Debt, credit and risk
Borrowing, the collateral behind it, and what happens when it goes wrong. 13 terms, defined in plain language by Ryan Hogan. Every one of them has been an answer in the daily puzzle.
bankruptcy · collateral · covenant · debt · default · deleveraging · haircut · hypothecation · leverage · mortgages · resolution · subprime · thrift
BANKRUPTCY
A legal process for an insolvent debtor, either reorganising obligations while continuing to operate or liquidating assets to repay creditors in order of priority.
In the US, Chapter 11 is reorganisation and Chapter 7 is liquidation. Equity holders sit last in the queue and are frequently wiped out entirely.
COLLATERAL
An asset pledged to secure a loan, which the lender can seize if the borrower defaults.
The value assigned to collateral is reduced by a 'haircut' to protect the lender against price falls. Widening haircuts in a stressed market are themselves a tightening of credit.
COVENANT
A condition in a loan agreement requiring the borrower to maintain certain financial ratios or refrain from certain actions. Breaching one can trigger default.
Covenant-lite lending strips most maintenance tests out, leaving lenders far less early warning that a borrower is deteriorating.
DEBT
Money borrowed that must be repaid, normally with interest, under terms agreed in advance.
Ranks ahead of equity in a liquidation. That seniority is why debt is cheaper for the borrower and lower-returning for the lender.
DEFAULT
Failure to meet a debt obligation - missing a payment, or breaching a term that makes the debt immediately repayable.
A technical default from a covenant breach can occur while payments are still being made on time, which is why the term needs care.
DELEVERAGING
Reducing debt relative to equity or assets, by repaying borrowings, raising capital, or selling assets.
Painful in aggregate: when many parties deleverage at once, the asset sales depress prices and worsen the ratios everyone is trying to repair.
A fund holds $100 of assets, financed with $20 of its own capital and $80 of borrowing. A 10% drop in asset prices cuts its capital in half, and the lender wants the original ratio back, so the fund sells. Other leveraged holders facing the same margin calls sell the same assets on the same morning, which pushes prices down further. For this reason forced selling tends to arrive in waves, and the assets that fall hardest are often the ones easiest to sell.
HAIRCUT
The discount applied to an asset's market value when it is pledged as collateral, protecting the lender against price falls.
Haircuts widen under stress, so a borrower must post more collateral for the same loan precisely when funding is hardest to obtain.
HYPOTHECATION
Pledging an asset as collateral for a loan while keeping ownership and use of it. A mortgage is the common example: the house secures the loan, and the borrower still lives in it.
Rehypothecation is when the lender reuses that collateral for its own borrowing. It is routine in brokerage and repo markets, and it means the same asset can support several layers of credit at once.
LEVERAGE
The use of borrowed money to increase the size of a position relative to the capital committed.
It scales gains and losses alike. The danger is asymmetric: losses can exceed the original capital and force liquidation at the worst possible moment.
MORTGAGES
Loans secured against real property, where the lender can foreclose if the borrower fails to pay.
Bundling them into securities spread US housing risk through the global financial system, which is how a domestic downturn became a worldwide crisis.
RESOLUTION
A continuing resolution: stopgap legislation that funds agencies at existing levels when Congress has not passed full-year appropriations.
Most funding gaps end with one. Agencies dislike them because level funding with no certainty makes it difficult to start anything new or plan hiring.
SUBPRIME
Lending to borrowers with weak credit histories, priced at higher rates to compensate for elevated default risk.
Subprime mortgage losses triggered the 2008 crisis, though the amplification came from how those loans were packaged and leveraged.
THRIFT
A savings institution focused on taking deposits and making home loans, distinct from a commercial bank.
The US savings and loan crisis of the 1980s remains the standard case study in how deposit insurance plus deregulation can distort incentives.