Credit Crisis Glossary

For additional definitions, please review the Financial Aid Glossary.

Auction-Rate Securitization (ARS). Auction rate securitizations are a form of asset-backed security in which the interest rates paid to investors are reset periodically (typically every 28 or 35 days) through an auction process. This makes long-term loans act like short-term loans. Auction-rate securitizations were a convenient place for a variety of investors, such as businesses, to park their cash at a good rate of return for a short-term investment. The liquidity of auction-rate securitizations depends on an active marketplace for these investments. Unfortunately, the auction-rate securitization market collapsed in February 2008. The collapse was partly due to investors becoming more risk-averse in the wake of the subprime mortgage credit crisis and partly due to the unwillingness of the market makers to support the auction-rate securitization market by themselves buying any leftover auction-rate securities.

Asset-Backed Security (ABS). ABS is a security backed by a pool of assets with predictable cash flows such as student loans.

Bond. A bond is a form of debt issued by a government or corporation. The bond issuer agrees to repay the debt by a specified date or over a specified period of time at a specified interest rate (usually fixed, but variable rates are also possible). Most bonds have a maturity of more than one year.

Capital Markets. The capital markets is a term that collectively refers to markets where investors buy and sell securities including ARS, ABS, stocks and bonds.

CCRAA. The College Cost Reduction and Access Act of 2007 (CCRAA) was signed into law by President Bush on September 27, 2007 (P.L. 110-84 ). It used cuts in lender subsidies on new loans first disbursed on or after October 1, 2007 to pay for improvements in federal student aid programs, such as increases in the maximum Pell Grant through mandatory funding and a phased-in interest rate reduction on unsubsidized Stafford loans for undergraduate students. The combination of the cuts to lender subsidies and the credit crisis cut lender spreads enough that the margins on new federal education loans became too thin to securitize.

Collateralized Debt Obligation (CDO). A CDO is a type of asset-backed security used for fixed-income assets.

Credit Enhancement. Credit enhancement provides reassurance to the investors in a securitization that they will be paid and that the issuer will not default on its obligation to make periodic payments of principal and interest. Excess spread is one form of credit enhancement, where the securitization’s assets produce more income than is required to pay the investors. The excess spread often results in residual income to the issuer, especially if the securitization is designed to have the issuer retain some risk-sharing. Bond insurance is another form of credit enhancement, where the bond insurer guarantees the bond against issuer default (as opposed to borrower default on the loans included in the securitization). The securitization might also include a haircut where the face value of the investments held by the trust exceeds the total amount invested by a percentage.

Credit Warehousing Facility. A credit warehousing facility is a large unsecured short-term loan from an international bank, typically at least $500 million. The facility is used by a non-bank lender to fund loans initially. Since credit warehousing facilities can be expensive, the lender will seek a lower cost of funds by securitizing their loan portfolio. But until the loan portfolio has grown large enough to securitize, the lender has to rely on the credit warehousing facility. Some of the more well-known credit warehousing facilities include JP Morgan Chase, Credit Suisse, Merrill Lynch, Bank of America, Citigroup, Morgan Stanely, Deutsche Bank, Nomura and Lehman Brothers.

Depression. A depression is a severe and sustained recession involving at least a 10% decline in the gross domestic product and lasting at least three years.

ECASLA. The Ensuring Continued Access to Student Loans Act of 2008 (ECASLA) was signed into law by President Bush on May 7, 2008 (P.L. 110-227 ). This legislation provided liquidity to education lenders to enable them to continue making new Stafford and PLUS loans. It provided the US Department of Education with the authority to buy Stafford and PLUS loans from education lenders provided that the purchase was at no net cost to the federal government. This was implemented by the US Department of Education as a combination of a loan purchase program (a hard put at origination costs plus $75 a loan) and a purchase of participation interests program (where loans were pledged as collateral for liquidity at a cost of the 3-month Commercial Paper Rate plus 0.50%). The legislation also increased annual and aggregate loan limits on the unsubsidized Stafford loan for undergraduate students and allowed Parent PLUS loans to be defered while the student was in school and for six months after graduation. A one-year extension was signed into law on October 7, 2008 (P.L. 110-350 ).

Facility. A facility is a source of liquidity established to enable the funding of loans or other provision of capital.

Federal Financing Bank (FFB). The Federal Financing Bank was established by Congress in 1973 under the auspices of the Treasury Department. The purpose of the Federal Financing Bank is to purchase obligations issued or guaranteed by federal agencies in order to centralize and reduce the cost of financing federal borrowing.

Federal Home Loan Bank (FHLB). The Federal Home Loan Banks are a set of twelve government-sponsored enterprises (GSE) established in 1932 that provide low-cost funds to financial institutions to help them make home mortgages and other loans. Federal home loan banks are privately capitalized and conservatively managed. Their focus is on improving access to housing and supporting community development.

Index Rate Mismatch. An index rate mismatch occurs when a lender’s interest income is based on one index and the lender’s cost of funds is based on another index. It can present additional risks to the lender if the two interest rates do not move synchronously, since the lender’s spread is not predictable. Securitizations may sometimes bundle in interest rate swaps to control the risk associated with an index rate mismatch. For example, the interest rate associated with the special allowance payments on federal education loans is pegged to the 3-month Commercial Paper Rate while the lender cost of funds is typically pegged to the 3-month LIBOR index. While the spread between the two indexes has historically been about 10 basis points plus or minus 3 basis points, during the credit crisis this spread widened causing additional pressure on education lender profit margins.

Lender of Last Resort. A lender of last resort is a lender that will make loans to borrowers when no other lenders are willing or able to make loans to the borrowers. In the federal education loan programs the state guarantee agencies typically act as lenders of last resort.

Legacy Assets. See Toxic Assets.

Liquidity. Liquidity means cash or financial instruments that are easily converted to cash. A lender is said to be liquidity constrained when the lender does not have money available to make new loans. A lender is said to have limited liquidity when the lender has money available to make new loans but the liquidity is insufficient to continue making loans or to fully fund all pending loans beyond sometime in the near future without a fresh set of additional funding.

Portfolio. A portfolio is a collection or pool of investments. For example, a student loan portfolio is a set of student loans held by an education lender.

Recession. A recession is a widespread period of economic decline, typically lasting six months to a year or two. It is typically defined as negative growth in the gross domestic product (GDP) for at least two consecutive quarters. A recession typically manifests itself through a significant increase in unemployment, declines in personal income and a significant drop in the stock market. The main approaches to reversing a recession involve deficit spending by the federal government and tax cuts.

Securitization. In a securitization, income-producing assets such as student loans are pooled and transfered to a trust and shares in the trust are sold to investors at a premium. The issuer uses the funds to make new loans and to pay off higher cost short-term debt obligations, such as credit warehousing facilities. The premiums also provide with issuer with some up-front revenue. The issuer agrees to make periodic payments of principal and interest to the investors from the payments it receives from the assets. The securitization is split into multiple tranches or classes, with the senior tranches rated AAA and mezzanine or junior tranches rated AA through BBB. (AAA is the highest rating, and BBB is the lowest investment grade rating.) Income in a securitization is applied in a prioritized waterfall fashion, with payments first being applied to the cost of servicing the loans and administering the trust, and then paid to the tranches in order of seniority. If any funds are leftover they represent residual income to the issuer. A securitization is usually designed to include residual income as a form of credit enhancement. Junior tranches usually are paid a higher coupon (interest rate) than more senior tranches to reflect the higher risk. In effect a securitization shifts most of the risk and reward associated with originating loans from the issuer to the investor. Issues have an incentive then to increase the loan volume, since their profits scale with the loan volume. Securitizing loans also removes them from the issuer’s balance sheet, which can reduce the amount of capital the issuer must maintain. This can improve the issuer’s return on investment. Issuers can also realize savings on the cost of servicing loans with the greater volume that comes with securitization.

SLARS. SLARS are Student Loan Auction Rate Securitizations, a form of auction-rate securitization where the assets of the trust are student loans.

SLABS. SLABS are Student Loan Asset-Backed Securitizations, a form of term securitization where the assets of the trust are student loans.

Spread. The spread is the difference between two prices, such as the difference between the interest paid to a lender by the borrower and the lender’s cost of funds (e.g. the interest paid to depositors or to investors in a securitization). In some cases one of the prices is assumed to be a risk-free rate of return such as US Treasuries, in which case a reference to a wider spread can actually mean a narrowing or compression of the spread between the lender’s interest income and cost of funds.

Structured Finance. Structured finance includes securitizations and other instruments where the cash flows associated with a pool of assets are used to provide financing to acquire the assets. The assets are isolated from the issuer so that a bankruptcy of the issuer or servicer does not affect the pool of assets.

Term Asset-Backed Securities Loan Facility (TALF). TALF is a $1 trillion facility funded by the Federal Reserve Bank of New York and backstopped by the US Treasury (a part of TARP) to try to thaw the asset-backed securities market through low-cost loans to investors in AAA-rated ABS involving newly or recently originated student loans, credit cards, auto loans, small business loans and mortgage-backed securities.

Term Securitization. A term securitization is a form of securitization in which the interest rates paid to investors for a pre-specified period that corresponds to the life of the assets that are securitized.

Toxic Assets. Toxic assets are illiquid assets that do not have easy-to-determine market value, such as nonperforming loans. (The value of an asset is often determined in part by measuring the cash flows associated with the asset.) Toxic assets are more difficult to sell and tie up a financial institution’s liquidity, making it more difficult for the financial institution to make new loans. Financial institutions may also be unwilling to sell a toxic asset because of mark-to-market rules that will require the financial institution to recognize a loss on the asset only when it is sold.

Troubled Assets Relief Program (TARP). TARP is a program established by the Emergency Economic Stabilization Act of 2008 to permit the US Treasury to purchase up to $700 billion of securities as needed to ensure financial market stability. The original intent was to permit the purchase of illiquid assets that were difficult to value such as subprime mortgages. This would get the loans off of lenders books and allow the lenders to make new loans. The design of the program, however, was effectively a blank check that the US Treasury used to fund a variety of kitchen sink approaches to solving the credit crisis, including providing large banks and insurers with capital and establishing TALF.

For additional definitions, please review the Financial Aid Glossary.