the jump, a starter list of terms we'll be defining, along with a few starter definitions.
Here's the ever-evolving Planet Money glossary. We welcome contributions. If you'd like to add to the glossary, please let us know.
Asset: This one depends on the eye of the beholder. An asset, in the broadest terms, is anything that could be sold for money -- ranging from a small used pencil to a great big idea. If you own stock in a company, that's an asset; you can sell it, theoretically, or you might get a dividend when the company makes a profit. For the company, that same stock is a liability, because it represents money the company has to pay out. This becomes important in the case of the U.S. plan to buy stocks in struggling (but not mortally wounded) banks. The language of the $700 billion bailout bill calls for the Treasury to buy assets. In this case, lawmakers appear to have intended that to include stock, even though strict accounting rules would consider those liabilities. (Laura Conaway)
Auction: A process in which multiple parties bid to determine who will buy an item from a seller; generally, the bidder offering the highest price gets the item. Auctions can be open (bids are seen by other bidders) or sealed (bidders do not see other bids), and vary on many other dimensions. Auctions can be held when there are many identical items (such as securities); in this case, the price is set so that just enough bidders are willing to pay that price or higher to buy all of the units available. An auction can also be held where multiple sellers are selling an identical good to multiple buyers. Auctions are widely considered to be an efficient means of determining the fair value of an item.
A reverse auction is one where multiple parties bid to determine who will sell an item to a buyer; in this case, the seller offering the lowest price gets to sell it.
Bad bank: To the average consumer, this might mean a financial institution in trouble. But to regulators, it's an idea for setting up a large government-controlled fund to buy groups of loans that have experienced high rates of default and have lost most or all of their value. It would essentially function as an investment bank -- one that intentionally puts money into the worst possible investments.
In theory, the "bad bank" would use government money buy toxic assets from other banks at a fraction of the loans' original value, then move the toxic assets to its own balance sheet. The bad bank would then hold the loans and they're eventually repaid. The aim is to provide cash to banks, which they could use to make new (hopefully better-managed) loans. An example of a "bad bank" is the Resolution Trust Corporation, which purchased assets from savings-and-loan institutions that failed in the late 1980s. (Alan Cordova)
Bond: A security that entitles the holder to receive a fixed payment on a periodic basis (such as monthly) for some period of time, and a larger payment at the end of that period. Bonds are typically used by companies to raise money. The company issues a bond to investors, who buy it from the company. For example, a bond might have a $1,000 face value, a 6 percent coupon, and a five-year maturity. This means that the the investor will get $60 (6 percent of $1,000) annually for five years; at the end of five years, he or she will get $1,000. At time of issue, the issuer sells this bond to the investor for something on the order of $1,000, but not necessarliy $1,000 exactly; the market determines how much investors will pay for that set of cash flows from that issuer. Bonds are then (usually) traded on a secondary market. Bonds carry credit risk, because if the issuer goes bankrupt, the investor will not get all of his or her money.
Although the typical bond is used by a company or government to raise money, there are many kinds of bonds, whose only common feature is that the payments made to the holder are fixed. For example, most mortgage-backed securities - where the payments are funded by the payments made on a pool of mortgages - are also bonds, because they make fixed periodic payments. (J.K.)
Breaking the Buck: Money market funds are traditionally uninsured mutual funds that invest in short-term, low-risk debt. Unlike most mutual funds, however, they aim to preserve a value of $1 per share; earnings do not increase the share price, but are paid out in dividends at the end of each month. As a result, they are widely seen as safe investments, because even if the returns are low, you will not lose your money. However, because they are uninsured, it is possible that the investments held by the money market fund could lose value, in which case individual investors would not be able to get out $1 for every $1 they put in. This is called "breaking the buck," and can lead to an immediate and sudden loss of confidence in money market funds. Large asset-management companies will typically avoid breaking the buck by adding their own cash to money market funds if necessary to make up for losses; however, not all fund managers will necessarily have the ability to do this. (J.K.)
Bretton Woods Agreement: The Bretton Woods Agreement was an international monetary policy developed in July 1944 following the Great Depression and World War II by representatives of the 44 Allied nations. It defined a system of exchangeable currencies and open rules of trade intended to prevent future depressions and to provide means of ending them if they did occur. Each country ratifying the agreement was to follow monetary policy that would fix the exchange rate of it's currency with respect to the gold-backed U.S. Dollar. The agreement also create the International Monetary Fund and the International Bank for Reconstruction and Development (part of the World Bank) to manage the system. The system worked well initially and allowed heavy investment in European reconstruction but by 1971 problems caused by the quickly growing world economy and U.S. balance of trade deficits lead to President Nixon's unilateral decision to drop dollar convertibility to gold, forcing a revision of the system to a floating currency scheme. (David Knaack)
Capital Injection: For a financial institution, capital is the difference between assets (things that have some value and theoretically could be sold for cash, like mortgages) and liabilities (debts to other people, like bank deposits or bonds issued). When a financial institution is low on capital (the margin between assets and liabilities becomes dangerously small), it needs to get more. In a capital injection, an external party (recently, the government) gives cash to the financial institution in exchange not for a promise to repay the cash, but for an ownership stake in the institution itself. This increases the financial institution's capital (because it now has more assets without increasing its liabilities). Because there is no such thing as a free lunch, existing shareholders get diluted, meaning that they now own a smaller proportion of the company than they used to. (J.K.)
Chapter 7 Bankruptcy: If a corporation declares bankruptcy under Chapter 7 of the United States Code, it immediately stops doing business of any sort. The government auctions off its assets to satisfy creditors (in part, if not in full). In some cases, entire divisions of a company get sold, in which case the divisions continue operations under new ownership. Most failed banks seized by the FDIC ended up filing for Chapter 7 bankruptcy as a part of their government-brokered sale. (A.C.)
Chapter 11 Bankruptcy: In Chapter 11 bankruptcy, the filer stays in business under a court-mediated agreement with its creditors, who take ownership of the company. The new owners get relief from the old owners' obligations. They also get a chance to reorganzie, which can take months or years, and may even decide to sell the company. Famous Chapter 11 bankruptcies include Lehman Brothers and Washington Mutual, which were sold, and Delta, Northwest and United, which entered bankruptcy after 9-11 but have since emerged intact. Some industries, such as airlines, are particularly vulnerable to bankruptcy due to volatile costs of supplies and equipment. In 2003, American Airlines used the threat of Chapter 11 bankruptcy to extract concessions from its unions. More recently, an error on the Bloomberg news service caused United's 2002 bankruptcy announcement to appear as breaking news, causing an immediate 75 percent drop in the price of the company's stock. Bonus: A company that takes bankruptcy repeatedly is known colloquially as a "Chapter 22." (A.C.)
Collateralized Debt Obligation
Commercial Paper: When a company needs to borrow a large sum of money for a short period of time, it often issues debt in this form. Think of commercial paper as a giant IOU, lasting from a day or two to nine months. Commercial paper lenders, which are often money market funds, may transfer many millions of dollars to borrowers at lightning speeds. During the 2008 credit crisis, the Federal Reserve made two dramatic moves in the commercial paper market. First, the Fed agreed to buy commercial paper from businesses that need to borrow money -- in other words, the Fed would make the loan. Second, it later agreed to buy commercial paper from lenders looking to get out of deals. (L.C.)
Common Stock: Securities representing residual ownership of a corporation. The common stock holders are viewed as the ultimate owners of the corporation, and thus it is often said that the duty of the board of directors is to maximize stockholder value. In return for the right to vote on directors and most other issues, common stock holders are entitled to a return on their investment only after the claims of creditors and preferred stock holders are paid. Thus, common stock holders take the most risk and stand to gain the greatest return. (Rachael Steigel, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials (3d. edition), 241-245 (2001))
Counterparty: When you make a trade, the counterparty is the person on the other side of the trade. (J.K.)
Counterparty Risk: The risk that the counterparty will not be able to fulfill his side of the bargain. When you make a trade that closes immediately (like going to the store to buy a gallon of milk), you don't have to worry about counterparty risk once it has closed. Many trades, however, remain open: futures contracts where one party agrees to deliver goods in exchange for money in the future; credit default swaps (or any kind of insurance, for that matter) where one party agrees to make a payment if something happens in the future; repurchase agreements where one party sells stock to the other and promises to buy it back at a preset price in the future; and so on. In these cases, each party takes on the risk that, at the time the trade is supposed to close, the other party may not exist or may not have enough money to fulfill the trade.
Counterparty risk has played a major role in the financial crisis because when financial institutions are not sure that their counterparties will be around in 30 days, they will not do any trades with them that will be open for 30 days or longer. (J.K.)
Credit Default Swap: A credit default swap, or CDS, is a contract used to insure the holder of a bond against default by the bond issuer. The "buyer" of the CDS holds the bond (theoretically, at least) and pays the "seller" of the CDS a periodic premium, just like an insurance premium; in exchange, if the bond issuer defaults, the seller of the CDS agrees to buy the bond from the buyer at face value. Let's say the bond is worth 9 cents (on the dollar), as happened with Lehman Brothers. The insurer would pay 100 cents and get a bond worth 9 cents in exchange.
In practice, because CDS are unregulated private contracts, you can buy one without holding the underlying bond. As a result, when most CDS settle, bonds do not change hands; instead, the seller pays the buyer the face value of the bond less the current market value of the bond.
A credit default swap is so named because the buyer of the CDS keeps the interest rate risk of the bond (if interest rates go up, bonds lose value), but "swaps" the credit risk (the risk of default) to the seller. (J.K.)
Credit Rating: A rating, or grade, given to an entity (company or government), to the bonds it issues, or to any other fixed-income security, by a rating agency. The ratings range from AAA to C or D (the largest rating agencies, Moody's and Standard & Poor's, have slightly different scales) and are supposed to indicate the risk of default on that bond. Rating agencies evalute the financial health of the issuing entity (or, in more complicated situations, the cash flows that are going into the security) and set a rating accordingly; ratings can go up or down over time as circumstances change. Ratings matter for several reasons. Many investors are limited to buying "investment-grade" securities (those with high credit ratings); companies with lower credit ratings are required by counterparties to post more collateral when making trades; and most importantly, investors tend to think that highly rated securities will not default.
One feature of the credit crisis has been that complex securities with high credit ratings are defaulting, leading many to believe that their credit ratings were given incorrectly. (J.K.)
Equity: Ownership or net worth. In a balance sheet, equity is equal to assets minus liabilities. In a mortage situation, one's equity in their home is equal to the value of the home minus the amount of money owed on the mortgage. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 9-16 .)
Gross Domestic Product
Interest: The amount charged for the use of some amount of money for some period of time. A circular but understandable reason for charging interest is that rather than lending a sum of money to another, one could put the money in the bank and receive interest on it. In other words, interest is the compensation for the opportunity cost of allowing someone else to use your money. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 9-16 .)
Leverage: This refers to how returns on an investment are enhanced through reducing the investor's initial investment by using borrowings. For example, assume a stock is trading at $100. If you buy the stock then you pay $100. For a $10 increase in the price of the stock (10 percent increase) you make a profit of $10 equivalent to a return of 10 percent (gain = $10/ investment = $100). Using leverage we can buy the stock using $10 of our money and borrowing $90. This means for the same $10 increase in the value of the stock we still make $10 but our return is higher -- 100% (gain = $10/ investment =$10). Leverage allows us to enhance returns in percentage terms.
Leverage can also enhance return in dollar terms. If I have $100 then I can buy only one share. However, if I use leverage as in the above example, then I can buy 10 shares (investment ($100) plus borrowings ($900) for a total outlay of $1000).
Leverage works for both increases and decreases in the value of what is purchased. For a $10 decrease in the value of the stock, I lose $10 in dollar terms; but because I am leveraged, the fall wipes out my entire investment of $10 (a return of --100 percent). This is because the borrowings still must be repaid in full with interest. (Satyajit Das)
LIBOR: Set daily by the British Bankers' Association, the London Interbank Offered Rate is the interest banks use for unsecured loans to other banks. The LIBOR for loans lasting three months is pne of the TED spread's two components. (L.C.)
Liquidity: The ability to convert an asset to cash quickly. It is safer to invest in liquid assets than illiquid ones because it is easier for an investor to get his/her money out of the investment. (R.V.)
Money Market Fund
Naked Short Selling: Selling a stock short (see "Short Selling") without ever buying the stock -- not even in the future. Ordinarily, traders must borrow a stock, or determine that it can be borrowed, before they sell it short. Due to various loopholes in the rules and discrepancies between paper and electronic trading systems, naked short selling does happen. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 529-540 .)
No Recourse Mortgage
Option: A contract that offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price during a certain period of time or on a specific date. The central idea behind stock options offered to employees is that they create an incentive for the employee to work hard and increase the value of the company's stock. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 528-529 .)
Preferred Stock: A share in company that's a grade above over other classes of stock. The use of the word "preferred" carries no implications except that somewhere and somehow the stock is alleged to have at least one preference right. This preference right usually pertains to the declaration of dividends. Thus, in most situations, preferred stock holders are paid before common stock holders. The preference right may also relate to liquidation rights or voting rights. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 312-315 .)
Risk: The chance that an investment's actual return will be different than expected. In investing, there are generally two types of risk: systematic risk and unsystematic risk. Unsystematic risk is the variability in stock prices that results from factors peculiar to an individual company. This is the type of risk that can be reduced by diversification. Systematic risk (or market risk) captures the reaction of individual stocks to overall market swings. Thus, one cannot mitigate systematic risk by having a diversified portfolio. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 40-56 .)
Short Selling: Selling a stock that one does not yet own. Traders borrow stock from Party A, believing that it is about to drop in value. They sell it to Party B and pocket the money. When the loan comes due, the traders buy enough of that same stock to repay the lender. If a trader's bet proves correct, he/she is able to buy the stock for less than it cost when Party A loaned it. In the past, there were stringent regulations on short sales. For example, the Securities and Exchange Commission "Tick Rule" (passed in 1938 as a reaction to the Great Depression) required the market to be advancing in order to sell short. This meant that if the price of the security was falling and the last trade was a down tick, a short sale was not permitted. The "Tick Rule" was officially repealed on July 6, 2007. During the economic crisis this year, the SEC moved to temporarily halt short selling of financial companies, fearing that the practice allowed traders to drive down the price of stocks. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 529-540 .)
Super Senior CDOs
Stock: A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings (also known as "shares" or "equity"). There are two main types of stock: common and preferred. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 9-16 .)
TED Spread: A key indicator of the ease with which banks are lending each other money, the TED spread refers to the gap between the three-month LIBOR (the London Interbank Offered Rate) and the return rate on a three-month U.S. Treasury bill. LIBOR is set daily in London; it reflects the interest banks are charging each other for loans, in this case loans lasting three months. When banks are feeling anxious, they charge higher interest and so LIBOR goes up. When investors are feeling anxious, they head for safe bets like Treasury bills -- the demand for them pushes the rate of return down. High LIBOR and low Treasury bill returns make for a high TED spread. In a healthy market, the TED spread is typically below a single point. During the 2008 credit crisis, the TED spread approached 5. "TED" stands for T-Bill and ED, "the ticker symbol for the Eurodollars futures contract." (L.C.)
Treasury Stock: Shares that the corporation has bought back. If a corporation originally sold all the stock they were authorized to issue, they may choose over time to repurchase previously sold stock. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 74-75 .)
Value: At its simplest, value is what something is worth. Unfortunately, not everyone measures worth using the same process. Some valuation methods are based on something's market price, its salvage value, its current production, its future production, its book value, or its future earnings. An interesting parable illustrating different valuation methods can be found here. (Rachael Vaughn, citing: Hamilton, Robert W. and Booth, Richard, Corporation Finance: Cases and Materials [3d. edition], 1-8 .)