Appendix

Glossary

Asset-backed securities (ABS): Securities whose value and income payments are derived from, and collateralized (or “backed”) by, a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. Pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments, and movie revenues.

Collateralized bond obligation: A form of securitization where payments from multiple investment-grade corporate bonds are pooled together and then subdivided into assets with different risk characteristics (tranches), which are sold to different investor groups.

Collateralized debt obligation (CDO): A security backed by a pool of assets, mainly non-mortgage loans or bonds, but also other asset-backed securities. CDOs are made up of tranches with various maturities and risk characteristics, with the equity tranches carrying the most risk, and therefore paying the highest interest rate to the buyer. CDOs are basically the same as traditional ABS in terms of their structure, but differ from traditional ABS with respect to the type of assets underlying the collateral pool, the motivation for issuance, and the relationship between the borrower and the special purpose vehicle. CDO asset pools typically consist of loans (collateralized loan obligations), higher yield bonds (collateralized bond obligations), or a mixture of both. The number of loans typically included is much lower than in traditional ABS (hundreds versus thousands), and the types of loans and bonds included can be much more diverse than in traditional ABS.

Collateralized loan obligation: A form of securitization where payments from multiple middle-sized and large business loans are pooled together and passed on to different classes of owners in various tranches.

Commercial mortgage-backed security: A security backed by one or more pools of mortgage loans secured by commercial (non-residential) properties.

Covenant-lite loan: A loan whose main terms have fewer or no maintenance covenants. A covenant-lite loan does not include the legal clauses which allow a lender to control and track the performance of a company and, if need be, declare a default if certain criteria are breached. With covenant-lite loans, a bank can only act if a borrower attempts to take specific actions, such as adding more debt or making an acquisition. More-traditional maintenance covenants allow banks to step in at any point if a borrower's performance drops below a certain benchmark.

Credit derivative: A contract between two parties which uses a derivative to transfer credit risk from one party to another, in exchange for a fee.

Credit default swap (CDS): A bilateral financial contract in which the protection buyer (risk shedder) pays a fixed periodic fee in return for a contingent payment by the protection seller (risk taker), which is triggered by a credit event of a specified firm or entity. Credit events, which are specified in CDS contracts, may include bankruptcy, default, or restructuring.

Credit default swap spread: This spread signals the market's view on a specified firm or entity's likeliness to experience a credit event that would trigger a contingent payment. The CDS spread is the premium paid by the protection buyer (expressed as basis points per annum of the notional amount of the CDS contract). A CDS spread of 500 basis points means that the annual cost of protection with respect to US$1 million of specified underlying debt is US$50,000.

Gross nominal value or gross notional value: Nominal or notional amounts outstanding are defined as the gross nominal or notional value of all deals concluded and not yet settled at the reporting date. The notional value to be reported is that of the maximum default protection specified in the contract itself and not the par value of financial instruments intended to be delivered.

Mortgage-backed security: A security backed by a pool of mortgage loans secured on real property. Investors receive payments of interest and principle derived from payments received on the underlying mortgage loans.

Macro-prudential framework: A framework for preserving financial stability that looks not just at the soundness of individual institutions, but also takes into account the interactions among various financial markets and institutions as possible sources of systemic risk. In other words, the risk to financial stability of the system as a whole may be greater than the sum of the risks to individual institutions.

Net notional value: Net notional balances, as opposed to gross balances, cancel out transactions that offset each other. For instance, if an investment bank buys US$100 million in creditdefault swaps to protect against a company default and sells US$50 million of swaps for protection on the same company, the net notional value would be US$50 million. The International Swaps and Derivatives Association (ISDA) estimates that the net notional value, which is the amount at risk in the CDS marketplace, is only 3% of the gross notional value.

Originate-to-distribute model: A business model for banks whereby banks make loans, but then package them into securities in order to sell them, thereby removing them from their balance sheets. Having a smaller balance sheet enables banks to reduce their capital requirements.

Procyclicality: The tendency of financial regulations to exacerbate the volatility of economic swings. For example, when the economy turns down, banks' capital declines, which forces them to reduce lending to maintain their capital adequacy ratios. However, this, in turn, puts further downward pressure on the economy, leading to further declines in banks' capital.

Residential mortgage-backed security: A security backed by a homogeneous pool of mortgage loans secured on real residential property.

Second lien loan: A form of loan with a security interest in the assets of a company that is second in ranking behind a traditional senior credit facility. The second lien lender will typically be required to agree contractually (through an intercreditor agreement or other contract) to subordinate its claims on the assets to the first lien secured lenders.

Special purpose vehicle (SPV) or Special purpose entity (SPE): “A special purpose vehicle (SPV) or special purpose entity (SPE) is a company that is created solely for a particular financial transaction or series of transactions. It may sometimes be something other than a company, such as a trust. The SPV's debts may, or may not, be raised with recourse to the “real” borrower. SPVs/SPEs are often used to make a transaction tax efficient by choosing the most favourable tax residence for the vehicle. This is commonly done with eurobonds so that foreign investors do not have to pay withholding taxes in the borrower's country of residence.” (Pietersz 2006–2009)

Structured investment vehicle: A type of SPE that funds the purchase of its assets (mainly highly-rated securities) through the issuance of both commercial-paper and medium-term notes. Structured investment vehicles are offshore entities, and therefore escape the regulations that banks and finance companies are subject to.

Trade compression: A process that involves terminating existing trades and replacing them with a smaller number of new “replacement trades,” which have the same risk profile and cash flows as the initial portfolio, but less capital exposure.

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