For those of you who don’t work on Wall Street, I thought it might be useful to define some terms that you may be reading or hearing in the news media, that might be used during testimony before a Congressional Banking Committee, and which will undoubtedly be used if a new Pecora Commission is constituted. If I leave anything important out, ping me in the comments and I can update this post.
Savings bank – A savings bank
Commercial Bank – "The primary function of commercial banking is to furnish short term credits for financing the production and distribution of consumer goods. " Pecora Commission Report, at 155. [pdf warning--this is a 400-ish page file and takes several lifetimes to download] "The commercial bank’s credit function is very definitely governed by its responsibility to meet its deposit liabilities on demand. It must not seek excessive profits by taking undue credit risks and it cannot wisely tie up its funds in long term credits however safe they may be." Id.
"[T]he flow of credit of the commercial banks in the form of brokers loans [to fund the buying of stocks on margin], the financing of syndicate or pool operations is securities, and loans on securities as collateral [can accentuate] speculative excesses during [a] boom period. The consequential disastrous results affected not only the investing public, but these banking institutions, whose capital was substantially impaired by the collapse and shrinkage of values of securities into which banks had frozen a large part of their funds." Id, at 156.
Investment Bank – An investment bank does not take deposits from the general public. The investment banker provides "long term capital financing for the production for ‘durable goods’, such as machinery, railroad equipment, building material, and construction work in general, is the proper field of the investment banker. Pecora Commission Report, at 155, citing testimony of Clarence Dillon at 2109-2110. The investment banker meets "long term needs, providing funds for plant and equipment or for permanent working capital. He does, and should, take speculative risks of a sort unsuitable to the commercial bank in providing capital funds for new and promising enterprises even though the major volume if his transactions is naturally to be found in providing additional capital for industries well established and less uncertain." Id at 156.
Stock – is a unit of ownership in a corporation. For that reason, it is called an "equity security," as distinguished from a "debt security." There can be several classes of stock. Preferred stock, which has priority over common stock in the receipt of dividends, but in most cases gives up some–and more often all–of its voting rights. Different classes of stock can have different voting rights, and some have no voting rights at all.
Bond – is a term that covers a range of financial devices, all of which are forms of indebtedness. It is a debt security. For example when you buy a government bond for which you pay $17 and which is worth $25 at maturity, you have loaned the government your $17 for a period of years, and the total amount of interest you will be paid for the use of your money for that period of years, is $8. Corporations can also issue bonds (more about that here). Usually corporate bonds are unsecured loans, however, sometimes bonds are issued that are backed by a security interest in some fixed asset, or in mortgages.
Mortgage backed security – is a form of a bond. However, unlike most bonds where the bondholder knows the amount of interest and principle payments he is to receive and when he is to receive them–assuming the bond does not default–mortgage backed bonds often pay the bondholder out of the stream of mortgage payments made by the people who took out the mortgage. If most of the mortgage paying people are able to pay their mortgages, the bond will have a robust return, giving the bondholder a steady income stream. If the mortgage paying people begin to default on their mortgages, the income stream to the bond holder could dwindle down to a trickle.
Debenture – is a special kind of bond it is a certificate that evidences unsecured debt by the corporation. When you buy a debenture, you are making a loan to the corporation. A convertible debenture which can be exchanged, sometimes at will or upon the occurrence of some triggering event–including the passage of time–for that reason trading in some convertible debentures is treated like trading in the underlying stock for some purposes, such as insider trading restrictions. (See, C.R.A. REALTY CORPORATION, v.TRI-SOUTH INVESTMENTS and Drexel Burnham Lambert, Inc.,738 F.2d 73.)
Margin – To buy on margin is to buy stock with loan money you have received by using other stock as collateral for the loan. For example, you own 100 shares of Wiget Corp. worth approximately $1,000 at market value. You are able to take a loan of 10% against it. This gives you $100 in cash, which you use to buy $10 shares of Acme Corp. As long as Wiget Corp stock remains stable or goes up in value, you are fine. But if Wiget Corp declines in value, you have to deposit additional stock or cash into the collateral. This is known as a "margin call."
Selling Short – Short Selling is a form of speculation where you "sell" stock that you don’t own yet. You are betting that the price of the stock will go down, between the time that you "sell" it, and the time when you are required to deliver it. It is a contract that requires you to sell, at a future date, X number of shares at $Y price, regardless of the market price on that day.
Option Contracts – A stock option contract is a contract that entitles the holder to either buy or sell stock at a set price regardless of the market price. An option contract that allows you to buy stock at a set price within a certain time frame (the expiration) is a "call." An option contract that allows you to sell a stock at a set price within a given time frame is called a "put." An form of option contract issued to an existing stockholder or other corporate insider allowing that person to purchase additional shares at a set price-usually AFTER a waiting period-is called a "warrant."
Credit Default Swap – This term has been in the news a great deal lately. It is a form of insurance contract used to protect investments in municipal bonds, corporate debt (debentures), and mortgage backed securities. The insurance contract is supposed to guarantee that if the debt instrument defaults the holder of the debt instrument will still get his expected return. In the past several years the market in swaps has exploded and the contracts are traded at both ends, both insured and insurers. The market in credit default stocks was unregulated, so no one was making sure that there were sufficient assets to cover in case the insurance had to actually pay out. Time Magazine had a good explanation of this in May 2008.
This is the second part of a continuing series on the original Pecora Commission and its relevance today. Part one can be found here.