Definitions and Explanations

The Secondary Market

As opposed to the primary market where prices are often set before hand, as in stock and bond issues, prices in the secondary market are fixed by the forces of supply and demand. For many it is where rehypothecated assets such as mortgage backed securities are bought and sold, and are therefore on step away from the original issuer.

Collateralised Debt Obligations, (CDO’s)

Put simply, a Collateralised Debt Obligation is a structured finance product that consists of a group of loans and other assets, which are sold to institutional investors and financial institutions. A CDO is a derivative, (rehypothecated assets and loans), as its value is derived from the underlying assets if in the event the loan defaults.

The Difference Between a Collateralised Mortgage Obligation, and Mortgage Backed Securities, (MBS)

Mortgage Backed Security is a debt instrument or security representing the amount of interest received from a group or pool of mortgages. An example of an MBS is where an Investment Bank either buys the mortgages from the mortgage company or buys the mortgage company. The bank now owns the mortgages and set up a special purpose vehicle to hold the mortgages which they sell of in tranches or shares know as MBS.

A collateralised mortgage obligation is a more distinct or specific type of MBS, and is where based on maturity dates and risk mortgages are pooled into a special purpose vehicle or entity and then sold in tranches.

Credit Default Swaps, (CDS)

A Credit Default Swap is a financial derivative and is a contract that allows a lender, (eg a purchaser of a CMO or a MBS), to offset their credit risk if they feel the counterparty, (eg the seller of a CMO or MBS) is going to default on their obligations. This instrument can be bought over the counter, (OTC), (which are non-listed securities), either in the market or from such companies as AIG or hedge funds.

Rating Agencies

The basic role of a rating agency is to provide information on bond and debt issuers as to whether they can meet their financial obligations. There are three agencies that are globally trusted, Standard and Poors, (S&P), Moody’s and Fitch. Each agency uses a unique letter-based scoring system to denote whether or not a debt instrument is low or high risk and they also denote the financial stability of the issuing company.

It is extremely relevant to note here that during the financial crisis of 2007-2009, the rating agencies had given high credit ratings, (denoting very low risk), to many of the instruments that failed, eg mortgage backed securities.

The rating agencies were criticized and rightly so, but managed to avoid any financial penalties or banishment of executives. There is a theory that the rating agencies were reluctant to give low ratings to various debt instruments, as the very issuers of these debt obligations pay the rating agencies for their services. A conflict of interest theory arose as the rating agencies did not want to upset those who effectively paid their salaries.

Bank for International Settlements, Basel, Switzerland, (BIS)

The Bank for International Settlements is the banker for central and amongst its many roles helps to set global monetary policy. The BIS is famous for their Basel accords I, ii and iii. This is extremely pertinent in relation to the financial meltdown of 2007-2009.

Basel i was established in July 1988 to set a minimum ratio of capital to risk-weighted assets

Basel ii was established in June 2004 to introduce supervisory responsibilities for Basel i and also to strengthen the minimum capital requirement

Basel iii was established in November 2010 to promote liquidity buffers, basically extra layers of equity and was in response to the financial meltdown 2007-2009.

Sadly, these measures where not really observed and was another reason for the financial meltdown. Today central banks stress test the banks in their jurisdictions to ensure they have a more than adequate capital adequacy in case of another financial catastrophe.