Orange County
On December 6 1994, Orange County, a prosperous district in California, declared bankruptcy after suffering losses of around $1.6 billion from a wrong-way bet on interest rates in one of its principal investment pools. Robert Citron, the hitherto widely respected Orange County treasurer who controlled the $7.5 billion pool, had invested the pools funds in a leveraged portfolio of mainly interest-linked securities at great risk. This was the largest financial failure of a local government in US history.
Subprime Lending
This involves financial institutions providing credit to borrowers deemed “subprime” i.e., those who have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with paltry incomes or a recorded bankruptcy, or those with limited debt experience. Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards.
Foreclosure
Foreclosure is the legal proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor’s equitable right of redemption. Usually a lender obtains a security interest from a borrower who mortgages or pledges an asset like a house to secure the loan.
Securitization
Securitization is the process of creating a more or less standard investment instrument by pooling assets to back the instrument. Financial institutions take an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.
A typical example of securitization is a mortgage-backed security (MBS). Till recently, some subprime originators (mortgage companies or brokers) used to promote residential loans with features that could trap low income borrowers into loans with increasing payment (of interest and part of principal) terms that eventually exceed borrower’s capability to make the payments. Most of these loans were originated for the purpose of reselling them to other financial institutions.
Derivatives
Derivatives are instruments or securities that are derived from another security, commodity, market index, or another derivative. In other words, a derivative is an instrument whose value is based on that of another asset. The base is referred to as the benchmark. Derivatives are also called “Contingent Claims” because they are dependent on variables which influence the valuation process. The more common derivatives include those traded in Foreign Exchange (FOREX) or Currency Forward Markets, Financial Futures Markets, Commodities Futures Markets and so on. They can be related to one another in numerous ways. For example, in currencies, there is a cash or spot forex market, a bank forward market, a currency futures market, options on actual or cash currencies, options on currency futures, swaps on currencies, instruments on stocks or shares (ADRs), options on swaps (swaptions) and so on.
Derivatives are used for risk management, investing, and speculative purposes. Important institutional users include banks, brokers, dealers and mutual funds. Broadly there are two distinct groups of derivative contracts.
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps (including credit default swaps), forward rate agreements, and exotic options are almost always traded in this way. The OTC market is the largest market for derivatives, and is unregulated. Exchange-traded derivatives (ETD) are products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the contract to act as a guarantee. Being routed through an exchange, they come under regulation by the board of that exchange and thus indirectly by the government of the country.
There are many types of derivatives, some of which are described below.
Collateralized Debt Obligations
CDOs are a type of asset-backed security constructed from a portfolio of fixed-income assets. In other words, a CDO is a security backed by a pool of bonds, loans and other assets. Since 1987, CDOs have become an important funding vehicle.
They represent different types of debt and credit risk, referred to as ‘tranches’ or ‘slices’ such as senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays. The various types include Collateralized loan obligations (CLOs) — CDOs backed primarily by leveraged bank loans; Collateralized bond obligations (CBOs) — CDOs backed primarily by leveraged fixed income securities; Collateralized synthetic obligations (CSOs) — CDOs backed primarily by credit derivatives and so on.
The issuer of the CDO, typically an investment bank, earns a commission at the time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favour of loan volume rather than loan quality. This is a structural flaw in the debt-securitization market that was directly responsible for both the credit bubble of the mid-2000s as well as the credit crisis, and the concomitant banking crisis of 2008.
Futures and Forwards
A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional “commodities” as foreign currencies, commercial or government paper [e.g., bonds], or “baskets” of corporate equity [“stock indices”] or other financial instruments) at a certain date in the future, at a price (the futures price) determined on the particular exchange at the time of the contract. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day’s trading session on the exchange is called the settlement price for that day of business on the exchange.
Both parties of a “futures contract” must fulfill the contract on the settlement date, whereas an option (see below) grants the buyer the right, but not the obligation, to exercise the contract. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit.
A futures contract is a standardized contract written by a clearing house that operates an exchange, while a forward contract is a non-standardized contract written by the parties themselves.
Options
These are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty must carry out the transaction.
Caps and Collars
These are contacts that offer protection to borrowers who borrow long term with an interest rate that resets periodically, as well as to borrowers who borrow for a short term at a fixed rate and plan to roll the loan each time it matures.
By purchasing a cap, a borrower can limit or “cap” his maximum interest cost regardless of how high the rate on his loan or bond gets. When the loan or bond rate exceeds the cap limit (usually referred to as the “strike” level) the borrower pays the higher interest rate but the seller of the cap compensates him for the exact amount of interest paid in excess of the strike price. The cost of the cap varies based on its term and the strike level chosen by the borrower.
Similar to a cap, a collar allows a floating-rate issuer/borrower to limit his maximum interest cost regardless of the rate on his bond or loan. However, to reduce the cost of the protection, the collar includes an interest rate floor that limits his maximum interest cost regardless of how low the bond or loan rate becomes. Therefore, a collar has two strike levels, an upper (cap) strike and a lower (floor) strike. For example, an issuer and seller may agree on a 3% floor and 5% cap. This hedge effectively guarantees the issuer/borrower interest cost will always be in a “collar” between 3% and 5% in this example. If the interest rate for an interest period is 6%, the seller will pay to the issuer the difference between 5% and 6% or 1%. If the interest rate drops to 2%, the issuer must pay the seller the difference between the 3% floor and actual 2% rate or 1%.
Credit Default Swaps
These are insurance contracts that purport to protect bondholders against the possibility of default. While purchasing bonds, an investor can also buy CDS issued by some financial institution like large commercial banks, investment banks or insurance companies to protect himself against the risk of default on the part of the firm that issued the bonds. The premium that the investor pays for the CDS, calculated at say two per cent of the amount insured, is called the “rate” or “spread”. If the firm that issued the bonds defaults, the financial institution which issued the CDS will pay the investor the amount insured (principal) plus interest on that amount.
CDS rates remain low when the market thinks the probability of default of firms issuing bonds are low and go up when the opposite belief prevails in the market. Thus they serve as a good barometer of faith in the financial markets.
Hedging
A strategy designed to reduce investment risk using call options, put options, futures contracts etc.
Hedge fund
An investment vehicle that somewhat resembles a mutual fund, but with a number of important differences. Hedge funds employ a number of different strategies that are not usually found in mutual funds. For example, there are two fees for managers: fixed and variable. The fixed fee is a percentage of assets under management. The variable or performance fee is a percentage of the profit of the fund. Another important difference is that the minimum required investment is usually quite large and, as a result, minimizes the participation of retail investors.
According to US law if the fund is “off-shore”, it can only sell to non-US investors and does not have to adhere to any SEC (Securities Exchange Commission) regulations. The term “hedge”, however, is often misleading. The traditional hedge fund is actually hedged. For example, a fund employing a long-short strategy would try to select the best securities for purchase and the worst for short sale. The combination of longs and shorts provides a natural hedge to market-wide shocks. However, much more common are funds that are not actually hedged and engage in high-risk speculative activities. There are funds that are either long-biased or short-biased. There are also funds of funds which invest in a portfolio of hedge funds.
