So you went to business school. But it’s been a few years . . . And perhaps some of the recent economic news has left you a little befuddled. We’ve unscrambled some particularly tricky terms that will put you back at the head of the class.
LBO (Leveraged Buyout)
Buying another company with a significant amount of borrowed money. Often the assets of the company being purchased are used as collateral for the loan. LBOs allow companies to make acquisitions without having to commit a lot of capital.
Why Important? As the economy rebounds, mergers and acquisitions are coming back. This is evidenced in the battle between Hewlett-Packard and Dell to purchase 3Par.
S&P Case-Shiller Index
A measure of single-family home prices. It compares the sale price of the same properties over time. Index data is distributed by Standard & Poor’s on the last Tuesday of each month.
Why Important? If you’re looking at buying a home, you’ll want to watch price trends. If the index shows prices rising, you may want to speed up your home purchase. Generally home prices are an indicator of the overall economy.
FNMA (Fannie Mae or Federal National Mortgage Association)
A publicly traded company sponsored by the U.S. government that purchases and guarantees mortgages, creating mortgage-backed securities (a type of CDO). Pension funds, insurance companies, and foreign governments are among those investing in Fannie Mae’s CDOs.
Why Important? The U.S. housing crisis nearly caused a collapse of Fannie Mae in 2008. As a result, the federal government has taken temporary ownership of it. If Fannie goes under, tax payers could be asked to cover billions of dollars in bad debt.
CDS (Credit Default Swap)
A contract that acts like insurance. One party in the contract sells the credit risk of a debt obligation to another party.
For example, you own a $10 million bond issued by a real estate corporation, and you want to insure against the risk that the corporation will default. You find someone to sell you $10 million worth of “insurance” (a CDS with a par value of $10 million), and you regularly pay a premium (called a spread). If the bond never goes into default, the seller pockets the premium. If the bond does default, the seller pays $10 million. The higher the risk of default, the greater the spread.
Why Important? Between 2003 and 2007 the market for CDSs exploded, but during the financial meltdown CDSs have been maligned for their ability to shift credit risk to parties not directly tied to the assets. AIG was a victim of overexposure to CDSs when the housing market crashed.
CDO (Collateralized Debt Obligation)
A security that packages the debt of individual companies and sells the expected cash flows (interest and principal payments) to investors. CDOs come in many different flavors, based on the type of assets backing the debts, and are split into multiple tranches associated with different risks.
Why Important? Because of the complexity of CDO structures, buyers don’t always understand the risk they are assuming when purchasing. To complicate matters, CDOs can be backed by credit default swaps rather than by the originating assets.
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Article written by Joseph D. Ogden, Robert G. Gardner, and Brent Wilson
