A Handy Glossary for Today's Economic Crisis

by: David Van Knapp

Many citizens today face a barrage of strange or confusing terms as they try to understand what has happened to the economy in the past year or two. This glossary will help. The entries are cross-referenced and allow you to build the true story in your own mind at your own pace. As you hop from entry to entry, you will develop a better understanding of what’s going on, plus maybe an occasional smile on your face.

A boldfaced term within an entry means that the term is itself a main entry in the glossary. Follow these cross references to hop around. Start anywhere. There is no beginning, middle, or end—which is very appropriate, because the economic crisis is a true network effect, based on complex interconnections among participants.

A tip of the hat to Wikipedia for much of the information. Any mistakes are mine. I put this together in a hurry.

  • AIGAmerican International Group, also sometimes known as Arrogance, Incompetence, and Greed. Once a very successful conventional insurer, the company became heavily involved in insuring debt instruments through credit default swaps. This part of its business collapsed in 2008 and threatened the world’s financial structure. Therefore, special bailout provisions were passed for it, under which more than $150 billion of public money has been injected to keep it solvent and operating. The United States has come to own about 80% of AIG through capital injections made via stock purchases. In a recent sideshow, AIG executives were paid some $16 million in bonuses for their work in 2008 (when AIG failed), provoking tremendous public and political outrage when the bonuses came to light in March, 2009.
  • American Recovery and Reinvestment Act—The so-called stimulus bill signed into law by President Barack Obama on February 17, 2009. The law is intended to provide a stimulus to the U.S. economy to combat the recession of 2007-2008-2009. It includes Federal tax cuts and re-apportionments, expansion of unemployment benefits, massive spending provisions, and payments to states for their use. The stimulus bill has been criticized as non-stimulative, although nobody really knows yet what its impact will be. At about $800 billion, this bill is much larger than the Economic Stimulus Act of 2008, which consisted primarily of tax rebate checks. It is also notable for having passed the House with no Republican votes and the Senate with only 3 Republican votes.
  • Bailout—Term used (often sarcastically) to describe when the Federal government or Federal Reserve System loans, gives, or otherwise spends massive amounts of public money to save a failing company or industry that screwed up in the free market system. The bailer injects capital into the bailee in order to save it from bankruptcy, insolvency, or other degrees of ruin. Governments are most prone to bail out companies that are deemed too big to fail. Ideologically pure believers in the free market system oppose bailouts, because they increase moral hazard. Firms requesting bailouts often display total cluelessness about their precarious situation by committing such acts as using private jets to go to Washington to plead for bailout money (as CEOs of the American auto industry did in 2008), or paying massive bonuses to executives of failed enterprises (as AIG did in 2009).
  • Bernanke, Ben—Chairman of the Board of Governors of the Federal Reserve.
  • Blow up—Highly technical financial term used to refer to the massive failure of a financial institution, market, or system following a series of bad bets and/or poor risk management, almost always abetted by overleverage, and sometimes encouraged by moral hazard.
  • Collateralized debt obligations (CDOs)—A type of structured security whose value and payments are derived from a portfolio of underlying debt instruments. CDOs are assigned different risk classes depending on their perceived safety. Detractors of CDOs, including Warren Buffett, have warned that they spread risk and uncertainty about the value of the underlying assets. Many see them as the main cause of the credit crisis of 2007-2008-2009. It is clear now that credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values or packages which contained subprime mortgages) when rating CDOs. Many CDOs have become toxic assets as their value has collapsed.
  • Credit crisis of 2007-2008-2009—A financial crisis that began in July 2007 and continues to the current day. The crisis is highly complex, but a simplified explanation would be that investors lost confidence in the value of mortgage-backed securities in the U.S. This resulted in a liquidity crisis that eventually prompted governments and central banks around the world to ignore moral hazard and develop myriad programs to inject capital into financial markets to avert the collapse of the world’s financial systems. The collapse of America's housing bubble, which was the unstable foundation of millions of intricate, risky, and highly-leveraged financial contracts and operations (commonly known as toxic assets), is seen by many as the root cause of the world-wide crisis, which really turned ugly after the failure of Lehman Brothers in late 2008. The latest U.S. attempt to reverse the credit crisis is the PPPIP, introduced in late March, 2009. See also Recession of 2007-2008-2009.
  • Credit default swap (CDS)--A contract between “counterparties” that, in effect, insures against defaults in financial instruments. The buyer makes periodic payments to the seller, and in return receives a payoff if the underlying investment instrument defaults. In the run-up to the housing bubble and credit crisis of 2007-2008-2009, more and more financial institutions invested in mortgage-backed securities and collateralized debt obligations. It turns out that nobody fully appreciated the risk in such instruments. They were routinely “insured” through credit default swaps, the far-and-away leader in which was AIG. As risk turned to defaults, the credit crisis of 2007-2008-2009 developed. AIG, in danger of collapse, was bailed out by the U.S. government to the tune of more than $150 billion, because it was deemed too big to fail, and it had counterparties all around the world.
  • Deleverage—To reduce borrowed funds that had been used to leverage an investment. This is usually done when the investment goes sour.
  • Emergency Economic Stabilization Act of 2008—See TARP.
  • FDIC—See Federal Deposit Insurance Corporation.
  • Federal Deposit Insurance Corporation (FDIC)—A Federal government corporation created in 1933 to stem panic runs on banks. It provides deposit insurance, guaranteeing (up to $250,000) the safety of deposits in participating banks. Its guarantees are backed by the full faith and credit of the U.S. As a result of the current economic and financial crisis, over 30 U.S. banks have become insolvent and been taken over by the FDIC since 2008. Combined, these banks held over $55 billion in deposits, and the takeovers cost the Federal government an estimated $17 billion. The FDIC also insures Individual Retirement Accounts, and under very recent legislation, it will play a key role in the bank bailout plan known as the Public-Private Partnership Investment Program.
  • Federal Reserve System—Informally known as The Fed, this was created in 1913 as the central banking system of the U.S. It is made up of providentially appointed Governors for twelve regions that blanket the country; the Federal Open Market Committee; twelve regional privately-owned Federal Reserve Banks that act as fiscal agents for the U.S. Treasury; numerous other private U.S. member banks; and various advisory councils. Since 2006, the Chairman of the Board of Governors has been Ben Bernanke. Functions of the Federal Reserve System include serving as the central bank of the U.S.; managing the nation's money supply to achieve the sometimes conflicting goals of maximum employment, stable prices, and moderate long-term interest rates; maintaining the stability of the financial system and contain systemic risk; and strengthening U.S. standing in the world economy.
  • Fiat currency—See printing money.
  • Free market system—An economic system characterized by markets that are free of government intervention and regulation, beyond the minimal functions of maintaining the legal system and protecting property rights. In a free market, property rights are voluntarily exchanged at a price arranged solely by the mutual consent of sellers and buyers. Free markets contrast with regulated markets, in which governments directly or indirectly regulate prices or other market functions, which according to free market theory causes markets to be less efficient. True believers in the free market system believe that any government intervention is a form of socialism. In a pure free market system, not all companies or other participants will succeed. They will blow up, and free marketeers believe that such enterprises should be allowed to fail rather than getting bailouts or other government assistance. Under this philosophy, the free markets, with participants acting in their own best interests, and subject to the forces of supply and demand, will determine what goods and services are produced, and who succeeds and fails.
  • Geithner, Timothy—First and present Treasury secretary of the Obama administration. Notable for having been confirmed despite not having paid tens of thousands in taxes—creating the irony that in his new position, he overseees the Internal Revenue Service. Geithner was previously president of the Federal Reserve Bank of New York. One of his tasks as Treasury secretary is directing how the remaining $350 billion of TARP money will be allocated. He introduced the PPPIP in March, 2009, to try to rid banks of toxic assets. Other high-profile responsibilities include funding (or not) the bailout of the American automobile industry; the restructuring of banks, financial institutions and insurance companies; recovery of the mortgage market; and relations with foreign governments that are dealing with similar crises.
  • Global financial meltdown—See Credit crisis of 2007-2008-2009.
  • Gold standard—A monetary system under which a country’s paper and coin money are freely exchangeable for pre-set quantities of gold. The gold standard is not currently used by any government. Many libertarians think we should return to the gold standard, because they distrust and object to the role of the government in issuing fiat currency. Gold remains a principal financial asset of almost all central banks. There is also a highly liquid market in the private ownership of gold, usually in the form of gold coins and gold bars, serving as a private source of wealth.
  • Housing bubble—A housing bubble is generally thought to have begun in the U.S. around 1995, exacerbated by increasingly risky mortgage lending practices, including subprime mortgages, that allowed way too much money to flow into the housing market. That encouraged speculation, overleveraging, and unsustainable house prices. Many believe that the collapse of the housing bubble, which began in 2007 as more and more borrowers defaulted on mortgages they could not pay, is one of the root causes of the credit crisis of 2007-2008-2009-2009. As described by the Treasury department in announcing its Public-Private Partnership Investing Program, the hangover from the housing bubble is that when it burst in 2007, investors and banks were stuck with mortgage-related legacy assets. They therefore suffered losses, which were compounded by the lax underwriting standards that had been used by some lenders in issuing subprime mortgages and by the proliferation of complex mortgage-backed securities, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale de-leveraging in these markets, rapid price declines in the legacy assets, and ultimately created the credit crisis of 2007-2008-2009.
  • Legacy assets—Term used by the Obama administration to describe pre-existing toxic assets, particularly (1) bad real estate loans held directly on the books of banks (legacy loans), and (2) securities backed by bad loan portfolios (legacy securities). These assets, it is said, lack clarity as to their value (because they contain embedded excessive discounts) that create uncertainty around the banks’ balance sheets, compromising their ability to raise capital and willingness to lend. Thus, beginning with the bursting of the housing bubble in 2007, a negative cycle developed where declining asset prices triggered further de-leveraging, which in turn led to further price declines. The end result was the credit crisis of 2007-2008-2009. To address the challenge of legacy assets, Treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve announced on March 23, 2009 its Public-Private Investment Program as part of its efforts to repair balance sheets throughout the financial system and ensure that credit is available to households and businesses that will help bring the country to economic recovery. See also toxic assets.
  • Lehman Brothers (OTC:LEHMQ)—Former giant in investment banking, trading, investment management, and private banking, with offices around the world. Lehman blew up in 2008 and, unlike large institutions before and after it, was allowed to fail. Its blowup was the result of poor decisions in its subprime mortgage operations and the resulting large losses it faced in that part of its business. Lehman’s filing for Federal bankruptcy protection on September 15, 2008, marked the largest bankruptcy in U.S. history. The failure to bail out Lehman Brothers is now widely seen as a principal reason the world financial crisis became as bad as it did, because Lehman had counterparties around the world, and they fell into a deep hole when Lehman could no longer meet its obligations to them. Worldwide credit markets seized up after that. In retrospect, Lehman was probably too big to fail because of its keystone status in the world’s financial system. Shortly after the bankruptcy, but too late to prevent it, Treasury Secretary Hank Paulson proposed TARP as emergency legislation.
  • Leverage—Borrowing money to supplement existing funds for investment. Leverage increases the potential payoff from an investment (the additional leveraged funds purchase more of the investment), but also make it more risky if the investment has a negative outcome. See also Deleverage and Overleverage.
  • Madoff, Bernie—Former chairman of the NASDAQ stock exchange who confessed to, and was convicted of, operating a Ponzi scheme that appears—at more then $50 Billion—to be the largest investor fraud ever committed by a single person. While not directly related to the credit crisis of 2007-2008-2009, Madoff’s fraud has helped to reduce citizen and investor confidence in and regard for Wall Street. He awaits sentencing in September 2009. At age 70, it is unlikely he will ever see the outside of a prison again.
  • Moral hazard--The prospect that a party insulated from risk—as by a bailout—may behave differently from the way it would if it were fully exposed to the consequences of its actions. In other words, it will act less carefully (assume more risk), knowing that it is protected in some fashion. Example: Bank bailouts can encourage risky lending in the future or shield bank management and shareholders from the unpleasant consequences of risky loans already made that fail (i.e., are not repaid). Believers in the free market system might say that in this case, the potential profit from risky loans remains private, while the risk has been socialized. Another example: Homebuyers who took out mortgages which they had no ability to repay are insulated from their stupidity if they are bailed out, leading to bumper stickers from outraged fellow motorists that say, “Honk if I’m paying your mortgage.”
  • Mortgage-backed securities (MBS)—An investment instrument whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Formerly considered sound investments, MBS became risky when (1) the housing bubble broke, bringing the value of the mortgaged properties down to or below the amounts owed on the mortgages, and (2) lenders greatly lowered their lending standards, issuing mortgages that could not be paid back under practically any circumstances. MBS then moved from being sound investments to being toxic assets.
  • Overleverage—Imprudent borrowing of too much money to add to existing funds to make an investment. Leverage increases the risk of any investment, as well as the potential rewards. Most large-scale financial blowups involve overleveraging and the assumption of too much risk.
  • Paulson, Hank—Final Treasury Secretary under President George W. Bush. Famous for proposing TARP, originally a mere 3-page document. The bill, which passed after being rejected once, ended up at over 100 pages. Its purpose was to purchase toxic assets, reduce uncertainty regarding the worth of other assets, and restore confidence in the credit markets. While most of the TARP’s original $700 billion has been spent, no toxic assets have been purchased. The latest plan for doing that is the Public-Private Partnership Investment Program. PPIF—Public-private investment fund, a fund of money used to buy toxic assets under the Public-Private Partnership Investment Program.
  • PPPIP—See Public-Private Partnership Investment Program
  • Printing money—Pejorative term used to describe the “creation of money out of thin air.” The possibility of this is based on the fact that the U.S. has a fiat currency system. That means that we use money which has been declared by the government to be legal tender to pay debts, goods, services, and taxes. Fiat currency works to the extent people trust it. It is philosophically opposite to the gold standard.
  • Public-Private Partnership Investment Program ((PPPIP)—Announced March 23, 2009 by the Treasury Department, this is the latest and most complex bailout program so far, designed to relieve banks of toxic assets. Using $75 to $100 billion from TARP plus capital from private investors, PPPIP hopes to generate up to $1 trillion to buy legacy assets. (Some have estimated that about $3 trillion of such troubled assets exist). PPPIP is characterized by five major features: (1) Financing comes from the Treasury, FDIC, Federal Reserve, and private investors; (2) risks and profit opportunities are shared between the government and private sector participants; (3) prices for the toxic assets are “discovered” via auctions to reduce the likelihood that the government will overpay; (4) 6-times leverage loans will be guaranteed by the FDIC; and (5) the private participants will manage the assets purchased (under “strict” FDIC oversight) until final liquidation. A broad array of private investors are expected to participate, thus creating a heretofore nonexistent private market for the toxic assets. The Treasury will provide 7% of the equity capital, private participants will provide another 7%, and the remaining 84% will come from 6-times leverage loans from the Federal Reserve and guaranteed by the FDIC. To start the process, banks will identify which legacy assets they wish to sell. The FDIC will analyze them to determine the amount of funding it is willing to guarantee. The assets will be packaged and auctioned by the FDIC (thus creating a market and a price), although the seller retains the option to refuse the highest bid. In a second part of the PPPIP, a similar process will be used to purchase legacy securities tied to residential and commercial real estate and consumer credit, partly using money from TALF.
  • Recession of 2007-2008-2009--In general, a recession is a broad slowdown in or contraction of economic activity over a sustained period of time. Gross Domestic Product (GDP), employment, investment spending, household incomes, and business profits all tend to fall during recessions. Many consider the shorthand definition of a recession to be two successive quarterly declines in GDP. In the U.S., recessions are “officially” declared by the National Bureau of Economic Research. By their reckoning, the U.S. has been in a recession since December, 2007. In February, 2009, a stimulus bill was enacted to try to pull the U.S. out of this recession.
  • Stimulus bill—See American Recovery and Reinvestment Act.
  • Subprime mortgage—A mortgage loan issued under standards that traditionally would have been considered inadequate to justify the loan. Subprime borrowers are more likely to not pay the loan back. Relaxed standards might involve loaning to borrowers whose credit ratings are low; do not verify their income with proper documentation; have a history of not paying loans back; have a recorded bankruptcy; do not meet usual qualifying guidelines; have a high debt-to-income ratio; are borrowing against a property of dubious value; are borrowing with little or no down-payment, or even borrowing more than 100% of the value of the property. Such loans can become toxic assets when there are too many of them, or when they are packaged together with higher quality loans into investment packages that are difficult or impossible to value. See also legacy assets.
  • Systemic risk—The risk of collapse of the entire global or national system of finance. The risk results from the interdependencies and linkages among the world’s largest financial institutions, coupled with the potential domino effect where the failure of a single institution can begin a cascade that could bring down the entire system. The risk is seen to be greatest among institutions that are too big to fail. Advocates of a pure free market systems approach do not seem to worry too much about this, basically saying, “Let ‘em fail.” They are in the minority at the current time, with governments and central banks providing bailouts of unprecedented size to avert what they see as risks of catastrophic failures. The impact on the world’s financial system following the collapse of Lehman Brothers is probably exhibit A against the free market system reasoning. The government’s failure to bail out Lehman is now widely seen as a mistake.
  • TALF—One of the lesser-known Federal government programs to solve credit crisis of 2007-2008-2009. Formally known as the the Term Asset-Backed Securities Loan Facility, TALF was created by the Federal Reserve in November, 2008 to facilitate renewed issuance of consumer and small business loans at “normal” interest rates. The program supports the issuance of securities backed by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Under TALF, the Federal Reserve will lend up to $1 trillion to holders of certain AAA-rated securities backed by new and recent consumer and small business loans. The reasoning behind the program is that new issuance of the types of loans covered declined precipitously in September, 2008 and came to a halt in October, 2008. At the same time, interest rates on them soared. It was thought that continued unavailability of these types of credit could significantly contribute to further weakening of U.S. economic activity.
  • TARP--The Emergency Economic Stabilization Act of 2008, commonly referred to as TARP, standing for “troubled assets relief program.” Popularly considered to be a bailout of the U.S. financial system, it authorizes the U.S. Treasury to spend $700 billion to purchase toxic assets, particularly mortgage-backed securities, and to make capital injections into banks. The Act was proposed by Treasury Secretary Hank Paulson as an antidote to the freezing of credit markets during the global financial crisis of 2007-2008-2009.After being considerably amended, rejected once, and rewritten in the course of a frenzied week, the bill was passed on October 3, 2008. It was signed by President George W. Bush a few hours later, reflecting its emergency aura.
  • Too big to fail--The notion that the largest and most interconnected banks, or other businesses, must be saved when they blow up by bailouts, because their failure would present unacceptable systemic risk. The notion has been used to justify bailouts for some of the largest banks involved in the credit crisis of 2007-2008-2009, including Bear Stearns, Goldman Sachs (NYSE:GS), and insurer AIG. True believers in the free market system mock the too big to fail doctrine, believing that big banks and other institutions should be allowed to fail if their risk management was not effective.
  • Toxic assets—Assets held by financial institutions that are highly risky, usually overleveraged, backed by other assets of dubious value, difficult to value, and therefore difficult to sell. Examples would include collateralized debt obligations and subprime mortgages. Institutions holding large proportions of toxic assets find themselves in big trouble. Example: Lehman Brothers, which collapsed in 2008. Toxic assets present a serious problem for would-be purchasers because of their complexity and dubious value. Often having been repackaged several times, it is difficult and time-consuming for auditors and accountants to determine their true value, which may depreciate steadily as the ability of underlying debtors to repay declines. See also legacy assets.
  • Treasury, Department of—An executive department of the U.S. Federal government. The Department is administered by the Secretary of the Treasury, currently Timothy Geithner, who is a member of the Cabinet and confirmed by the Senate before taking office. The Treasury Department prints and mints all paper currency and coins in circulation, collects all Federal taxes through the Internal Revenue Service, and manages U.S. government debt instruments. The Department is currently prominently engaged in various bailout activities, including the recently established PPPIC.
  • Wall Street—Generic term referring collectively to the major financial institutions and the most influential interests in the financial system of the U.S. The “real” Wall Street is in lower Manhattan and is the center of the biggest financial district in the world. Several major U.S. stock and other exchanges are headquartered on Wall Street and in the surrounding financial district, including the New York Stock Exchange, the NASDAQ stock exchange, and the New York Board of Trade. When the general public wants to assess blame for the credit crisis of 2007-2008-2009, it commonly just refers to Wall Street as the root of the entire problem.