Page last updated at 15:44 GMT, Tuesday, 16 September 2008 16:44 UK

Glossary of the credit crunch

Business news has been topping the headlines in recent days as some of the biggest names in global banking have struggled to survive.

Our journalists do their best not to use jargon, or to explain it if it appears in a quote.

But just in case any words have slipped through, or other publications confound you, here is a handy glossary.


DELEVERAGING

The degree of leveraging in your business is the amount of money you have borrowed compared with the amount that has been put in by yourself, investors or shareholders.

Some investment companies borrow money to supplement the money they have been asked to invest so that they can increase the amount of money they can make.

But that is a high risk strategy, because it also means that you can lose more money than you originally invested.

So at the moment, with confidence low, many investors and businesses are reducing the amount of money they are borrowing, which is known as deleveraging.

UNWIND

A lot of the trades carried out by big banks involve agreeing to buy or sell or deliver or receive something on a particular date in the future.

You might, for example, pay $10,000 for 100 barrels of a particular type of oil to be delivered in November.

To unwind a position, you just do the opposite of what you did in the first place.

So if you bought 100 barrels of oil to be delivered in November then to unwind the position you have to sell someone 100 barrels of oil to be delivered in November.

It is very important to unwind a position because otherwise you end up having 100 barrels of oil delivered to your desk, which is embarrassing.

Also, you do not get the $10,000 back or make any profits until you have unwound your position.

The problem at Lehman Brothers is that there are all sorts of trades that have been made that will not be unwound because the traders have been laid off.

So the challenge for the administrators is to unwind all the positions before they start receiving oil or gold or whatever the traders have been dealing in.

This will be an enormous task and the administrators need to try to lose as little money as they can while doing it.

Meanwhile, the banks that have done deals with Lehman don't know when they will get their money back - until all deals have been unwound.

LIQUIDITY

We've been hearing a lot about how the big problem for the banks is liquidity.

The liquidity of an investment is how easy it is to turn it into cash.

So your most liquid investment is probably your current account and your most illiquid could be your house or car.

If you desperately needed cash to pay a bill, for example, you might end up selling your house or car to raise it, but if you had to sell in a hurry you might not get a very good price for them.

The banks have the same problem because some of the things they have bought, especially anything to do with mortgages in the US, are of questionable value. That means they are very difficult to sell, especially if they are trying to make back anything like the amount they paid for them.

So banks own lots of things that will probably be worth a lot of money one day, but they find it very difficult to turn them into cash. As a result banks have been reluctant to lend money to each other or to customers.

And that's how a rich bank can run out of money and go bankrupt.

INVESTMENT BANK

There are basically two types of banks: investment banks and commercial banks.

Commercial banks are the ones that you see on the High Street, where you have your current account or savings and where you might go for a mortgage.

Investment banks invest money and provide financial services for governments, companies or extremely rich individuals.

The distinction is not as clear as it once was, because many banks now own both a High Street bank and an investment bank.

Barclays Bank, for example, has an investment banking arm called Barclays Capital.

The distinction between the two types of bank is important because of the way they are treated by governments.

Governments need to make sure that if a commercial bank collapses, nobody with money in a savings account or a current account loses their money, but they are less concerned about what happens to investment banks.

Lehman Brothers is an investment bank while Northern Rock is a commercial bank.

There was some surprise and criticism in the US when the government helped Bear Stearns, an investment bank, to be taken over by JP Morgan as its policy in the past had been not to spend money on rescuing investment banks.

SECURITISATION

Securitisation has been in the news because of what has been done to mortgages in the US.

Institutions that had lent money to people who wanted to buy houses took the debt from a number of mortgages and put them together to make a single product.

The product, which is known as a mortgage-backed security, could then be sold onto banks and other institutions, which would receive income as the original house-buyers made their mortgage payments.

The problems started because it turned out that some of the banks and other institutions that had bought the securities did not realise that some of the people who had taken out the mortgages were a high risk of not being able to repay them.

When record numbers of borrowers defaulted on their mortgages, it called into question the value of the securities and effectively closed down the market in buying and selling them.

CHAPTER 11

If a company in the United States finds it cannot pay people to whom it owes money (creditors), then it can apply to the bankruptcy court for protection from its creditors.

The idea is that with the supervision of the court, the company can reorganise its debts and perhaps sell parts of the business so that it can make a fresh start.

Among the many companies that have reorganised under Chapter 11 is Delta Airlines, which had bankruptcy protection between September 2005 and April 2007.

Chapter 11 refers to a chapter of the US Bankruptcy Code.

It is similar to going into administration in the UK, when a team of administrators tries to maximise the value of a company so that people who are owed money can be paid.

CREDIT CRUNCH

Last year, many banks worldwide found themselves holding debt based on US mortgages, which were of questionable value because so many homeowners were having trouble keeping up with their payments.

That made them reluctant to lend money for two reasons.

The first was that because they did not know how much the debt was worth or when they would be able to sell it, they did not know how much cash they could afford to lend.

The second was that they did not know which banks had been worst-hit by the crisis and so were not sure which were credit-worthy.

As a result, the amount that banks charged to lend money to each other rose significantly. That in turn resulted in higher interest rates on loans and mortgages.

The sudden reluctance by banks to lend money is known as the credit crunch.

DERIVATIVES

Derivatives are a type of investment that changes its value in line with the price of something like shares, a currency or a food crop, but the investor does not actually have to own any shares or currency or crop.

The handy thing about derivatives is that because they can be based on almost anything they can be used as insurance to limit the risk of a particular investment.

The sort of derivatives that have been in the news a lot have been credit derivatives, which are based on the risk of borrowers not being able to repay their loans, a so-called default. The idea is that a bank could buy a lot of mortgage debt and then use a credit derivative to insure itself against defaults.

The current problems started when the companies that provide these credit derivatives, such as investment banks and insurance companies, did not take proper account of how risky they were and so lost a great deal of money.

SUB-PRIME

The problems in the US housing market began with sub-prime mortgages.

Sub-prime mortgages are those offered to people who have had financial problems in the past or who have low or unpredictable incomes.

They carry a higher risk to the lender and so tend to be at higher interest rates than prime mortgages.

The criticism in the US is that sub-prime mortgages were offered to people who probably would not be able to afford the repayments, which led to hefty defaults.

Another problem were so-called balloon mortgages that were offered at a low and affordable starter rate. After a while the rates ballooned to levels that borrowers could not afford.

There are suggestions that some mortgages were mis-sold. In other cases, borrowers had hoped to replace the balloon mortgage with a new mortgage at a cheap starter rate, but because of the credit crunch these mortgage are no longer available.





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