Subprime Glossary

Subprime Glossary

Key terminology related to the credit crisis.

Adjustable-rate Mortgage

A mortgage carrying an interest rate that is reset at regular intervals, typically every 12 months, after the initial low “teaser” rate expires. Resets are calculated by adding a fixed number of percentage points, or “margin,” to an index that moves up and down as market conditions change. Typical indexes are the interest rate paid by U.S. Treasury bonds with one year to maturity. Margins on traditional “prime” ARMs are usually around 2.75%age points. Subprime loans often carry margins of more than 5 percentage points.

Appraiser

Real estate appraisers inspect homes prior to sale to determine their value, typically by comparing them to nearby properties that have recently been sold. Mortgage lenders require appraisals to assure the property is valuable enough to serve as collateral for the loan. Many critics believe that sloppy or dishonest appraisals contributed to the recent home-price bubble, setting the market up for the fall that followed. Critics point to several conflicts of interest: appraisers are paid by home buyers but frequently are recommended by real estate agents working for sellers. The agents make money only when a sale goes through and have no financial interest in the homeowner’s ability to continue making mortgage payments or to sell the property for enough to pay off the loan. Critics also note that lenders ignored inflated home appraisals because lenders also can disregard borrowers’ ability to make future payments. Lenders collect upfront fees and typically sell the mortgages they initiate to investors.

Auction-rate Security

A type of debt security, such as a corporate or municipal bond, that carries a floating interest rate that is frequently reset through an auction process. Rates may be reset as often as daily, but rarely at intervals longer than 35 days. These securities have generally been promoted as safe, liquid investments offering higher yields than other “cash” equivalents, such as money market funds. But the credit crunch that grew out of the subprime crisis caused this market to dry up, making it difficult or impossible for investors to sell these holdings even though few, if any, of the securities’ issuers had actually defaulted. Problems in the auction-rate securities market are thus seen as a measure of the fear sweeping the credit markets.

Automated Underwriting

Using a computer program to assess whether a borrower is likely to repay a loan. Systems developed in the 1980s and 1990s looked at factors such as the applicant’s credit history and information on the property and the loan, as well as and the data on how similar applicants in similar circumstances had performed in the past. The system speeds the loan-review process and removes human bias, but there was too little data on subprime loans and other new types of mortgages to accurately predict loan performance as interest rates rose and home prices fell.

Collateralized Debt Obligation

A security backed by a pool of loans, bonds or other debt. Typically, CDOs come in slices, or tranches, with riskier ones paying higher yields.

Commercial Bank

Although distinctions are blurring, commercial banks’ primary business is taking deposits and making loans. This contrasts with investment banks, which are involved in underwriting new issues of stocks and bonds, as well as other activities in the securities markets. Repeal of the Glass-Steagall Act, a Depression-era law that barred commercial banks from engaging in investment-bank activities, and vice versa, made the blurring of those lines possible.

Credit Crunch

A situation in which banks and other financial institutions cut back on lending, or raise interest rates so high that individuals, businesses and institutions reduce their borrowing. In the subprime crisis, the credit crunch arose from widespread fear that borrowers would default. This began with uncertainty about the financial health of market participants which held large numbers of mortgage-backed securities whose values were unknown.

Discount Rate and Discount Window

Wharton Professor Marshall Blume The discount window is a mechanism used by the Federal Reserve to make short term loans to qualifying banks which need cash to maintain liquidity. The discount rate is the interest rate charged on these loans. Historically, the discount window was limited to overnight loans to help with temporary emergencies. When the credit crunch arising from the subprime crisis made it difficult for banks to borrow, the Fed moved to open the window wider. In September 2007, it changed the terms so banks could borrow for as long as 30 days, and it cut the discount rate to 5.25% from 5.75%. Further cuts reduced the rate to 2.25% on April 30, 2008. On March 16, 2008, the discount-loan term was extended to as long as 90 days.

Equity

The difference between the value of a home and the debt remaining on the mortgage. In the years after a mortgage is taken out, a homeowner’s monthly payments gradually reduce the remaining principal, or debt. During most periods, home values gradually increase. These two factors cause the equity to grow, assuring the homeowner that the property can be sold for enough to pay off the loan. However, in the past year or two, home prices have fallen by an average of about 13% nationwide, and by much more in some markets that had experienced very large price gains early in the decade. Since borrowers who took out loans only recently have not yet made enough payments to significantly reduce their debt, they are now “underwater” – their homes are not worth as much as they owe.

Fed Funds Rate

An interest rate set by the Federal Reserve’s Open Market Committee that banks with deposits at the Fed charge one another for short-term loans. The Fed raises the rate to discourage borrowing, causing the economy to slow down and reducing the threat of inflation. Cutting the rate encourages borrowing, making money available to stimulate the economy.

Foreclosure

The process of a lender taking ownership of a property after the borrower has defaulted, or stopped making monthly payments. The home is used for collateral to minimize the lender’s losses. This is why mortgages charge lower interest rates than credit cards, which have no collateral. Typically, lenders resorting to foreclosure recover only about half of what they are owed, because of legal fees, the missed payments for the many months the process takes and the difficulty in selling a poorly maintained property.

Glass-Steagall Act
Wharton Professor Marshall Blume Passed in 1933 in response to the stock-market crash of 1929, the federal law barred commercial banks from engaging in investment-bank activities, and vice versa. The act was repealed in 1999 to encourage innovation, allowing commercial and investment banks to move into one another’s lines of business. Many experts say repeal left gaps in regulatory oversight.

Investment Bank

A financial institution primarily engaged in underwriting new issues of stocks, bonds and other securities, advising companies on mergers and acquisitions and other lines of business related to the financial markets. Until the repeal of the Glass-Steagall act in 1999, investment banks were barred from commercial bank activities such as taking deposits and making loans. The distinctions between the two types of banks have blurred in recent years.

Liquidity

Describes the ease with which things of value can be bought and sold. A liquid investment, such as a stock in a well-known company, can be bought or sold on short notice, while an illiquid investment cannot. Homes are generally seen as illiquid investments, since they often take months to sell. Liquid investments can become illiquid ones when conditions deteriorate. A corporate bond, for example, may become less liquid if the company that issued it runs into financial trouble, making investors worry that the company may not make the principal and interest payments promised.

Loan-to-Value Ratio

Wharton Professor Todd Sinai Refers to the size of the mortgage relative to the value of the property. In the 1980s, lenders typically required down payments of 10% to 20% of the property’s purchase price, writing mortgages to cover 80% to 90% of the cost. In the 1990s and 2000s, lenders took to writing mortgages for 95 to 100% of the purchase price, and sometimes even more, with the extra used by the homeowner to pay closing costs or make home improvements. Homeowners who have not made significant down payments do not have their own wealth at risk, and are more likely to stop making mortgage payments when they have financial problems.

Monoline Insurance

An insurance policy that guarantees that the issuer of a bond or other type of debt will make the interest and principal payments promised. By obtaining this insurance, the issuer can increase the debt security’s rating, reducing the interest rate that must be paid to attract investors. Monoline insurance was originally used for municipal bonds. The insurers gradually expanded the types of debt they would cover, and many suffered deep losses when they were forced to pay claims when issuers of subprime mortgage debt defaulted.

Moral Hazard
Wharton Professor Franklin Allen Originally an insurance industry term, this refers to situations where providing a safety net encourages risky behavior. Some argue that measures to help homeowners and lenders who have lost money in the subprime crisis will lead to more high-risk lending, while leaving them to suffer the full brunt of their losses will discourage it.

Mortgage-backed Security

A form of security, similar to a bond that is backed up, or collateralized, by thousands of home loan bundled together by a securities firm such as an investment bank. Investors who purchase mortgaged-backed securities receive regular payments representing their share of the interest and principal payments made by homeowners. Often, a pool of mortgages is divided into slices, or tranches, each offering differing risks and rewards from the others. Owners of the safest tranches receive the lowest interest rates but have first rights to homeowners’ payments, while owners of the riskiest tranches receive high interest payments but are the first to lose money if any homeowners fail to make their monthly payments.

Off-Balance-Sheet Entities

A type of subsidiary set up by a parent corporation to finance or engage in a specific line of business. Because the subsidiary is a separate legal entity, its assets and liabilities do not appear on the parent’s balance sheet, or accounting reports. While they have legitimate uses, off-balance-sheet entities have been used to conceal liabilities from the parent’s shareholders. In the subprime crisis, financial firms used these entities for high-risk lines of business such as selling mortgage-backed securities backed by subprime loans. While the parent firms were not legally required to help when entities suffered losses, some felt compelled to in order to preserve relationships with customers who were losing money through the entities. As a result, the parent firms suffered losses their own shareholders did not expect.

Prepayment Penalty

Many subprime mortgages contained provisions for an extra charge to homeowners who paid their loans off within the first few years. This created an additional obstacle to borrowers who wanted to take out new loans under better terms to pay off subprime loans that were requiring higher monthly payments as interest rates rose.

Rating Agencies
Wharton Professor Marshall Blume Credit-rating agencies give scores, or ratings, to securities such as corporate bonds. Their chief job is to assess risks that could determine whether the bond issuer makes the principal and interest payments promised to investors. Factors include the issuer’s financial health, general conditions in the financial markets, even the health of other companies with which the issuer does business. A bond or other security with a top-quality rating, such as AAA, generally pays less interest than a riskier, lower-quality bond. Therefore, issuers save money when their securities receive high ratings. In the subprime crisis, many mortgage-backed securities turned out to be far riskier than their ratings indicated, leading to much criticism of ratings agencies. Some experts say ratings agencies did their best to assess new types of securities that had little track record. Critics point to the fact that ratings agencies have a financial incentive to satisfy the issuers who pay for ratings, and that ratings agencies often have other lucrative business ties to those firms.

Reset

The process of changing the interest rate charged for an adjustable-rate mortgage, or ARM. Most ARMs start with a low “teaser” rate that stays the same for one to three years. After that, the rate typically changes every 12 months as prevailing rates rise or fall.

Risk Premium

Refers to the higher return investors demand to offset greater risks. “Junk” bonds issued by corporations with shaky finances typically pay higher interest than ultra-safe U.S. Treasury bonds, since investors worry the corporations will not make the payments promised.

Securitization
Wharton Professor Richard Herring Streams of income, such as homeowners’ monthly mortgage payments, can be bundled together into a form of bond that is sold to investors. Securitization allows the original lender to exchange a holding with a long-term value, such as the payments it is to receive on 30-year mortgages, into an immediate payment, providing cash for making additional loans. Securitization thus makes more mortgage money available, and it allows the risk of mortgage lending to be dispersed among investors around the world. Investors’ appetite for high-yield investments may have encouraged mortgage lenders to offer more subprime loans than was wise, contributing to the subprime crisis.

Structured Investment Vehicle

A fund that makes money by selling short-term securities on which it pays low interest rates and buying long-term securities paying high interest rates. Many SIVs ran into trouble in 2007 as short-term rates rose and mortgage-backed securities became harder to trade. Although financial firms that set up SIVs generally were not legally obligated to back up these independent entities, many felt they had to in order to preserve relationships with investors.

Subprime Mortgage
Wharton Professor Todd Sinai Generally understood to be a mortgage offered to borrowers with low credit ratings or some other characteristic that increases the risk they will default, or fail to make their monthly loan payments. To offset this risk, subprime loans charge higher interest rates than ordinary “prime” loans. Most subprime loans start with a low “teaser” rate charged for the first one to three years. After than, the rate is reset by adding a set number of percentage points to a base rate, such as market driven rates on certain bonds. Starting in 2005, resets caused monthly payments for many subprime borrowers to increase by 50% or more, leading to a rising rate of delinquent payments and home foreclosures.

Systemic Risk
Wharton Professor Franklin Allen Refers to risk to the financial system as a whole, like a contagion or domino effect. For example, the bankruptcy of one institution can harm other institutions with claims on its assets. The harm to those institutions can harm others in the same manner, creating a domino effect. The fear of systemic risk led the Federal Reserve to take steps to prevent the collapse of Bear Stearns.

Term Auction Facility

Set up by the Federal Reserve in December 2007 to improve liquidity in the financial markets. The TAF provides loans to banks for up to 28 days. The Fed has gradually increased the amount of funding available through the TAF to $150 billion.

Term Securities Lending Facility

Set up by the Federal Reserve in March 2008 to make 28-day loans to primary dealers – the major banks and investment banks. Loans can total up to $200 billion. Instead of cash, the TSLF lends U.S. Treasury securities, taking riskier securities as collateral. Those include mortgage-back securities and securities backed by student loans, credit card debt, home equity loans and automobile loans.

Tranche

A slice of something bigger. Mortgages are bundled together and converted to a kind of bond sold to investors. Although the pool as a whole may be too risky to earn an AAA investment rating, the securities can be offered in a series of tranches with varying risks. A high-risk tranche would be the first to suffer losses if homeowners stop making their monthly payments, but this tranche would pay the highest yield. Other tranches would have first rights to borrowers’ monthly payments, making them safer, but their yields would be lower. By concentrating risks in low-rated tranches, investment banks can create AAA-rated securities out of a mortgage pool that as a whole could not qualify for such a high rating.

Transparency
Wharton Professor Franklin Allen Refers to how easily outsiders can see what is going on. The U.S. stock market is said to be transparent because financial reporting requirements provide detailed information on profits, losses, assets, liabilities, executive pay, lawsuits and other factors that can affect stock prices. A lack of transparency, or opaqueness, contributed to the subprime crisis because