Language of the new economy
The bailouts have brought a new list of terms to the conversation about the economy.
NEW YORK (CNNMoney.com) -- The government's economic recovery efforts have brought many new and unfamiliar financial terms into the conversation. Here's a list of some we think are vital to understanding the recession and the government's attempts to fix it:
Alternative Minimum Tax (AMT): The provision was originally intended to prevent high-income taxpayers from using tax breaks to sharply reduce their tax bill. But Congress never adjusted for inflation the amount of income exempt from AMT, putting tens of millions of middle- and upper-middle-income taxpayers at risk of having to pay it. Every year, Congress approves a "patch" that temporarily lifts the income exemption levels.
American Recovery and Reinvestment Act: The $787 billion economic stimulus package contains $212 billion of tax relief, $308 billion of appropriations and $267 billion in direct spending. The Obama administration estimates that the plan will create or save 3.5 million jobs by the end of 2010 and boost consumer spending.
Asset-backed security (ABS): Asset-backed securities are bundles of loans, such as auto or home loans. After a bank issues the loan, it sells it to another bank, which packages it together with other loans. That pool is turned into a security which is divided up into shares for investors to buy. As the borrowers of the underlying loans make payments to the bank, ABS investors receive pieces of those payments in the form of a dividend.
Balance sheet: A balance sheet is a list of a company's assets and liabilities. A company's balance sheet, which is usually revealed on a quarterly and annual basis, tells investors what the company owns and how much it owes.
Bonds: Bonds are debt issued to investors by companies or governments that are used to finance a firm's business or a government's projects. Bonds pay out a fixed interest rate to investors over a set duration of time. U.S. government bonds are often called Treasurys and are considered "safe" investments because they are backed by the government. Municipalities issue so-called muni bonds, and businesses' debt issuances are called corporate bonds.
Capital: The amount of cash and assets that an institution has available for immediate use. Depending on their credit rating, financial institutions need to maintain a certain level of capital that can be used as collateral to back loans.
Collateralized Debt Obligation (CDO): CDOs comprise various asset-backed securities that are bundled together, divided up into shares of varying risk levels called "tranches," and sold to investors. To balance risk for investors, most CDOs are backed by a wide diversity of ABS's, which themselves are backed by underlying loans, such as credit card, mortgage and auto loans. As values of underlying loans deteriorated during the recession, the market for CDOs dried up and the CDOs themselves have become hard to value.
Commercial paper: Commercial paper is short-term debt that big businesses and financial institutions sell primarily to money-market fund managers and other institutional investors. The companies use the loans to fund day-to-day business operations, including payrolls. The market for commercial paper dried up after the collapse of Lehman Brothers in mid-September.
Commercial Paper Funding Facility (CPFF): On Oct. 27, 2008, the Federal Reserve began to buy up hundreds of billions of dollars of high-quality, three-month commercial paper through the CPFF. The program immediately boosted the market. It is credited for bringing bank-to-bank lending rates down and helping companies secure crucial short-term financing.
Credit: Credit is debt, which can be bought or sold in the form of bonds, loans or other similar assets. The market for most credit dwindled after the subprime loan meltdown led many investors to question the value of loans and the holder's ability to pay them. Government bonds have been in large demand recently for their perceived safety.
Credit Default Swap (CDS): CDS's are essentially insurance contracts on CDOs and other securities. A holder of a security buys a CDS to guarantee against default. In exchange for that guarantee, they pay the insurer a fee, sort of like an insurance premium. If the underlying loans of the security default, the insurer must pay out. Since CDS's transfer risk from the owner of the security onto the insurer, they were central to the turmoil at American International Group (AIG, Fortune 500). As the values of CDOs plummeted, investors demanded that AIG pay out on the credit default swap agreements.
Equity: Equity can mean a number of things, including a stock or ownership holding. In housing terms, equity is the current market value of a home subtracted by the amount a borrower owes on the mortgage. As home values have plummeted, many borrowers have found themselves underwater -- owing more on their home than their house is worth.
Federal Deposit Insurance Corp. (FDIC): The FDIC is a government agency that, among other functions, guarantees bank deposits if a bank fails. In the event of a bank failure, the FDIC will take over the bank and try to sell it to a potential buyer. On Oct. 10, 2008, the agency temporarily raised its guarantee on interest-bearing bank accounts to $250,000 from $100,000 and issued unlimited guarantees on non-interest- bearing accounts, also up from $100,000.
Free market: An open-ended term that some take to mean completely unregulated financial markets. Some say that free markets are necessary to allow businesses to innovate and grow. Others say that the government's lack of regulation in previous years led to unscrupulous business behavior that caused the current downfall.
Government-Sponsored Enterprise (GSE): These are companies that can draw on the Treasury's reserves for capital, namely mortgage finance giants Fannie Mae, Freddie Mac and Ginnie Mae. GSEs are the primary source of funding for banks and lenders, as they buy up trillions of dollars of loans, attach a guarantee, then sell securities backed by the loans' income stream. When home prices declined and foreclosures began to escalate, Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) faced significant losses, and the government placed them under conservatorship -- meaning the government runs the companies, but they are still owned by shareholders.
Gross Domestic Product (GDP): GDP is the broadest measure of the nation's economic activity, measuring total spending by consumers, businesses and the government, and the nation's net exports. About 70% of GDP is composed of consumer spending.
Liquidity: The ability to buy or sell an asset or security and turn it into immediate cash. During the recession, liquidity of many stocks, corporate bonds, asset-backed securities and other holdings froze, leading to a sharp decline in equity and home prices and sending some borrowing rates soaring.
London Interbank Offered Rate (LIBOR): Libor is a daily average of rates that 16 different banks charge each other to lend money, set by the British Bankers' Association. More than $350 billion of assets, including many mortgage, auto and student loans, are tied to Libor. After Lehman Brothers' collapse in September, Libor rates soared, but have eased significantly since the government began its credit-easing programs in October.
Nationalization: A somewhat open-ended term, which usually implies some kind of government ownership of a private company. Some say nationalization means complete government control of a company, but others say the term can mean any level of ownership in a private business. Some say nationalization is an affront to free markets, but others say it is necessary to restore the financial markets to normalcy, since only the government has the capital necessary to keep some enormous companies afloat.
Refinance: A modification of the payment terms on a loan, usually in the form of a lower interest rate and lower monthly payments. Many borrowers with little or no equity on their homes have been unable to lower their housing costs through refinancing because of falling home prices, because lenders tend to charge hefty fees to people in that group. As a result, the government has recently begun a new program to help an estimated 5 million of those borrowers with little or no equity quickly refinance with no fees so they can keep their homes.
Security: A holding such as a stock, bond or share of an asset that can be traded. Many securities backed by loans -- especially mortgages -- have plummeted in value as borrowers became unable to make monthly payments on the underlying loan.
Subprime: A term used to describe borrowers with poor credit history or loans that typically go borrowers with bad credit. If lenders choose to issue loans to subprime borrowers, the interest rates are typically higher than those given to borrowers with good credit, or "prime" borrowers. Many experts blame unscrupulous subprime lending and borrowing practices for the housing downturn, as borrowers were unable to make the necessary payments on their mortgages.
Temporary Liquidity Guarantee Program (TLGP): An FDIC program created on Oct. 14, 2008, that guarantees certain bank's bonds with a maturity of up to 10 years. The program only guarantees covered bonds - those backed by assets on the bank's balance sheet. Other bonds can be backed by assets held by the bank in a portfolio of securities, but the bank does not actually own them outright. Under TLGP, If a bank defaults, the FDIC will pay what the investor is owed on those bonds. The program has been credited for expanding the corporate bond market and lowering the financing costs for businesses' debt issuance.
Term Asset-backed securities Lending Facility (TALF): Also called the Consumer and Business Lending Initiative, the TALF program provides up to $1 trillion in financing to private investors to buy up securities backed by various types of consumer loans as well as small business loans. Through TALF, the Fed and Treasury aim to boost lending to consumers and business in order to restore the flow of credit and lower borrowing costs.
Term Auction Facility (TAF): A Federal Reserve program that lends short-term money to banks in exchange for toxic assets (see below), like some mortgage-backed securities that are hard to value and difficult to sell, as collateral. The program was one of the first of many unprecedented liquidity programs the Fed introduced, debuting in December 2007. So far, the Fed has loaned out about $3 trillion for periods of 28 and 84 days.
Toxic asset: An asset on a company's balance sheet that is difficult to value or sell because the market for those assets has dried up. Companies have struggled to sell many loans and asset-backed securities, like those backed by mortgage and credit card loans, because of worries that the borrowers of the underlying loans will default. Toxic assets have plagued companies with steep losses, oftentimes resulting in diminished stock prices.
Troubled Asset Relief Program (TARP): The $700 billion financial sector bailout package was enacted on Oct. 3, 2008. Though the initial intent of the program was to buy up banks' toxic assets, the Treasury Department has so far used most of the funds to invest capital in banks to prop up their balance sheets and rescue failing companies. Some of the funds have also gone to foreclosure prevention and supporting TALF lending.