Since the credit crisis began, investors have been bombarded with acronyms and phrases that most had very little direct experience with. Since the credit crisis is far from over and has both real and financial economy affects (that will result in a transformation of the US economy in the years ahead as the credit creation machine retools), it might be advisable for investors to get acquainted with some of the more germane acronyms and phrases as they will likely be with us for longer than many suspect.
Therefore, as a public service, I have listed below several key acronyms and phrases catalogued by area:
Credit derivative: A financial contract under which an agent buys or sells risk protection against the credit risk associated with a specific reference entity (or specific entities). For a periodic fee, the protection seller agrees to make a contingent payment to the buyer on the occurrence of a credit event (default in the case of a credit default swap).
Collateralized debt obligation (CDO): A structured credit security backed by a pool of securities, loans, or credit default swaps, where securitized interests in the security are divided into tranches with differing repayment and interest earning streams. The pool can be either managed within preset parameters or static. If the CDO is backed by other structured credit securities, it is called a structured finance CDO, and if it is backed solely by other CDOs, it is called a CDO-squared.
Collateralized loan obligation (CLO): A collateralized debt obligation backed by whole commercial loans, revolving credit facilities, or letters of credit.
Credit default swap (CDS): A default-triggered credit derivative. Most CDS default settlements are “physical,” whereby the protection seller buys a defaulted reference asset from the protection buyer at its face value. “Cash” settlement involves a net payment to the protection buyer equal to the difference between the reference asset face value and the price of the defaulted asset.
Credit-linked note (CLN): A security that is bundled with an embedded credit default swap and is intended to transfer a specific credit risk to investors. The CLN issuance proceeds are usually invested in liquid and highly rated securities to cover the principal repayment at maturity plus any interim conditional payments associated with the underlying credit default swap.
Securitization: The creation of securities from a pool of pre-existing assets and receivables that are placed under the legal control of investors through a special intermediary created for this purpose (a “special purpose vehicle” [SPV] or “special purpose entity” [SPE]). In the case of “synthetic” securitizations, the securities are created from a portfolio of derivative instruments.
Structured credit product: An instrument that pools and tranches credit risk exposure, including mortgage-backed securities and collateralized debt obligations.
Structured investment vehicle (SIV): A legal entity, whose assets consist of asset-backed securities and various types of loans and receivables. An SIV’s funding liabilities are usually tranched and include short- and medium-term debt; the solvency of the SIV is put at risk if the value of the assets of the SIV falls below the value of the maturing liabilities.
Conduit: A legal entity whose assets consist of various types of loans, receivables, and structured credit products. A conduit’s liabilities are short-term commercial paper and are supported by a liquidity facility with 100 percent coverage.
Source: IMF “Global Financial Stability Report” April 2008