Financial Terms

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Terms

I’ll keep from getting too nerdy, so these are just some basic terms you should understand before reading the article.

Types of Banks

Banking is you putting money in an institution to invest for you. Basically, they loan it to others (for interest), and split the profits (interest) with you, and take a transaction fee for lining up buyers/sellers. Due to government regulation, there are three kinds of banks; commercial and investment, universal (both).

  • Commercial banks loan money to businesses in the form of cash (and give you interest in cash), and you can take out your cash at any time. Most investments are low risk (floating lines of credit, property/asset backed investments, etc.). But the overhead and low-risk investments means you get lower-returns. (This is what most people think of as banks).
  • Investment banks are more about stocks (equity). They help companies and individuals buy/sell stock/bonds/derivatives with each other (stock offerings, bond sales, Mergers & Acquisition, stock accounts and so on). So customers hold these things (paper/securities) that can be turned into cash through trades, but aren't cash themselves (thus there's more volatility/risk). Because customers are accepting more risk (the paper is more volatile than cash), they get much higher returns than traditional banking. (This is what most people think of as Wall St. or eTrade)
  • Universal banks are banks that can do both -- they're definitely less risky that Investment houses, but arguably safer than either since they're more diversified.

Combined, they provide the economy the "credit market". The idea that you can borrow cash (in some form) as long as you pay it back with interest. And that interest rate will be based on many factors -- but basically how risky that investment is, just the risk-reward ratio I was talking about. I must balance.

Glass-Steagall

Glass-Steagall was the 1930's new deal regulation that said Commercial and Investment had to be separated. There would be no universal banks.

  • The theory was that consumers were easily confused by the differences and so didn't understand the risks they were taking, and this would prevent banks from deceiving the public -- since they'd know the difference between walking into one kind of bank or the other.
  • There's an added layer of abstraction where by requiring Commercial Banks to transact with Investment banks to do certain things, there was more transparency (governments could audit those two companies transaction).
  • Because of those transactions (between the two types of banks), there's more waste (two companies get a piece of the transaction instead of one in universal banks), but there’s theoretically less conflict of interest (investment is looking out for equity, and commercial is looking out for cashflow, and somehow this helps consumers). So in their theory, there's less returns (more waste), and thus less risks. In truth, there’s just more inefficiency and the same risk.

Mark-to-Market accounting

  • FAS-157 passed in 2007 by Democrats said that instead of valuing an asset on a low-volatility manner (pegging a value to a 3-5 year rolling average), all assets of a like kind must be pegged to the last market sale. (Mark that value to the last market sale -- or [Mark-to-Market] ).
  • To those who don't understand economics, this sounds good: it's transparent, and instantaneous -- no one can hide what's happening. This was to try to compensate for Enron and other tricks of accounting -- but when it was passed, it was fought as being dangerous and injecting volatility into the market. Democrats don't listen.
  • What this means is when the one bank is struggling and required to sell an asset that no one wants for $.10 on the $1.00, then every other bank must peg all their assets as having an immediate 90% drop in value too. This injects/magnified volatility into the market, since your value is swinging much faster (and stronger) than the dampening effect that a rolling average has.

Mortgages, Fannie/Freddie and GSE's

  • Remember how loans work: you get a loan (mortgage) from your bank, which is giving you that loan based on someone else's underwriting standards (who they sell the loan too).
  • Banks don’t hold most of the loans they write, and they don’t write the standards they must follow — both of those are by who is buying (and reselling) those loans.
  • The largest buyer/reseller of these loans (handing 70-80% of all private mortgages) is Fannie/Freddie(they set 80% of the standards for the nation)
  • Fannie Mae and Freddy Mac are GSE’s (Government Sponsored Entities), which means a financial services corporation created/owned by the United States Congress
  • Fannie/Freddy don’t hold most of those loans either once they buy them. They bundle a bunch of these loans together into an MBS (mortgage backed security), and sell that to investors all over the world (including back to the banks), which frees up that money to rinse and repeat.
  • The whole point of Fannie/Freddy was as a Depression era New Deal program to create these MBS’s in order to lower the standards for getting loans, so more poor and middle class people into debt (and homes), in order to shift people from leveraging themselves (borrowing) to buy/invest in stocks, and to get them to do the same but for hard assets (homes).

Mortgage backed security

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  • An MBS (Mortgage Backed Security) is where a company (Fannie/Freddy) buys a bunch of loans, package them up in sort of a stock (security), and then sells them like they’re on the stock market.
  • The idea is that if you're a local bank, and you make a bunch of loans in your area, you're not very diversified geographically. If the local market tanks, all your assets tank. That increase risk.
  • The idea of an MBS is that you mix in lots of loans (from all over the nation) to geographically diversify the risk — you’re not buying in just one market (and riding the ups and downs), you’re doing it nationally. This creates a national market for real-estate, instead of problems with local supply and demand. And the whole nation’s real-estate market would have to tank at once, before your assets tanked (and that hadn't happened since the 1930's so was unlikely). So it reduced risk (and thus the cost of money — as the risk/reward ratio says).
  • It also bundles different types of property (demographically diversified), instead of buying just McMansions and Middle Class homes with great credit ratings (prime), you also got some poorer homes, lower credit ratings and higher risk (sub-prime) . MBS’s (and Fannie/Freddy) were created to get investors to all take on this risk of poorer / higher risk loans as part of their portfolio. Otherwise, the costs of capital (interest rates) would be too high for many poor people to get into homes.

Risk-Reward ratio

  • The more risk you take, the more reward you need to get to be worth the risk.

An analogy is, you put in $1, and I’ll flip a coin. Heads I keep it, tails you get $2. Regardless of whether you’re a gambler, that’s fair.

But if I said, we’ll roll a dice (die), and a 1 and you get $2, otherwise I keep the $1, and you’d know it is unfair. There’s only a 1:6 chance you’ll win, and a 1:1 payout, you’d need a $6 payout to make it fair. Why? Because there’s more risk of a loss, so the reward has to balance the risk. That's the risk-reward ratio.


Financial crisis of 2007-2008 : CRA, Fannie/Freddie TheoryBig Fraud TheoryGlass-SteagallFinancial Terms