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Buzz Words of the Credit Crisis Defined

We decipher the lingo surrounding credit problems.

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These days, an investor practically needs a financial dictionary to read The Wall Street Journal. With credit problems occurring in areas most people have never heard of, we thought we would provide our readers with definitions for the buzz words or abbreviations commonly found in the papers.

Although some of these terms have been in the news for several months, others are new and could warn of lasting damage. The CDOs, RMBSs, and Alt-A mortgages have already caused tremendous damage, and we are carefully monitoring the ARS, CDS, and CMBS markets for additional weakness that could lead to a second series of costly write-offs among banks. Despite the aggressive actions by the Federal Reserve and even Congress, the danger in the financial services landscape remains.

GSE � Government Sponsored Entity
A generic name for Fannie Mae and Freddie Mac, these two companies are regulated by the Office of Housing Enterprise Oversight (OFHEO) and buy mortgages meeting certain underwriting standards.

LTV � Loan to Value
A basic measure of the size of the loan to the value of the underlying collateral. In the case of first mortgages, banks often state it as the size of the loan to the value of the property at the time the loan was made. For home equity loans, banks report combined-loan-to-value ratios (CLTVs), which add together the first mortgage and home equity lines and compare this figure with the value of the house at origination.

Alt-A � Alternative-A Mortgage Loan
Alt-A loans are a specific type of mortgage requiring little to no documentation on a borrower's income or wealth. Originally popular with business owners who had a hard time producing the required documentation for a home purchase, these loans soon became the vehicle of choice for small-time real estate investors and mortgage brokers trying to find a way to obtain loans for people who might not otherwise qualify for a mortgage. Due to the ease and frequency of false representation, many have dubbed Alt-A loans "Liar Loans," which has been borne out by their credit performance. Although the original credit metrics and scores make these loans appear close to prime, their performance has more closely mimicked that of the disastrous subprime mortgage industry. Alt-A loans account for just under 10% of mortgages outstanding.

RMBS � Residential Mortgage-Backed Security
A collection of residential mortgages bundled together by a trust and sold to a variety of investors in the form of securities. Each batch of mortgages are supporting several tranches of securities--with the upper levels receiving the right to be paid first, and the lower levels taking most of the credit risk. RMBSs are created by Fannie Mae, Freddie Mac, and various investment banks and can contain a range of mortgage types and quality.

CMBS � Commercial Mortgage-Backed Security
Similar to an RMBS, except the loans in this security are mortgages on commercial buildings. These securities are created by investment banks and are sold to a variety of investors, including other banks, pension funds, and insurance companies. Recent increases in credit spreads have made some wonder if the CMBS market will start to have similar problems to the RMBS market. However, commercial mortgage credit quality has remained high. According to the SIFMA, just over $2 trillion of mortgage-backed securities (residential and commercial) were issued in 2007.

CDO � Collateralized Debt Obligations
A collection of debt combined together to create a new security. CDOs can contain commercial loans, commercial mortgage-backed securities, and residential mortgage-backed securities. Created in the same way as mortgage-backed securities, CDOs were often used to take higher-risk tranches of mortgage-backed securities, bundle them, and disperse the debt into new tranches. (See table below for visual explanation). CDO-Squared is the next step, where banks took a series of CDOs and bundled them again into another security. CDO-Cubed went through the process a third time. According to the Securities Industry and Financial Markets Association (SIFMA), $486 billion of CDOs were issued in 2007, compared with $552 billion in 2006.

CLO � Collateralized Loan Obligations
A CLO is actually a form of a CDO with primarily leveraged bank loans serving as the securitized debt.

ABCP � Asset-Backed Commercial Paper
Asset-backed commercial paper is short-term debt, usually with a maturity of 30-180 days, which is collateralized by a variety of assets, including securities. As of the middle of 2007, the market was just over $1 trillion. Many money market funds buy ABCP for its low risk and decent yield. However, when investors started questioning the value of underlying assets (which included subprime residential mortgage-backed securities), investors ran, essentially shutting down the market for ABCP.

SIV � Structured Investment Vehicle
SIVs are basically tiny companies created by banks to earn extra money without reporting certain assets on their balance sheets. By using some creative financing, the banks were able to create companies that bought a variety of long-term securities and funded them through a series of short- and medium-term debt. One source of this funding was the asset-backed commercial paper market described above. When the SIVs were worried about their funding, fear spread through the market that they would have to dump several billion dollars' worth of mortgage-backed securities into an illiquid market, causing asset prices to plummet artificially from oversupply. Consequently, the Treasury and several large banks attempted to create a Super-SIV to provide replacement funding for the asset-backed commercial paper. As prospects for the Super-SIV petered out, many banks finally brought SIVs onto their balance sheet and provided the necessary funding.

ARS � Auction Rate Securities
The latest "problem securities" that few have ever heard of, auction rate securities are long-term debt instruments whose interest rates are determined on a frequent basis (daily, weekly, or every 28 or 35 days) via a Dutch auction. Municipalities and student lenders are common users of the system. As credit fears continue to spread across the market, the demand for these securities dried up quickly, causing many to be reset to their maximum interest rate, which can be 20% or more. This has resulted in both short-term funding problems for issuers and a headache for the investment banks that perform the auctions. The auction rate security market is estimated to be about $200 billion.

Monoline � Monoline Bond Insurer
Monoline bond insurers are companies that guarantee the repayment of principal and interest in the case of a default on a bond. They will do so either through a traditional insurance policy or a credit default swap (discussed below). The four largest monolines are  MBIA (MBI),  Ambac (ABK), privately owned FGIC, and Financial Security Assurance.

CDS � Credit Default Swaps
A credit default swap is similar to an insurance policy. The buyer of the swap pays a fee to the seller in exchange for a promise to pay if the underlying security (typically a bond or loan) defaults. If the bond or loan performs as expected, the seller does not pay anything and keeps the fee. At the end of June 2007, the Bank for International Settlement estimated the notional value of this market to be $42.6 trillion. The monoline bond insurers used this product to insure billions of dollars of bonds in the troubled CDO market. If ratings agencies downgrade the monoline insurers because of the huge potential liability from CDS exposure, the ripple effect would likely cause another series of write-downs across the banks.

Jaime Peters does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.