Simple explanation of some banking terms.
The idea of this post is to explain the meaning of some of the terminology that I use in some of the other posts.
1. What is negative equity?
This best understood with a simple example. Lets say you have £30,000 and you want to buy a house for £100,000. You would usually borrow the £70,000 difference from a bank. Your equity is £30,000. Now if house prices drop and your house is now only worth £70,000, the bank will take all the money when you come to sell the property so your equity is zero. If your house is worth less than £70,000 you are in a state of negative equity.
2. What is a run on a bank?
A run on a bank happens when people with accounts in the bank all want to take out their money at the same time because they have lost confidence in the bank. Banks are not set up to handle this eventuality, because they are typically using the money to make profits for their shareholders. This is every bankers worst nightmare because it can bring down the bank altogether. Most governments offer protection to their banks by guaranteeing that the central banks will meet debts that the bank has to its account holders up to a predefined limit.
3. What is a CDO?
A CDO is an instrument which pools together lots of debts backed by assets. The assets backing the debts can be things like the houses of people who have mortgages and the debts are the mortgages themselves. This is then split into different risk classes and sold to the markets. Naturally higher risk classes are cheaper. People in the market can then choose how much risk they are willing to take to get higher returns. The reason that this is done is because it artificially transforms a mixed bag of debt into some very reliable debt for those who need to be sure that they will be paid and some less reliable debt for those who want more risk.
4. What is a CDO squared?
A CDO squared is where a new CDO is created using existing CDOs as the underlying assets.
1. What is negative equity?
This best understood with a simple example. Lets say you have £30,000 and you want to buy a house for £100,000. You would usually borrow the £70,000 difference from a bank. Your equity is £30,000. Now if house prices drop and your house is now only worth £70,000, the bank will take all the money when you come to sell the property so your equity is zero. If your house is worth less than £70,000 you are in a state of negative equity.
2. What is a run on a bank?
A run on a bank happens when people with accounts in the bank all want to take out their money at the same time because they have lost confidence in the bank. Banks are not set up to handle this eventuality, because they are typically using the money to make profits for their shareholders. This is every bankers worst nightmare because it can bring down the bank altogether. Most governments offer protection to their banks by guaranteeing that the central banks will meet debts that the bank has to its account holders up to a predefined limit.
3. What is a CDO?
A CDO is an instrument which pools together lots of debts backed by assets. The assets backing the debts can be things like the houses of people who have mortgages and the debts are the mortgages themselves. This is then split into different risk classes and sold to the markets. Naturally higher risk classes are cheaper. People in the market can then choose how much risk they are willing to take to get higher returns. The reason that this is done is because it artificially transforms a mixed bag of debt into some very reliable debt for those who need to be sure that they will be paid and some less reliable debt for those who want more risk.
4. What is a CDO squared?
A CDO squared is where a new CDO is created using existing CDOs as the underlying assets.
