The financial turmoil gripping the world has introduced a host of new words into common usage. We try to decipher some them here:
Asset-backed commercial paper (ABCP) —A short-term corporate debt that is backed up by a bundle of loans, such as mortgages, credit card receivables and car loans.
The loans or receivables are sold by the original lender to other companies that bundle them and sell them off in slices to investors. The asset slices were used to back the issue of short-term commercial paper. The method became popular because it offered higher rates of return than traditional products.
Loan payments kept the money flowing, allowing the credit market to roll. However, when the U.S. housing market started to fail, the ABCP market dramatically froze.
Over $30 billion in Canadian non-bank ABCP has been stuck since August 2007 while the parties involved tried to work out a solution to get the market working again.
Baltic Dry Index – Once described as "the best economic indicator you’ve never heard of," the Baltic Dry Index actually has nothing to do northern Europe and everything to do with shipping activity.
The London-based Baltic Exchange publishes a daily index of the cost of shipping raw materials on freighters between various destinations. The theory is that the higher the index, the greater the demand for those commodities and hence the more likely the economy is expanding.
By October, the Baltic Index had fallen a whopping 79 per cent, no surprise given the extraordinarily weak economic weak conditions in many countries.
CDOR – A clunky acronym, this one stands for ‘Canadian Dealer Offered Rate’ and is the Canadian equivalent of the European LIBOR.
The Canadian rate is the average of all the bankers’ acceptance rates. That instrument is something banks issue in the name of corporate clients who want to borrow cash. The bankers’ acceptance will differ slightly between banks and throughout the day.
In October, the CDOR stood above three per cent, higher than the rate in September.
Credit Default Swap — Devised by a team of derivative experts at JP Morgan Chase in 1997, a credit default swap allows one company to protect itself against the failure of another firm in which the first player holds some debt.
Think of it like bankruptcy insurance.
For example, suppose company A has issued debt, say, some bonds. Another firm, company B, pays $100,000 a month to a third company, C, for a two-year contract concerning company A's debt. In return for the monthly stipend, company B will get a lump-sum payout, say $2.4 million, from company C if company A cannot cover its debts, in this instance the bonds.
The financial instrument can be used to protect a company's balance sheet if that firm holds the debt of another corporation.
But, two firms which are not related at all to the bond-issuing company can trade credit swaps. That kind of transaction is riskier and might have contributed to the bankruptcies of Bear Stearns and Lehman Brothers.
LIBOR – Another clumsy term is actually an acronym and stands for the London Interbank Offered Rate.
LIBOR is the interest rate at which major banks can borrow short-term money on the London interbank market. The rate is actually set daily by the British Bankers’ Association and is an average of the deposit rate for the globe’s most creditworthy banks.
Before the September financial meltdown, tripleA-rated corporations could borrow money at the LIBOR rate plus a couple of basis points.
Because of the uncertainty of the world’s economic situation, however, the LIBOR soared to higher than five per cent, a sign of a significantly tightening credit market.Overnight rate — The overnight rate is what the chartered banks charge to lend cash to other banks for a single day.
When the Bank of Canada alters its target for the overnight rate, the central bank picks the mid-point between what the bank pays to borrow money from chartered financial institutions and what it demands to lend funds to that same group.
The Bank of Canada cannot order Canada’s banks to cut rates in response to its move; instead it uses the overnight target to signal to the financial system the desired direction for borrowing costs.
Subprime mortgages — Loans targeted at people who couldn't qualify for regular mortgages because their credit records were not good enough (i.e. subprime). They came with higher interest rates. But for the first couple of years, those rates were far lower. People who took out these mortgages were told they would never have to worry about the interest rate reset two years down the road because they could always just refinance the home.
Problems arose when the U.S. housing market began sagging. People couldn't afford to make their payments when their interest rates were reset to higher levels. The fallout has seen wilting home sales and prices, and rising foreclosures.
Toxic debt— This is a catch-all expression to describe any debt that may have been honestly acquired but is now worthless. Subprime debt was the mother of all toxic debt, but the term has been expanded to include any debt that's poisonous to the holder. Car finance debt and even credit card debt have been called toxic, but usually what is meant is the debt owned by primarily U.S. banks that's made it so difficult for them to lend.
Washington's Public-Private Investment Program includes an offer of low-interest loans to help private investors buy as much as $1 trillion worth of toxic assets from banks so the banks can get back to lending.
While toxic debt is primarily a U.S. invention, the recession it's caused is a worldwide problem. Toxic debt was actually voted the 2008 "word of the year" in the Macquarie dictionary, a record of Australian English. (They must have a different definition for "word" in Australia. )