Glossary of Industry Terms & Supporting Information

ICON Securities Lending (S1)

Savings & Loan Crisis: The savings and loan crisis of the 1980s and 1990s (commonly referred to as the S&L crisis) was the failure of 745 savings and loan associations (S&Ls aka thrifts). A Savings and Loan is a financial institution in the United States that accepts savings deposits and makes mortgage, car and other personal loans to individual members. The ultimate cost of the crisis is estimated to have totaled around $160.1 billion, about $124.6 billion of which was directly paid for by the US government—that is, the US taxpayer, either directly or through charges on their savings and loan accounts – which contributed to the large budget deficits of the early 1990s.

The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990–1991 economic recession. Between 1986 and 1991, the number of new homes constructed per year dropped from 1.8 million to 1 million, which was at the time the lowest rate since World War II.

Background

The thrift industry has its origins in the British building society movement that emerged in the late 19th century. American thrifts (known then as “building and loans” or “B&Ls”) shared many of the same basic goals: to help working-class men and women save for the future and purchase homes. Thrifts were not-for-profit cooperative organizations that were typically managed by the membership and local institutions that served well-defined groups of aspiring homeowners. While banks offered a wide array of products to individuals and businesses, thrifts often made only home mortgages primarily to working-class men and women. Thrift leaders believed they were part of a broader social reform effort and not a financial industry. According to thrift leaders, B&Ls not only helped people become better citizens by making it easier to buy a home, they also taught the habits of systematic savings and mutual cooperation which strengthened personal morals.

The first thrift was formed in 1831, and for 40 years there were few B&Ls, found in only a handful of Midwestern and Eastern states. This situation changed in the late 19th century as urban growth and the demand for housing related to the Second Industrial Revolution caused the number of thrifts to explode. The popularity of B&Ls led to the creation of a new type of thrift in the 1880s called the “national” B&L. The “nationals” were often for-profit businesses formed by bankers or industrialists that employed promoters to form local branches to sell shares to prospective members. The “nationals” promised to pay savings rates up to four times greater than any other financial institution.

The Depression of 1893 (the Panic of 1893) caused a decline in members, and so “nationals” experienced a sudden reversal of fortunes. Because a steady stream of new members was critical for a “national” to pay both the interest on savings and the hefty salaries for the organizers, the falloff in payments caused dozens of “nationals” to fail. By the end of the 19th century, nearly all the “nationals” were out of business (National Building and Loans Crisis). This led to the creation of the first state regulations governing B&Ls, to make thrift operations more uniform, and the formation of a national trade association to not only protect B&L interests, but also promote business growth. The trade association led efforts to create more uniform accounting, appraisal, and lending procedures. It also spearheaded the drive to have all thrifts refer to themselves as “savings and loans” not B&Ls, and to convince managers of the need to assume more professional roles as financiers.

In the 20th century, the two decades that followed the end of World War II were the most successful period in the history of the thrift industry. The return of millions of servicemen eager to take up their prewar lives led to a dramatic increase in new families, and this “baby boom” caused a surge in new mostly suburban home construction. By the 1940s S&Ls (the name change occurred in the late 1930s) provided most of the financing for this expansion. The result was strong industry expansion that lasted through the early 1960s.

An important trend involved raising rates paid on savings to lure deposits, a practice that resulted in periodic rate wars between thrifts and even commercial banks. These wars became so severe that in 1966 the US Congress took the highly unusual move of setting limits on savings rates for both commercial banks and S&Ls. From 1966 to 1979, the enactment of rate controls presented thrifts with a number of unprecedented challenges, chief of which was finding ways to continue to expand in an economy characterized by slow growth, high interest rates and inflation. These conditions, which came to be known as stagflation, wreaked havoc with thrift finances for a variety of reasons. Because regulators controlled the rates thrifts could pay on savings, when interest rates rose depositors often withdrew their funds and placed them in accounts that earned market rates, a process known as disintermediation. At the same time, rising rates and a slow growth economy made it harder for people to qualify for mortgages, which in turn limited people’s ability to generate income.

In response to these complex economic conditions, thrift managers came up with several innovations, such as alternative mortgage instruments and interest-bearing chequeing accounts, as a way to retain funds and generate lending business. Such actions allowed the industry to continue to record steady asset growth and profitability during the 1970s even though the actual number of thrifts was falling. Despite such growth, there were still clear signs that the industry was chafing under the constraints of regulation. This was especially true with the large S&Ls in the western US that yearned for additional lending powers to ensure continued growth. Despite several efforts to modernize these laws in the 1970s, few substantive changes were enacted.

In 1979, the financial health of the thrift industry was again challenged by a return of high interest rates and inflation, sparked this time by a doubling of oil prices. Because the sudden nature of these changes threatened to cause hundreds of S&L failures, Congress finally acted on deregulating the thrift industry. It passed two laws, the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn–St. Germain Depository Institutions Act of 1982. The deregulation not only allowed thrifts to offer a wider array of savings products, but also significantly expanded their lending authority. These changes were intended to allow S&Ls to “grow” out of their problems, and as such represented the first time that the government explicitly sought to increase S&L profits as opposed to promoting housing and homeownership. Other changes in thrift oversight included authorizing the use of more lenient accounting rules to report their financial condition, and the elimination of restrictions on the minimum numbers of S&L stockholders. Such policies, combined with an overall decline in regulatory oversight (known as forbearance), would later be cited as factors in the later collapse of the thrift industry.

Causes

Tax Reform Act of 1986

By enacting 26 U.S.C. § 469 (relating to limitations on deductions for passive activity losses and limitations on passive activity credits) to remove many tax shelters, especially for real estate investments, the Tax Reform Act of 1986 significantly decreased the value of many such investments which had been held more for their tax-advantaged status than for their inherent profitability. This contributed to the end of the real estate boom of the early to mid ’80s and facilitated the Savings and Loan crisis. Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor’s gross income. This, in turn, encouraged the holders of loss-generating properties to try and unload them, which contributed further to the problem of sinking real estate values. This turmoil and repositioning in real estate markets was caused not by changes in market conditions.

Deregulation

The deregulation of S&Ls gave them many of the capabilities of banks, without the same regulations as banks. Savings and loan associations could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states such as California and Texas changed their regulations so to be similar to federal regulations.

Imprudent real estate lending

In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1976 $700 billion; 1980 $1.5 trillion)^{[citation needed]} and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and too-risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation, stated, “The banking problems of the ’80s and ’90s came primarily, but not exclusively, from unsound real estate lending.”

Brokered deposits

One of the most important contributors to the problem was deposit brokerage.^{[citation needed]} Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers’ money in those CDs. These CDs, however, are usually short-term $100,000 CDs.  Previously, banks and thrifts could only have five percent of their deposits be brokered deposits; the race to the bottom caused this limit to be lifted. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. To make money off this expensive money, it had to lend at even higher rates, meaning that it had to make more, riskier investments. This system was made even more damaging when certain deposit brokers instituted a scam known as “linked financing.” In “linked financing”, a deposit broker would approach a thrift and say he would steer a large amount of deposits to that thrift if the thrift would lend certain people money (the people, however, were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be tricked into taking on bad loans.

End of inflation

Another factor was the efforts of the federal reserve to wring inflation out of the economy, marked by Paul Volcker‘s speech of October 6, 1979, with a series of rises in short-term interest rates. This led to increases in the short-term cost of funding to be higher than the return on portfolios of mortgage loans, a large proportion of which may have been fixed rate mortgages (a problem that is known as an asset-liability mismatch). This effort failed and interest rates continued to skyrocket, placing even more pressure on S&Ls as the 1980s dawned and led to increased focus on high interest-rate transactions. Zvi Bodie, professor of finance and economics at Boston University School of Management, writing in the St. Louis Federal Reserve Review wrote, “asset-liability mismatch was a principal cause of the Savings and Loan Crisis”.

Major causes according to United States League of Savings Institutions

The following is a detailed summary of the major causes for losses that hurt the savings and loan business in the 1980s:

1. Lack of net worth for many institutions as they entered the ’80s, and a wholly inadequate net worth regulation.
2. Decline in the effectiveness of Regulation Q in preserving the spread between the cost of money and the rate of return on assets, basically stemming from inflation and the accompanying increase in market interest rates.
3. Absence of an ability to vary the return on assets with increases in the rate of interest required to be paid for deposits.
4. Increased competition on the deposit gathering and mortgage origination sides of the business, with a sudden burst of new technology making possible a whole new way of conducting financial institutions generally and the mortgage business specifically.
5. Savings and Loans gained a wide range of new investment powers with the passage of the Depository Institutions Deregulation and Monetary Control Act and the Garn-St. Germain Depository Institutions Act. A number of states also passed legislation that similarly increased investment options. These introduced new risks and speculative opportunities which were difficult to administer. In many instances management lacked the ability or experience to evaluate them, or to administer large volumes of nonresidential construction loans.
6. Elimination of regulations initially designed to prevent lending excesses and minimize failures. Regulatory relaxation permitted lending, directly and through participations, in distant loan markets on the promise of high returns. Lenders, however, were not familiar with these distant markets. It also permitted associations to participate extensively in speculative construction activities with builders and developers who had little or no financial stake in the projects.
7. Fraud and insider transaction abuses were the principal cause for some 20% of savings and loan failures and a greater percentage of the dollar losses borne by the Federal Savings and Loan Insurance Corporation (FSLIC).
8. A new type and generation of opportunistic savings and loan executives and owners—some of whom operated in a fraudulent manner — whose takeover of many institutions was facilitated by a change in FSLIC rules reducing the minimum number of stockholders of an insured association from 400 to one.
9. Dereliction of duty on the part of the board of directors of some savings associations. This permitted management to make uncontrolled use of some new operating authority, while directors failed to control expenses and prohibit obvious conflict of interest situations.

10. A virtual end of inflation in the American economy, together with overbuilding in multifamily, condominium type residences and in commercial real estate in many cities. In addition, real estate values collapsed in the energy states — Texas, Louisiana, Oklahoma particularly due to falling oil prices — and weakness occurred in the mining and agricultural sectors of the economy.

11. Pressures felt by the management of many associations to restore net worth ratios. Anxious to improve earnings, they departed from their traditional lending practices into credits and markets involving higher risks, but with which they had little experience.

12. The lack of appropriate, accurate, and effective evaluations of the savings and loan business by public accounting firms, security analysts, and the financial community.

13. Organizational structure and supervisory laws, adequate for policing and controlling the business in the protected environment of the 1960s and 1970s, resulted in fatal delays and indecision in the examination/supervision process in the 1980s.

14. Federal and state examination and supervisory staffs insufficient in number, experience, or ability to deal with the new world of savings and loan operations.

15. The inability or unwillingness of the Bank Board and its legal and supervisory staff to deal with problem institutions in a timely manner. Many institutions, which ultimately closed with big losses, were known problem cases for a year or more. Often, it appeared, political considerations delayed necessary supervisory action.

Failures

The United States Congress granted all thrifts in 1980, including savings and loan associations, the power to make consumer and commercial loans and to issue transaction accounts. Designed to help the thrift industry retain its deposit base and to improve its profitability, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 allowed thrifts to make consumer loans up to 20 percent of their assets, issue credit cards, accept negotiable order of withdrawal (NOW) accounts from individuals and nonprofit organizations, and invest up to 20 percent of their assets in commercial real estate loans.

The damage to S&L operations led Congress to act, passing a bill in September 1981 allowing S&Ls to sell their mortgage loans and use the cash generated to seek better returns; ^]http://www.fdic.gov/bank/Historical/s&l/ the losses created by the sales were to be amortized over the life of the loan, and any losses could also be offset against taxes paid over the preceding 10 years. This all made S&Ls eager to sell their loans. The buyers—major Wall Street firms—were quick to take advantage of the S&Ls’ lack of expertise, buying at 60%-90% of value and then transforming the loans by bundling them as, effectively, government-backed bonds (by virtue of Ginnie Mae, Freddie Mac, or Fannie Mae guarantees). S&Ls were one group buying these bonds, holding $150 billion by 1986, and being charged substantial fees for the transactions.

In 1982, the Garn-St Germain Depository Institutions Act was passed and increased the proportion of assets that thrifts could hold in consumer and commercial real estate loans and allowed thrifts to invest 5 percent of their assets in commercial loans until January 1, 1984, when this percentage increased to 10 percent.

A large number of S&L customers’ defaults and bankruptcies ensued, and the S&Ls that had overextended themselves were forced into insolvency proceedings themselves.

The US government agency FSLIC, which at the time insured S&L accounts in the same way the Federal Deposit Insurance Corporation insures commercial bank accounts, then had to repay all the depositors whose money was lost. From 1986 to 1989, FSLIC closed or otherwise resolved 296 institutions with total assets of $125 billion. An even more traumatic period followed, with the creation of the Resolution Trust Corporation in 1989 and that agency’s resolution by mid-1995 of an additional 747 thrifts.

A Federal Reserve Bank panel stated the resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse selection incentives that compounded the system’s losses.

There also were state-chartered S&Ls that failed. Some state insurance funds failed, requiring state taxpayer bailouts.

Home State Savings Bank of Cincinnati

In March 1985, it came to public knowledge that the large Cincinnati, Ohio-based Home State Savings Bank was about to collapse. Ohio Gov. Dick Celeste declared a bank holiday in the state as Home State depositors lined up in a “run” on the bank’s branches to withdraw their deposits. Celeste ordered the closure of all the state’s S&Ls. Only those that were able to qualify for membership in the Federal Deposit Insurance Corporation were allowed to reopen. Claims by Ohio S&L depositors drained the state’s deposit insurance funds. A similar event took place in Maryland.

Midwest Federal Savings & Loan of Minneapolis, Minnesota

Midwest Federal Savings & Loan was a federally chartered savings and loan based in Minneapolis, Minnesota until its failure in 1990.^[10] The St. Paul Pioneer Press called the bank’s failure the “largest financial disaster in Minnesota history.”^{[citation needed]}

The chairman, Hal Greenwood Jr., his daughter, Susan Greenwood Olson, and two former executives, Robert A. Mampel, and Charlotte E. Masica, were convicted of racketeering that lead to the institution’s collapse. The failure cost taxpayers $1.2 billion.

Lincoln Savings and Loan

The Lincoln Savings led to the Keating five political scandal, in which five US senators were implicated in an influence-peddling scheme. It was named for Charles Keating, who headed Lincoln Savings and made $300,000 as political contributions to them in the 1980s. Three of those senators—Alan Cranston (D-CA), Don Riegle (D-MI), and Dennis DeConcini (D-AZ)—found their political careers cut short as a result. Two others—John Glenn (D-OH) and John McCain (R-AZ)—were rebuked by the Senate Ethics Committee for exercising “poor judgment” for intervening with the federal regulators on behalf of Keating.

Silverado Savings and Loan

Silverado Savings and Loan collapsed in 1988, costing taxpayers $1.3 billion. Neil Bush, son of then Vice President of the United States George H. W. Bush, was Director of Silverado at the time. Neil Bush was accused of giving himself a loan from Silverado, but he denied all wrongdoing.

The US Office of Thrift Supervision investigated Silverado’s failure and determined that Neil Bush had engaged in numerous “breaches of his fiduciary duties involving multiple conflicts of interest.” Although Bush was not indicted on criminal charges, a civil action was brought against him and the other Silverado directors by the Federal Deposit Insurance Corporation; it was eventually settled out of court, with Bush paying $50,000 as part of the settlement, the Washington Post reported.

As a director of a failing thrift, Bush voted to approve $100 million in what were ultimately bad loans to two of his business partners. And in voting for the loans, he failed to inform fellow board members at Silverado Savings & Loan that the loan applicants were his business partners.

Neil Bush paid a $50,000 fine and was banned from banking activities for his role in taking down Silverado, which cost taxpayers $1.3 billion. A Resolution Trust Corporation Suit against Bush and other officers of Silverado was settled in 1991 for $26.5 million.

Financial Institutions Reform, Recovery, and Enforcement Act of 1989

As a result,^{[clarification needed]} the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) dramatically changed the savings and loan industry and its federal regulation. The highlights of the legislation, signed into law August 9, 1989, were:

1. The Federal Home Loan Bank Board (FHLBB) and the Federal Savings and Loan Insurance Corporation (FSLIC) were abolished.
2. The Office of Thrift Supervision (OTS), a bureau of the Treasury Department, was created to charter, regulate, examine, and supervise savings institutions.
3. The Federal Housing Finance Board (FHFB) was created as an independent agency to oversee the 12 federal home loan banks (also called district banks).
4. The Savings Association Insurance Fund (SAIF) replaced the FSLIC as an ongoing insurance fund for thrift institutions (like the FDIC, the FSLIC was a permanent corporation that insured savings and loan accounts up to $100,000). SAIF is administered by the Federal Deposit Insurance Corp.
5. The Resolution Trust Corporation (RTC) was established to dispose of failed thrift institutions taken over by regulators after January 1, 1989. The RTC will make insured deposits at those institutions available to their customers.
6. FIRREA gives both Freddie Mac and Fannie Mae additional responsibility to support mortgages for low- and moderate-income families.

Consequences

While not part of the savings and loan crisis, many other banks failed. Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance.

From 1986 to 1995, the number of US federally insured savings and loans in the United States declined from 3,234 to 1,645.^[7] This was primarily, but not exclusively, due to unsound real estate lending.

The market share of S&Ls for single family mortgage loans went from 53% in 1975 to 30% in 1990.^[2] US General Accounting Office estimated cost of the crisis to around USD $160.1 billion, about $124.6 billion of which was directly paid for by the US government from 1986 to 1996.^[1] That figure does not include thrift insurance funds used before 1986 or after 1996. It also does not include state run thrift insurance funds or state bailouts.

The US government ultimately appropriated 105 billion dollars to resolve the crisis. After banks repaid loans through various procedures, there was a net loss to taxpayers of approximately $124 billion dollars by the end of 1999.

The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990–1991 economic recession. Between 1986 and 1991, the number of new homes constructed dropped from 1.8 to 1 million, the lowest rate since World War II.

Some commentators believe that a taxpayer-funded government bailout related to mortgages during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis.
SEC: See Securities and Exchange Commission.

Secured loan: A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral — in the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to satisfy the debt by regaining the amount originally lent to the borrower, for example, foreclosure of a home. From the creditor’s perspective this is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. The opposite of secured debt/loan is unsecured debt, which is not connected to any specific piece of property and instead the creditor may satisfy the debt against the borrower rather than just the borrower’s collateral.

Purpose

There are two purposes for a loan secured by debt. In the first purpose, by extending the loan through securing the debt, the creditor is relieved of most of the financial risks involved because it allows the creditor to take the property in the event that the debt is not properly repaid. In exchange, this permits the second purpose where the debtors may receive loans on more favorable terms than that available for unsecured debt, or to be extended credit under circumstances when credit under terms of unsecured debt would not be extended at all. The creditor may offer a loan with attractive interest rates and repayment periods for the secured debt.

Types

• A mortgage loan is a secured loan in which the collateral is property, such as a home.
• A nonrecourse loan is a secured loan where the collateral is the only security or claim the creditor has against the borrower, and the creditor has no further recourse against the borrower for any deficiency remaining after foreclosure against the property.
• A foreclosure is a legal process in which mortgaged property is sold to pay the debt of the defaulting borrower.
• A repossession is a process in which property, such as a car, is taken back by the creditor when the borrower does not make payments due on the property. Depending on the jurisdiction, it may or may not require a court order.

United States law of debt secured by property

In the case of real estate, the most common form of secured debt is the lien. Liens may either be voluntarily created, as with a mortgage, or involuntarily created, such as a mechanics lien. A mortgage may only be created with the express consent of the title owner, without regard to other facts of the situation. In contrast, the primary condition required to create a mechanics lien is that real estate is somehow improved through the work or materials provided by the person filing a mechanics lien. Although the rules are complex, consent of the title owner to the mechanics lien itself is not required.

In the case of personal property, the most common procedure for securing the debt is described through the Uniform Commercial Code or UCC. This statute provides a system of forms and public filing of documents by which the creditor‘s interest in the property is made known.

In the event that the underlying debt is not properly paid, the creditor may decide to foreclose the interest in order to take the property. Generally, the law that allows the secured debt to be made also provides a procedure whereby the property will be sold at public auction, or through some other means of sale. The law commonly also provides a right of redemption, whereby a debtor may arrange for late payment of the debt but keep the property.

How to create secured debt

Debt can become secured by a contractual agreement, statutory lien, or judgment lien. Contractual agreements can be secured by either a Purchase Money Security Interest (PMSI) loan, where the creditor takes a security interest in the items purchased (i.e. vehicle, furniture, electronics); or, a Non-Purchase Money Security Interest (NPMSI) loan, where the creditor takes a security interest in items that the debtor already owns.
Securities and Exchange Commission: The U.S. Securities and Exchange Commission (commonly known as the SEC) is an independent agency of the United States government which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation’s stock and options exchanges, and other electronic securities markets. The SEC was created by section 4 of the Securities Exchange Act of 1934 (now codified as 15 U.S.C. § 78d and commonly referred to as the 1934 Act). In addition to the 1934 Act that created it, the SEC enforces the Securities Act of 1933, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Sarbanes-Oxley Act of 2002 and other statutes.

Securities Act of 1933: Congress enacted the Securities Act of 1933 (the “1933 Act,” the “Truth in Securities Act” or the “Federal Securities Act”, 48 Stat. 74, enacted 1933-05-27, codified at 15 U.S.C. § 77a et seq.), in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression. It is often referred to as the 1933 Act, the ’33 Act, or the Securities Act. Legislated pursuant to the interstate commerce clause of the Constitution, it requires that any offer or sale of securities using the means and instrumentalities of interstate commerce be registered pursuant to the 1933 Act, unless an exemption from registration exists under the law. It was the first major federal legislation to regulate the offer and sale of securities. Prior to that time, regulation of securities was chiefly governed by state laws (commonly referred to as blue sky laws). When Congress enacted the 1933 Act, it left in place the patchwork of existing state securities laws to supplement federal laws in part because there were questions as to the constitutionality of federal legislation.

Part of the New Deal, it was drafted by Benjamin V. Cohen, Thomas Corcoran, and James M. Landis; and signed into law by President Franklin D. Roosevelt.

Purpose

The 1933 Act has two basic objectives:

• to require that investors receive significant (or “material”) information concerning securities being offered for public sale; and
• to prohibit deceit, misrepresentations, and other fraud in the sale of securities to the public.

Underlying the 1933 Act is the idea that a company (i.e., an “issuer”) offering securities should provide potential investors with sufficient information about both the issuer and the securities to make an informed investment decision. To assist in achieving its objectives of informing potential investors and fostering fair dealing in the securities markets, the 1933 Act requires issuers to publicly disclose significant information about themselves and the terms of the securities. Disclosure also has the added benefit of discouraging bad behavior. Supreme Court Justice Louis Brandeis coined the phrase “sunlight is the best disinfectant,” which also is part of the philosophy underlying the 1933 Act.

Disclosure of material information is accomplished through the registration of securities with the Securities and Exchange Commission (the “SEC” or the “Commission”). The SEC is the principal federal agency responsible for oversight of the securities markets and enforcement of the federal securities laws. The SEC was created pursuant to the Securities Exchange Act of 1934 (the “1934 Act”). Prior to the passage of the 1934 Act, securities were registered with the Federal Trade Commission.
Securities Exchange Act of 1934: The Securities Exchange Act of 1934 is a law governing the secondary trading of securities (stocks, bonds, and debentures) in the United States of America. The Act, 48 Stat. 881 (enacted June 6, 1934), codified at 15 U.S.C. § 78a et seq., was a sweeping piece of legislation. The Act and related statutes form the basis of regulation of the financial marketsand their participants in the United States. It is commonly referred to as the “Exchange Act”, the “’34 Act”, and the “Act of ’34″.

Companies raise billions of dollars by issuing securities in what is known as the primary market. Contrasted with the Securities Act of 1933, which regulates these original issues, the Securities Exchange Act of 1934 regulates the secondary trading of those securities between persons often unrelated to the issuer. Trillions of dollars are made and lost each year through trading in the secondary market.

Securities exchanges

One area subject to 34 Act regulation is the actual securities exchange — the physical place where people purchase and sell securities (stocks, bonds, notes of debenture). Some of the more well known exchanges include the New York Stock Exchange, the American Stock Exchange, and regional exchanges like the Cincinnati Stock Exchange, Philadelphia Stock Exchange and Pacific Stock Exchange. At those places, agents of the exchange, or specialists, act as middlemen for the competing interests to buy and sell securities. An important function of the specialist is to inject liquidity and price continuity into the market. Given that people come to the exchange to easily acquire securities or to easily dispose of a portfolio of securities, the specialist’s role is important to the exchange.

Securities associations

The ’34 Act also regulates broker-dealers without a status for trading securities. A telecommunications infrastructure has developed to provide for trading without a physical location. Previously these brokers would find stock prices through newspaper printings and conduct trades verbally by telephone. Today, a digital information network connects these brokers. This system is called NASDAQ, standing for the National Association of Securities Dealers Automated Quotation System.

Self-regulatory organizations (SRO)

In 1938 the Exchange Act was amended by the Maloney Act, which authorized the formation and registration of national securities associations, which would supervise the conduct of their members subject to the oversight of the SEC. That amendment led to the creation of the National Association of Securities Dealers, Inc. – the NASD, which is a Self-Regulatory Organization (or SRO). The NASD had primary responsibility for oversight of brokers and brokerage firms, and later, the NASDAQ stock market. In 1996 the SEC criticized the NASD for putting its interests as the operator of Nasdaq ahead of its responsibilities.
Securities Investor’s Protection Corporation (SIPC): The Securities Investor Protection Corporation (SIPC, sometimes pronounced /?s?p?k/) is a federally mandated non-profit corporation in the United States that protects securities investors from financial harm if a broker-dealer company fails. Investors are not insured for any potential loss while invested in the securities market.

The United States Congress created SIPC in 1970 through the Securities Investor Protection Act (15 U.S.C. 78aaa-lll).

SIPC it is not a government agency; rather, it is a membership corporation funded by its members.

SIPC serves two primary roles in the event that a broker-dealer fails. First, SIPC acts to organize the distribution of customer cash and securities to investors. Second, to the extent a customer’s cash and/or securities are unavailable, SIPC provides insurance coverage up to $500,000 of the customer’s net equity balance, including up to $100,000 in cash.

As interpreted, the Act protects customers whose securities were misappropriated, never purchased, or stolen. However, it has not covered sales practice claims against broker-dealers that do not involve misappropriation or conversion (e.g., fraudulent sales practices, unsuitable investments, failure to execute sell orders).

While customers are protected for cash and most types of securities, such as notes, stocks, bonds, and certificates of deposit, other items, such as commodity or futures contracts, are not covered. Investment contracts, certificates of interest or participations in profit-sharing agreements, and oil, gas, or mineral royalties or leases are not covered unless registered with the Securities and Exchange Commission.

“SIPC is led by 7 directors, some appointed by the President of the United States, and others by the member firms. It employs a staff of only 29, and does not advertise job openings on its website. In 2007, total employee compensation and benefits were a generous $5.8 million.”
Security: A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities (such as banknotes, bonds and debentures); equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country’s regulatory structure determines what qualifies as a security. For example, private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions.

Securities may be represented by a certificate or, more typically, “non-certificated”, that is in electronic or “book entry” only form. Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable and fungible.

Securitization: Securitization is a structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool. The term “securitization” is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities. As a portfolio risk backed by amortizing cash flows – and unlike general corporate debt – the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.  All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of securitization processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.

Securitization often utilizes a special purpose vehicle (SPV), alternatively known as a special purpose entity (SPE) or special purpose company (SPC), reducing the risk of bankruptcy and thereby obtaining lower interest rates from potential lenders. A credit derivative is also sometimes used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors. Securitization has evolved from its tentative beginnings in the late 1970s to a vital funding source with an estimated outstanding of $10.24 trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance amounted to $3,455 billion in the US and $652 billion in Europe.

Overview

Securitization, in its most basic form, is a method of financing assets. Rather than selling those assets “whole,” the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or “spinning off,” a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now. A very basic example would be as follows. XYZ Bank loans 10 people $100,000 a piece, which they will use to buy homes. XYZ has invested in the success and/or failure of those 10 home buyers- if the buyers make their payments and pay off the loans, XYZ makes a profit. Looking at it another way, XYZ has taken the risk that some borrowers won’t repay the loan. In exchange for taking that risk, the borrowers pay XYZ a premium in addition to the interest on the money they borrow.

History

“Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank (rather than a claim on specific assets). But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well.”

In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-party and structural enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.

Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

The first public securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.

As estimated by the Bond Market Association, in the United States, total amount outstanding at the end of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6 trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995-2004,) ABS amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong, setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion.

At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent), home-equity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt obligations (15 percent). Among the other market segments are student loan-backed securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to convenience stores and gas stations), and aircraft leases.   More recently an attempt to securitize excess energy generated by renewable energy resources is being attempted by Joseph Brant Arseneau and his team.

Securitization only reached Europe in late 80′s, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90′s or early 2000, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards), Insurance-backed transaction (such as the ones implemented by the insurance securitization guru Emmanuel Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables for the Greek government, executed by Philippe Tapernoux).

As the result of the credit crunch precipitated by the subprime mortgage crisis the market for bonds backed by securitized loans was very weak in 2008 unless the bonds were guaranteed by a federally backed agency. As a result interest rates are rising for loans that were previously securitized such as home mortgages, student loans, auto loans and commercial mortgages

Structure

Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.

A suitably large portfolio of assets is “pooled” and sold to a “special purpose vehicle” or “SPV” (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is “bankruptcy remote,” meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing.^[9] In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator.  Under US accounting standards, the originator achieves a sale by being at arm’s length from the issuer, in which case the issuer is classified as a “qualifying special purpose entity” or “qSPE“.

Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.

Issuance

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued in order to provide an external perspective on the liabilities being created and help the investor make a more informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate. Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds. Floating rate securities may be backed by both amortizing and nonamortizing assets. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.

Credit enhancement and tranching

Unlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are “credit enhanced,” meaning their credit quality is increased above that of the originator’s unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).

Individual securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as a cash flow waterfall. In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk.

The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate “waterfalls” because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.

Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.

In addition to subordination, credit may be enhanced through:

• A reserve or spread account, in which funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE expenses are greater than its income.
• Third-party insurance, or guarantees of principal and interest payments on the securities.
• Over-collateralization, usually by using finance income to pay off principal on some securities before principal on the corresponding share of collateral is collected.
• Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments purchased either from the seller’s own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows.
• A third-party letter of credit or corporate guarantee.
• A back-up servicer for the loans.
• Discounted receivables for the pool.

Servicing

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.

The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.

Repayment structures

Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralized by fully amortizing assets such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model is a well-known example.

A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortizing. After a predetermined “revolving” period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.

On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth.  Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.

Structural Risks and Misincentives

Originators (e.g. of mortgages) have less incentive towards credit quality and greater incentive towards loan volume since they do not bear the long-term risk of the assets they have created and may simply profit by the fees associated with origination and securitization.

Special types of securitization

Master trust

A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards.

There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.

A second risk is that the total investor interests and the seller’s interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors.

A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller’s interest, and if there was a decrease then an early amortization event would occur.

Issuance trust

In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.

Grantor trust

Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.

Owner trust

In an owner trust, there is more flexibility in allocating principal and interest received to different classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.

Motives for securitization

Advantages to issuer

Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody’s downgraded Ford Motor Credit’s rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.

Reduces asset-liability mismatch: “Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis.”   Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining the “earning power” of the asset.

Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good example of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.

Off balance sheet: Derivatives of many types have in the past been referred to as “off-balance-sheet.” This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.

Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a “true sale” that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the “true sale” to stick and thus this sale is reflected on the parent company’s balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.

Admissibility: Future cashflows may not get full credit in a company’s accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.

Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.

Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.

Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality credit-enhanced assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the “parent,” because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.

However, the credit crisis of 2007-2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn’t encourage improvement of underwriting standards.

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal’s excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.^[11]

Recent Lawsuits

Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating agencies. In July, 2009, the USA’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies.

Selling away: Selling away in the U.S. securities brokerage industry is the inappropriate practice of an investment professional (such as a registered representative, stock broker, or financial adviser) who sells, or solicits the sale of, securities not held or offered by the brokerage firm with which he is associated (affiliated) ^[1]. An example of the term expressed in a sentence is, “The broker was selling investments away from the firm.” Brokers marketing securities must have obtained the appropriate securities licenses for various types of investments. Brokers in the U.S. may be “associated” with only one Brokerage firm and they obtain such licenses or “series” by passing standardized FINRA exams such as the Series 6 or Series 7 exam. See List of Securities Examinations for types of securities licenses in the U.S.

More specifically, selling away describes the situation where the transaction or securities in question are not approved for sale by the firm, they are not on the firm’s approved product list. The approved product list identifies the types of securities and investments that are approved for brokers to sell after the securities have been subjected to the brokerage firm’s due diligence process which includes receiving the necessary risk and compliance department reviews and approvals, and so forth.

Selling away often involves investment securities that are in the form of a private placement or other non-public investment^[2], though not always. Sometimes a transaction may not be an obvious or apparent ‘investment’ or security. Selling away may not always be deliberate or intentional or with even intent to deceive an investor, but in many cases, the broker knew what he or she was doing. Selling away is often associated with a broker’s other (“outside”) business activities (those other businesses or activities that a broker conducts outside or separate from his/her securities brokerage activities.)

Selling away situations result from a broker’s desire to not pass up on earning a commission on an investment his client is willing to buy, and further, to not have to share any of the commission with his/her associated firm. Selling away schemes are particularly dangerous for investors because they usually end up becoming victims of theft, securities fraud, or some other loss related to the investment. These schemes also often involve the sale of promissory notes which are essentially loan investments wherein the borrower promises to pay investors high interest rates in exchange for the loan amount from the investor. Once the investor (client) pays the money, the borrower sooner or later stops (or never begins) paying interest payments and the client’s investment vanishes
Selling short: In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as he will pay less to buy the assets than he received on selling them. Conversely, the short seller will make a loss if the price of the assets rises. Other costs of shorting may include a fee for borrowing the assets and payment of any dividends paid on the borrowed assets. Shorting and going short also refer to entering into any derivative or other contract whereby one profits from the fall in the value of an asset.

Going short can be contrasted with the more conventional practice of “going long“, whereby an investor profits from any increase in the price of the asset.

Settlement: Settlement (of securities) is the process whereby securities or interests in securities are delivered, usually against payment, to fulfill contractual obligations, such as those arising under securities trades.

This involves the delivery of securities to perform contractual delivery obligations. It usually also involves the corresponding payment of a purchase price. Usually settlement is preceded by trading, which involves entering into contracts of sale and purchase.

Although settlement is generally becoming quicker, in most markets a number of business days still elapse between trading and settlement (the settlement date). The settlement date for marketable stocks is usually three business days after the trade was executed and for listed options and government securities it is usually one day. A number of risks arise for the parties during the settlement interval, which are managed by the process of clearing, which follows trading and precedes settlement. Clearing involves modifying those contractual obligations so as to facilitate settlement, often by netting and novation.

Nature of settlement

Settlement involves the delivery of securities from one party to another. Delivery usually takes place against payment, but some deliveries are made without a corresponding payment. Examples are the delivery of securities collateral against a loan of securities, and a delivery made pursuant to a margin call.

Traditional settlement

Traditionally, securities settlement has involved the physical movement of paper instruments, or certificates and transfer forms. Payment was usually made by cheque. It was also risky, inasmuch as paper instruments, certificates, and transfer forms were relatively easy to lose, steal, and forge (see indirect holding system). The United States markets experienced what has become known as “the paper crunch,” as settlement delays threatened to disrupt the operations of the securities markets.

This led to the formation of the Depository Trust Company (DTC), and ultimately its parent, the Depository Trust & Clearing Corporation. In the United Kingdom, the weakness of paper-based settlement was exposed by a programmer of privatization of nationalized industries in the 1980s, and the Big Bang of 1986 led to an explosion in the volume of trades, and settlement delays became significant. In the market crash of 1987, many investors sought to limit their losses by selling their securities, but found that the failure of timely settlement left them exposed.

Electronic settlement

The electronic settlement system came about largely as a result of Clearance and Settlement Systems in the World’s Securities Markets, a major report in 1989 by the Washington-based think tank, the Group of Thirty. This report made nine recommendations with a view to achieving more efficient settlement. This was followed up in 2003 with a report, Clearing and Settlement: A Plan of Action, with 20 recommendations.

In an electronic settlement system, electronic settlement takes place between participants. If a non-participant wishes to settle its interests, it must do so through a participant acting as a custodian. The interests of participants are recorded by credit entries in securities accounts maintained in their names by the operator of the system. It permits both quick and efficient settlement by removing the need for paperwork, and the synchronization of the delivery of securities with the payment of a corresponding cash sum (called delivery versus payment, or DVP).

The recent development of electronic securities trading has brought about settlement pressures akin to the paper crunch of the 1970s and 1980s, rendering the need for further efficiencies urgent.

Legal significance

After the trade and before settlement, the rights of the purchaser are contractual and therefore personal. Because they are merely personal, their rights are at risk in the event of the insolvency of the vendor. After settlement, the purchaser owns securities and their rights are proprietary. Settlement is the delivery of securities to complete trades. It involves upgrading personal rights into property rights and thus protects market participants from the risk of the default of their counterparties.

Immobilization and dematerialization

Immobilization and dematerialization are the two broad goals of electronic settlement. Both were identified by the influential report by the Group of Thirty in 1989.

Immobilization

Immobilization entails the use of securities in paper form and the use of depositaries, which are electronically linked to a settlement system. Securities (either constituted by paper instruments or represented by paper certificates) are immobilized in the sense that they are held by the depositary at all times. In the historic transition from paper-based to electronic practice, immobilization often serves as a transitional phase prior to dematerialization.

The Depository Trust Company in New York is the largest immobilizer of securities in the world. Euroclear and Clearstream Banking,Luxembourg are two important examples of international immobilization systems. Both originally settled eurobonds, but now a wide range of international securities are settled through them including many types of sovereign debt and equity securities.

Dematerialization

Dematerialization involves dispensing of paper instruments and certificates altogether. Dematerialized securities exist only in the form of electronic records. The legal impact of dematerialization differs in relation to bearer and registered securities respectively.
Short: In options, the position of the writer of an option. In securities, the position of a seller of stock he does not own, but hopes to buy later.

Short interest theory: Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the total, number of shares issued by the company is one hundred million; the Short Interest is 10% (10 million / 100 million). If however, shares are being created through naked short selling, “fails” data must be accessed to assess accurately the true level of short interest.

Short sale: In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as he will pay less to buy the assets than he received on selling them. Conversely, the short seller will make a loss if the price of the assets rises. Other costs of shorting may include a fee for borrowing the assets and payment of any dividends paid on the borrowed assets. Shorting and going short also refer to entering into any derivative or other contract whereby one profits from the fall in the value of an asset.

Going short can be contrasted with the more conventional practice of “going long“, whereby an investor profits from any increase in the price of the asset.

Concept

To profit from a decrease in the price of a security, a short seller can borrow the security and sell it, expecting that it will be cheaper to repurchase in the future. When the seller decides that the time is right (or when the lender recalls the securities), the seller buys equivalent securities and returns them to the lender. The process relies on the fact that the securities (or the other assets being sold short) are fungible; the term “borrowing” is used in the sense of borrowing $10, where a different $10 note can be returned to the lender, rather than in the sense of borrowing a car, where the same car needs to be returned.

A short seller typically borrows through a broker, who is usually holding the securities for another investor who owns the securities; the broker itself seldom purchases the securities to lend to the short seller.  The lender does not lose the right to sell the securities while they have been lent, as the broker will usually hold a large pool of such securities for a number of investors which, as such securities are fungible, can instead be transferred to any buyer. In most market conditions there is a ready supply of securities to be borrowed, held by pension funds, mutual funds and other investors.

The act of buying back the securities that were sold short is called “covering the short” or “covering the position”. A short position can be covered at any time before the securities are due to be returned. Once the position is covered, the short seller will not be affected by any subsequent rises or falls in the price of the securities, as he already holds the securities required to repay the lender.

The terms shorting and going short are also used as blanket terms for tactics that allow an investor to gain from the decline in price of a security. Such tactics are generally based on a derivative contract, such as an option, a future or a similar synthetic position. For example, a put option consists of the right to sell an asset at a given strike price; the owner of the option therefore benefits when the market price of the asset falls below that price, as he can buy the asset at the lower price and sell it under the option at the strike price. Similarly, a short position in a futures contract means the holder of the position has an obligation to sell the underlying asset later at a given price; if the price falls below the given price, the person with the short position can buy the asset at the lower price and sell it under the future at the higher price.

Worked Example

If shares in XYZ Company currently trade at $10 per share, a short seller can borrow 100 shares of XYZ Company and immediately sell those shares for a total of $1,000. If the price of the shares falls to $8 per share, the short seller can buy 100 shares back for $800, return the shares to lender and keep the $200 profit (minus borrowing fees). However, if the price of the shares in XYZ Company instead rises to $25 per share following the short sale, and the short seller is required to return the shares, the short seller would have to buy back 100 shares at $2,500 and would make a loss of $1,500 (plus borrowing fees).

Comparison with long positions

Short selling is the opposite of “going long“. A short seller takes a negative, or “bearish” stance, believing that the price of a security will fall. Investors which employ short selling often use it to allow them to profit on trading in securities which they believe are overvalued, just as traditional long investors attempt to profit on securities which are undervalued by buying them.

Because a short position is the opposite of a long position, many features of the position are reversed in comparison. In particular, the profit (rather than the loss) is limited to the value of the security, but the loss (rather than the profit) is unlimited. In practice, as the price of a security rises the short seller will receive a margin call from the broker, demanding that the short seller either cover his short position (by purchasing the security) or provide additional cash in order to meet the margin requirement for the security, which effectively places a limit on the amount that can be lost.

History

Some theories hold that the practice was invented in 1609 by Dutch trader Isaac Le Maire, a big shareholder of the Vereenigde Oostindische Compagnie (VOC). In 1602, he invested about 85,000 guilders in the VOC. By 1609, the VOC still was not paying dividend, and Le Maire’s ships on the Baltic routes were under constant threats of attack by English ships due to trading conflicts between the British and the VOC. Le Maire decided to sell his shares and sold even more than he had. The notables spoke of an outrageous act and this led to the first real stock exchange regulations: a ban on short selling. The ban was revoked a couple of years later.

Short selling has been a target of ire since at least the eighteenth century when England banned it outright.  It was perceived as a magnifying effect in the violent downturn in the Dutch tulip market in the seventeenth century. In another well-referenced example, George Soros became notorious for “breaking the Bank of England” on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling.

The term “short” was in use from at least the mid-nineteenth century. It is commonly understood that “short” is used because the short seller is in a deficit position with his brokerage house. Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in 1822.

Short sellers were blamed for the Wall Street Crash of 1929.  Regulations governing short selling were implemented in the United States in 1929 and in 1940. Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick; this was known as the uptick rule, and this was in effect until July 3, 2007 when it was removed by the SEC (SEC Release No. 34-55970).

President Herbert Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. Legislation introduced in 1940 banned mutual funds from short selling (this law was lifted in 1997). A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.

Some typical examples of mass short-selling activity are during “bubbles“, such as the Dot-com bubble.  At such periods, short-sellers sell hoping for a market correction. Food and Drug Administration (FDA) announcements approving a drug often cause the market to react irrationally due to media attention; short sellers use the opportunity to sell into the buying frenzy and wait for the exaggerated reaction to subside before covering their position.  Negative news, such as litigation against a company, will also entice professional traders to sell the stock short.

During the Dot-com bubble, shorting a start-up company could backfire since it could be taken over at a higher price than what speculators shorted. Short-sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.

Short selling restrictions in 2008

In September 2008 short selling was seen as a contributing factor to undesirable market volatility and subsequently was prohibited by the U.S. Securities and Exchange Commission (SEC) for 799 financial companies for three weeks in an effort to stabilize those companies. at the same time the U.K. Financial Services Authority (FSA) prohibited short selling for 32 financial companies.  On September 22, Australia enacted even more extensive measures with a total ban of short selling.  Also on September 22, the Spanish market regulator, CNMV, required investors to notify it of any short positions in financial institutions, if they exceed 0.25% of a company’s share capital.  Naked shorting was also restricted.

In an interview with the Washington Post in late December 2008, U.S. Securities and Exchange Commission Chairman Christopher Cox said the decision to impose a three-week ban on short selling of financial company stocks was taken reluctantly, but that the view at the time, including from Treasury Secretary Henry M. Paulson and Federal Reserve chairman Ben S. Bernanke, was that “if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save.” Later he changed his mind and thought the ban unproductive.  In a December 2008 interview with Reuters, he explained that the SEC’s Office of Economic Analysis was still evaluating data from the temporary ban, and that preliminary findings point to several unintended market consequences and side effects. “While the actual effects of this temporary action will not be fully understood for many more months, if not years,” he said, “knowing what we know now, I believe on balance the Commission would not do it again.”

Mechanism

Short selling stock consists of the following:

• The investor instructs the broker to sell the shares and the proceeds are credited to his broker’s account at the firm upon which the firm can earn interest. Generally, the short seller does not earn interest on the short proceeds.
• Upon completion of the sale, the investor has 3 days (in the US) to borrow the shares. If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in the illegal practice of naked short selling, where the shorted shares are not borrowed or delivered.
• The investor may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced, he takes a loss.
• Finally, the investor may return the shares to the lender or stay short indefinitely.
• At any time, the lender may call for the return of his shares i.e. because he wants to sell them. The borrower must buy shares on the market and return them to the lender (or he must borrow the shares from elsewhere). When the broker completes this transaction automatically, it is called a ‘buy-in’.

Shorting stock in the U.S.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a “locate.” Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Depending on specific account agreements, brokers are able to borrow stocks from their customers who own “long” positions, particularly those in “margin” accounts. In these cases, and again, depending on account agreement, and only if the customer has fully paid for the long position, the broker may or may not be able to borrow the security without the express permission of the customer; the broker must provide the customer with collateral and may or may not pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client’s short sale.

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the “locate” process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the “short interest” of a stock, which gives the number of shares that have been legally sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares legally sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements but in order to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters. Investors are cautioned to remember that for every share that has been shorted (owned by a new owner), a ‘shadow owner’ exists (i.e. the original owner) who also is part of the universe of owners of that stock, i.e. Despite not having any voting rights, he has not relinquished his interest and some rights in that stock.

Securities lending

Main article: Securities lending

When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will “fail to deliver,” the transaction will not settle, and the seller may be subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.

Sources of short interest data

Time delayed short interest data (for legally shorted shares) is available in a number of countries, including the US, the UK, Hong Kong, and Spain. Some market participants (like Data Explorers and ShortSide.com) believe that stock lending data provides a good proxy for short interest levels (excluding any naked short interest). The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (e.g. the growth of 130/30 type strategies, short or bear ETFs).

Short selling terms

Days to Cover (DTC) is a numerical term that describes the relationship between the amount of shares in a given equity that have been legally short sold and the number of days of typical trading that it would require to ‘cover’ all legal short positions outstanding. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the average daily volume of XYZ shares traded each day is one million, it would require ten days of trading for all legal short positions to be covered (10 million / 1 million).

Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent. For example, if there are ten million shares of XYZ Inc. that are currently legally short sold and the total, number of shares issued by the company is one hundred million; the Short Interest is 10% (10 million / 100 million). If however, shares are being created through naked short selling, “fails” data must be accessed to assess accurately the true level of short interest.

Smart card: A smart card, chip card, or integrated circuit card (ICC), is any pocket-sized card with embedded integrated circuits which can process data. This implies that it can receive input which is processed — by way of the ICC applications — and delivered as an output. There are two broad categories of ICCs. Memory cards contain only non-volatile memory storage components, and perhaps some specific security logic. Microprocessor cards contain volatile memory and microprocessor components. The card is made of plastic, generally PVC, but sometimes ABS. The card may embed a hologram to avoid counterfeiting. Using smartcards is also a form of strong security authentication for single sign-on within large companies and organizations.

Overview

A “smart card” is also characterized as follows:

• Dimensions are normally credit card size. The ID-1 of ISO/IEC 7810 standard defines them as 85.60 × 53.98 mm. Another popular size is ID-000 which is 25 × 15 mm (commonly used in SIM cards). Both are 0.76 mm thick.
• Contains a security system with tamper-resistant properties (e.g. a secure cryptoprocessor, secure file system, human-readable features) and is capable of providing security services (e.g. confidentiality of information in the memory).
• Asset managed by way of a central administration system which interchanges information and configuration settings with the card through the security system. The latter includes card hotlisting, updates for application data.
• Card data is transferred to the central administration system through card reading devices, such as ticket readers, ATMs etc.

Benefits

Smart cards can be used for identification, authentication, and data storage.

Smart cards provide a means of effecting business transactions in a flexible, secure, standard way with minimal human intervention.

Smart card can provide strong authentication^[2] for single sign-on or enterprise single sign-on to computers, laptops, data with encryption, enterprise resource planning platforms such as SAP, etc.

History

The automated chip card was invented by German rocket scientist Helmut Gröttrup and his colleague Jürgen Dethloff in 1968; the patent was finally approved in 1982. The first mass use of the cards was for payment in French pay phones, starting in 1983 (Télécarte).

French inventor Roland Moreno actually patented his first concept of the memory card in 1974. In 1977, Michel Ugon from Honeywell Bull invented the first microprocessor smart card. In 1978, Bull patented the SPOM (Self Programmable One-chip Microcomputer) that defines the necessary architecture to auto-program the chip. Three years later, the very first “CP8″ based on this patent was produced by Motorola. At that time, Bull had 1200 patents related to smart cards. In 2001, Bull sold its CP8 Division together with all its patents to Schlumberger. Subsequently, Schlumberger combined its smart card department and CP8 and created Axalto. In 2006, Axalto and Gemplus, at the time the world’s no.2 and no.1 smart card manufacturers, merged and became Gemalto.

The second use was with the integration of microchips into all French debit cards (Carte Bleue) completed in 1992. When paying in France with a Carte Bleue, one inserts the card into the merchant’s terminal, then types the PIN, before the transaction is accepted. Only very limited transactions (such as paying small autoroute tolls) are accepted without PIN.

Smart-card-based electronic purse systems (in which value is stored on the card chip, not in an externally recorded account, so that machines accepting the card need no network connectivity) were tried throughout Europe from the mid-1990s, most notably in Germany (Geldkarte), Austria (Quick), Belgium (Proton), France (Moneo), the Netherlands (Chipknip and Chipper), Switzerland (“Cash”), Norway (“Mondex”), Sweden (“Cash”), Finland (“Avant”), UK (“Mondex”), Denmark (“Danmønt”) and Portugal (“Porta-moedas Multibanco”).

The major boom in smart card use came in the 1990s, with the introduction of the smart-card-based SIM used in GSM mobile phone equipment in Europe. With the ubiquity of mobile phones in Europe, smart cards have become very common.

The international payment brands MasterCard, Visa, and Europay agreed in 1993 to work together to develop the specifications for the use of smart cards in payment cards used as either a debit or a credit card. The first version of the EMV system was released in 1994. In 1998 a stable release of the specifications was available. EMVco, the company responsible for the long-term maintenance of the system, upgraded the specification in 2000 and most recently in 2004. The goal of EMVco is to assure the various financial institutions and retailers that the specifications retain backward compatibility with the 1998 version.

With the exception of countries such as the United States of America there has been significant progress in the deployment of EMV-compliant point of sale equipment and the issuance of debit and or credit cards adhering the EMV specifications. Typically, a country’s national payment association, in coordination with MasterCard International, Visa International, American Express and JCB, develop detailed implementation plans assuring a coordinated effort by the various stakeholders involved.

The backers of EMV claim it is a paradigm shift in the way one looks at payment systems. In countries where banks do not currently offer a single card capable of supporting multiple account types, there may be merit to this statement. Though some banks in these countries are considering issuing one card that will serve as both a debit card and as a credit card, the business justification for this is still quite elusive. Within EMV a concept called Application Selection defines how the consumer selects which means of payment to employ for that purchase at the point of sale.

For the banks interested in introducing smart cards the only quantifiable benefit is the ability to forecast a significant reduction in fraud, in particular counterfeit, lost and stolen. The current level of fraud a country is experiencing, coupled with whether that country’s laws assign the risk of fraud to the consumer or the bank, determines if there is a business case for the financial institutions. Some critics claim that the savings are far less than the cost of implementing EMV, and thus many believe that the USA payments industry will opt to wait out the current EMV life cycle in order to implement new, contactless technology.

Smart cards with contactless interfaces are becoming increasingly popular for payment and ticketing applications such as mass transit. Visa and MasterCard have agreed to an easy-to-implement version currently being deployed (2004-2006) in the USA. Across the globe, contactless fare collection systems are being implemented to drive efficiencies in public transit. The various standards emerging are local in focus and are not compatible, though the MIFARE Standard card from Philips has a considerable market share in the US and Europe.

Smart cards are also being introduced in personal identification and entitlement schemes at regional, national, and international levels. Citizen cards, drivers’ licenses, and patient card schemes are becoming more prevalent; For example in Malaysia, the compulsory national ID scheme MyKad includes 8 different applications and is rolled out for 18 million users. Contactless smart cards are being integrated into ICAObiometric passports to enhance security for international travel.

Contact smart card

Contact smart cards have a contact area, comprising several gold-plated contact pads, that is about 1 cm square. When inserted into a reader, the chip makes contact with electrical connectors that can read information from the chip and write information back

The ISO/IEC 7816 and ISO/IEC 7810 series of standards define:

• the physical shape
• the positions and shapes of the electrical connectors
• the electrical characteristics
• the communications protocols, that includes the format of the commands sent to the card and the responses returned by the card.
• robustness of the card
• the functionality

The cards do not contain batteries; energy is supplied by the card reader.

Electrical signals description

VCC : Power supply input

RST : Either used itself (reset signal supplied from the interface device) or in combination with an internal reset control circuit (optional use by the card). If internal reset is implemented, the voltage supply on Vcc is mandatory.

CLK : Clocking or timing signal (optional use by the card).

GND : Ground (reference voltage).

VPP : Programming voltage input (deprecated / optional use by the card).

I/O : Input or Output for serial data to the integrated circuit inside the card.

NOTE – The use of the two remaining contacts will be defined in the appropriate application standards.

Reader

See also: Card reader#Smart card readers

Contact smart card readers are used as a communications medium between the smart card and a host, e.g. a computer, a point of sale terminal, or a mobile telephone.

Since the chips in the financial cards are the same as those used for mobile phone Subscriber Identity Module (SIM) cards, just programmed differently and embedded in a different shaped piece of PVC, the chip manufacturers are building to the more demanding GSM/3G standards. So, for instance, although EMV allows a chip card to draw 50 mA from its terminal, cards are normally well inside the telephone industry’s 6mA limit. This is allowing financial card terminals to become smaller and cheaper, and moves are afoot to equip every home PC with a card reader and software to make internet shopping more secure.

Contactless smart card

Main Article

See also: List of smart cards

A second type is the contactless smart card, in which the chip communicates with the card reader through RFID induction technology (at data rates of 106 to 848 kbit/s). These cards require only close proximity to an antenna to complete transaction. They are often used when transactions must be processed quickly or hands-free, such as on mass transit systems, where smart cards can be used without even removing them from a wallet.

The standard for contactless smart card communications is ISO/IEC 14443. It defines two types of contactless cards (“A” and “B”), allows for communications at distances up to 10 cm. There had been proposals for ISO/IEC 14443 types C, D, E, F and G that have been rejected by the International Organization for Standardization.  An alternative standard for contactless smart cards is ISO 15693, which allows communications at distances up to 50 cm.

Examples of widely used contactless smart cards are Hong Kong’s Octopus card, South Korea‘s T-money (Bus, Subway, Taxi), Melbourne’s myki, London’s Oyster card, London’s sQuidcard which is used for small payments in Thames Ditton, Bolton and Dundee, Japan Rail’s Suica Card and Mumbai Bus transportation service BEST uses smart cards for bus pass, which predate the ISO/IEC 14443 standard. All of them are primarily designed for public transportation payment and other electronic purse applications.

A related contactless technology is RFID (radio frequency identification). In certain cases, it can be used for applications similar to those of contactless smart cards, such as for electronic toll collection. RFID devices usually do not include writeable memory or microcontroller processing capability as contactless smart cards often do.

There are dual-interface cards that implement contactless and contact interfaces on a single card with some shared storage and processing. An example is Porto‘s multi-application transport card, called Andante, that uses a chip in contact and contactless (ISO/IEC 14443 Type B).

Like smart cards with contacts, contactless cards do not have a battery. Instead, they use a built-in inductor to capture some of the incident radio-frequency interrogation signal, rectify it, and use it to power the card’s electronics.

Communication protocols

Credit card contactless technology

Main article: contactless smart card

These are the best known payment cards (classical plastic card):

• Visa: Visa Contactless, Quick VSDC – “qVSDC”, Visa Wave, MSD, payWave
• MasterCard: PayPass Magstripe, PayPass MChip
• American Express: ExpressPay
• Chase: Blink (credit and debit cards)

Roll-outs started in 2005 in USA (Asia and Europe – 2006). Contactless (non PIN) transactions cover a payment range of ~$5–50. There is an ISO/IEC 14443 PayPass implementation. All PayPass implementations may be separated on EMV and non EMV.

Non-EMV cards work like magnetic stripe cards. This is a typical card technology in the USA (PayPass Magstripe and VISA MSD). The cards do not control amount remaining. All payment passes without a PIN and usually in off-line mode. The security level of such a transaction is no greater than with classical magnetic stripe card transaction.

EMV cards have two interfaces (contact and contactless) and they work as a normal EMV card via contact interface. Via contactless interface they work almost like an EMV (card command sequence adopted on contactless features as low power and short transaction time).

Cryptographic smart cards

Cryptographic smart cards are often used for single sign-on. Most advanced smart cards are equipped with specialized cryptographic hardware that let you use algorithms such as RSA and DSA on board. Today’s cryptographic smart cards are also able to generate key pairs on board, to avoid the risk of having more than one copy of the key (since by design there usually isn’t a way to extract private keys from a smart card).

Such smart cards are mainly used for digital signature and secure identification, (see applications section).

The most common way to access cryptographic smart card functions on a computer is to use a PKCS#11 library provided by the vendor. On Microsoft Windows platforms the CSP API is also adopted.

The most widely used cryptographic algorithms in smart cards (excluding the GSM so-called “crypto algorithm”) are 3DES (Triple DES) and RSA. The key set is usually loaded (DES) or generated (RSA) on the card at the personalization stage.

Applications

Computer security

The Mozilla Firefox web browser can use smart cards to store certificates for use in secure web browsing.

Some disk encryption systems, such as FreeOTFE or TrueCrypt, can use smart cards to securely hold encryption keys, and also to add another layer of encryption to critical parts of the secured disk^[6].

Smartcards are also used for single sign-on to log on to computers

Smartcards support functionality has been added to Windows Live Passports

Financial

The applications of smart cards include their use as credit or ATM cards, in a fuel card, SIMs for mobile phones, authorization cards for pay television, pre-pay utilities in household, high-security identification and access-control cards, and public transport and public phone payment cards.

Smart cards may also be used as electronic wallets. The smart card chip can be loaded with funds which can be spent in parking meters and vending machines or at various merchants. Cryptographic protocols protect the exchange of money between the smart card and the accepting machine. There is no connection to the issuing bank necessary, so the holder of the card can use it regardless of him being the owner. Examples are Proton, Geldkarte, Chipknip and Mon€o. The German Geldkarte is also used to validate customer age at vending machines for cigarettes.

Health care (Medical)

Smart health cards can improve the security and privacy of patient information, provide the secure carrier for portable medical records, reduce health care fraud, support new processes for portable medical records, provide secure access to emergency medical information, enable compliance with government initiatives and mandates, and provide the platform to implement other applications as needed by the health care organization.

Identification

A quickly growing application is in digital identification cards. In this application, the cards are used for authentication of identity. The most common example is in conjunction with a PKI. The smart card will store an encrypted digital certificate issued from the PKI along with any other relevant or needed information about the card holder. Examples include the U.S. Department of Defense (DoD) Common Access Card (CAC), and the use of various smart cards by many governments as identification cards for their citizens. When combined with biometrics, smart cards can provide two- or three-factor authentication. Smart cards are not always a privacy-enhancing technology, for the subject carries possibly incriminating information about him all the time. By employing contactless smart cards, that can be read without having to remove the card from the wallet or even the garment it is in, one can add even more authentication value to the human carrier of the cards.

The first smart card driver’s license system in the world was issued in 1995 in Mendoza, a province of Argentina. Mendoza has a high level of road accidents, driving offenses, and a poor record of recovering outstanding fines.  The smart licenses keep an up-to-date record of driving offenses and unpaid fines. They also store personal information, license type and number, and a photograph of the holder. Emergency medical information like blood type, allergies, and biometrics (fingerprints) can be stored on the chip if the cardholder wishes. The Argentina government anticipates that this new system will help to recover more than $10 million per year in fines.

Gujarat was the first state in India to introduce the smart card license system in 1999. To date the Gujarat Government has issued 5 million smart card driving licenses to its people.  This card is basically a plastic card having ISO/IEC 7810 certification and integrated circuit, capable of storing and verifying information according to its programming.

“a national ID card, protected by a 1,024-bit key code, is impossible to break “without a supercomputer working away for a hundred years”

By the start of 2009 the entire population of Spain and Belgium will have an eID card, that is issued by the Spanish and Belgian Governments and that is used to identify an individual. These cards contain 2 certificates: one for authentication and one for signature. This signature is legally adopted. More and more services in these countries are using the eID card as an authorization token. More information on and

Other

Smart cards are widely used to protect digital television streams. See television encryption for an overview, and VideoGuard is a specific example of how smart card security worked (and was cracked).

The Malaysian government uses smart card technology in identity cards carried by all Malaysian citizens and resident non-citizens. The personal information inside the smart card (called MYKAD) can be read using special APDU commands.MYKAD SDK

Toppan Printing Company developed smart card material with paper, instead of plastic, which is reusable and no need to incineration or buried in the soil after disposal, this paper based smart card put in market from April 2009.  It is used for money transfer also.

Security

Smart cards have been advertised as suitable for personal identification tasks, because they are engineered to be tamper resistant. The embedded chip of a smart card usually implements some cryptographic algorithm. There are, however, several methods of recovering some of the algorithm’s internal state.

Differential power analysis

Differential power analysis involves measuring the precise time and electrical current required for certain encryption or decryption operations. This is most often used against public key algorithms such asRSA in order to deduce the on-chip private key, although some implementations of symmetric ciphers can be vulnerable to timing or power attacks as well.

Physical disassembly

Smart cards can be physically disassembled by using acid, abrasives, or some other technique to obtain direct, unrestricted access to the on-board microprocessor. Although such techniques obviously involve a fairly high risk of permanent damage to the chip, they permit much more detailed information (e.g. photomicrographs of encryption hardware) to be extracted.

Problems

Another problem of smart cards may be the failure rate. The plastic card in which the chip is embedded is fairly flexible, and the larger the chip, the higher the probability of breaking. Smart cards are often carried in wallets or pockets — a fairly harsh environment for a chip. However, for large banking systems, the failure-management cost can be more than offset by the fraud reduction.  A card enclosure might be a good idea.

Using a smart card for mass transit presents a risk for privacy, because such a system enables the mass transit operator (and the authorities) to track the movement of individuals. In Finland, the Data Protection Ombudsman prohibited the transport operator YTV from collecting such information, in spite of YTV’s argument that the owner of the card has the right to get a list of journeys paid with the card. Prior to this, such information was used in the investigation of the Myyrmanni bombing.

Smart cards used for client-side identification and authentication are the most secure way for eg. internet banking applications, but the security is never 100% sure. In the example of internet banking, if the PC is infected with any kind of malware, the security model is broken. Malware can override the communication (both input via keyboard and output via application screen) between the user and the internet banking application (eg. browser). This would result in modifying transactions by the malware and unnoticed by the user. There is malware in the wild with this capability (eg. Trojan. Silentbanker). Banks like Fortis and Dexia in Belgium combine a Smart card with an unconnected card reader to avoid this problem. The customer enters a challenge received from the bank’s website, his PIN and the transaction amount into the card reader, the card reader returns an 8-digit signature. This signature is manually copied to the PC and verified by the bank. This method prevents malware from changing the transaction amount.

In addition to technical hurdles is the lack of standards for smart card functionality and security. To address this problem, the ERIDANE Project was launched by The Berlin Group to develop a proposal for “a new functional and security framework for smart-card based Point of Interaction (POI) equipment”, equipment that would be used, for instance, in retail environments.

Speculation: In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum.  Speculation typically involves the lending of money or the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, “speculation,” which is formally defined as above in Graham and Dodd‘s 1934 text, Security Analysis, contrasts with the term “investment,” which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.

In a financial context, the terms “speculation” and “investment” are actually quite specific. For instance, although the word “investment” is typically used, in a general sense, to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured money—including funds placed in the world’s stock markets—is actually not investment, but speculation.

Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers’ changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities.

There are also some financial vehicles that are, by definition, speculation. For instance, trading in certain commodities, such as oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative.

Financial speculation can involve the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price, irrespective of its underlying value.

Investment vs. Speculation

Identifying speculation can be best done by distinguishing it from investment. According to Ben Graham in Intelligent Investor, the prototypical defensive investor is “…one interested chiefly in safety plus freedom from bother.” He admits, however, that “…some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone.”  Many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.

Speculators can be increasingly distinguishable by shorter holding times, the use of leverage, by being willing to take short positions as well as long positions. A degree of speculation exists in a wide range of financial decisions, from the purchase of a house to a bet on a horse; this is what modern market economists call “ubiquitous speculation.”

The economic benefits of speculation

The well known speculator Victor Niederhoffer, in “The Speculator as Hero”^[4] describes the benefits of speculation:

Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby chequeing consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

If a certain market—for example, pork bellies—had no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g. a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see winner’s curse. The winner’s curse is however not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner’s curse phenomenon from causing mispricing to any degree greater than the spread.

Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. For example, speculative purchasing can push prices above their true value (real value – adjusted for inflation) simply because the speculative purchasing artificially increases the demand.  Speculative selling can also have the opposite effect, causing prices to artificially decrease below their true value in a similar fashion.  In various situations, price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes.

It is a controversial point whether the presence of speculators increases or decreases the short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility at times.

Etymology

The Etymology of the word is as follows; from O.Fr. speculation, from L.L. speculationem (nom. speculatio) “contemplation, observation,” from L. speculatus, pp. of speculari “observe,” from specere “to look at, view”. Speculator in the financial sense is first recorded 1778.

What is significant to note is the change from a passive to an active form of use. Specifically from a strict observer to one who contemplates what they observe then further to one who contemplates and acts on what they observe.

With these changes, the word as now commonly used, describes one who observes an object, event, or situation and takes some form of action with regard to the observed, all the while aware they may not know all the facts or factors regarding or affecting that which they observe. E.g. the financial speculator, one who understands and accepts he may not know all the facts or risks involved with a venture, yet chooses to invest his capital in the venture for the possibility of receiving greater capital in return.

Regulating Speculation

The Tobin tax is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange.

In May 2008, German leaders have planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds.

Spot price: The spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate (spot) settlement (payment and delivery). Spot settlement is normally one or two business days from trade date. This is in contrast with the forward price established in a forward contract or futures contract, where contract terms (price) are set now, but delivery and payment will occur at a future date. Spot rates are estimated via the bootstrapping method, which uses prices of the securities currently trading in market, that is, from the cash or coupon curve. The result is the spot curve, which exists for each of the various classes of securities.

For securities, the synonymous term cash price is more often used.

Spot prices and future price expectations

Depending on the item being traded, spot prices can indicate market expectations of future price movements in different ways. For a security or non-perishable commodity (e.g., gold), the spot price reflects market expectations of future price movements. In theory, the difference in spot and forward prices should be equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry model. For example, on a share the difference in price between the spot and forward is usually accounted for almost entirely by any dividends payable in the period minus the interest payable on the purchase price. Any other price would yield an arbitrage opportunity and riskless profit (see rational pricing for the arbitrage mechanics).

In contrast, a perishable commodity does not allow this arbitrage – the cost of storage is effectively higher than the expected future price of the commodity. As a result, spot prices will reflect current supply and demand, not future price movements. Spot prices can therefore be quite volatile and move independently from forward prices. According to the unbiased forward hypothesis, the difference between these prices will equal the expected price change of the commodity over the period.

A simple example: even if you know tomatoes are cheap in July and will be expensive in January, you can’t buy them in July and take delivery in January, since they will spoil before you can take advantage of January’s high prices. The July price will reflect tomato supply and demand in July. The forward price for January will reflect the market’s expectations of supply and demand in January. July tomatoes are effectively a different commodity from January tomatoes (contrast contango and backwardation).

Standard & Poor’s (S & P): Standard & Poor’s (S&P) is a division of McGraw-Hill that publishes financial research and analysis on stocks and bonds. It is well known for the stock market indexes, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian S&P/TSX, the Italian S&P/MIB and India’s S&P CNX Nifty.

Business description

Standard & Poor’s operates as a financial services company. Its products and services include credit ratings, equity research, S&P indices, funds ratings, risk solutions, governance services, evaluations, and data services. The company’s division, Capital IQ, provides information and workflow solutions to financial institutions, advisory firms, and corporations. Capital IQ provides integrated financial information and technology solutions, including auditable company financials, a screener combining financial and nonfinancial items, an integrated public and private capital market database, and various relationship development tools. The company serves institutional professionals, financial institutions, corporations, financial advisors, and individual investors worldwide.

Corporate history

Standard & Poor’s traces its history back to 1860, with the publication by Henry Varnum Poor of History of Railroads and Canals in the United States. This book was an attempt to compile comprehensive information about the financial and operational state of U.S. railroad companies. Henry Varnum went on to establish H.V. and H.W. Poor Cowith his son, Henry William, and published updated versions of this book on an annual basis.

In 1906 Luther Lee Blake founded the Standard Statistics Bureau, with the view to providing financial information on non-railroad companies. Instead of an annually published book Standard Statistics would use 5″ x 7″ cards, allowing for more frequent updates.

In 1966 S&P was acquired by The McGraw-Hill Companies, and now encompasses the Financial Services division.

Credit ratings

Standard & Poor’s, as a credit rating agency (CRA), issues credit ratings for the debt of public and private corporations. It is one of several CRAs that have been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission.

It issues both short-term and long-term credit ratings.

Long-term credit ratings

S&P rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between AA and CCC (i.e., BBB+, BBB and BBB-). For some borrowers, S&P may also offer guidance (termed a “credit watch”) as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain (neutral).

Investment Grade

• AAA : the best quality borrowers, reliable and stable (many of them governments)
• AA : quality borrowers, a bit higher risk than AAA
• A : economic situation can affect finance
• BBB : medium class borrowers, which are satisfactory at the moment

Non-Investment Grade (also known as junk bonds)

• BB : more prone to changes in the economy
• B : financial situation varies noticeably
• CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments
• CC : highly vulnerable, very speculative bonds
• C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
• CI : past due on interest
• R : under regulatory supervision due to its financial situation
• SD : has selectively defaulted on some obligations
• D : has defaulted on obligations and S&P believes that it will generally default on most or all obligations
• NR : not rated

Short-term issue credit ratings

S&P rates specific issues on a scale from A-1 to D. Within the A-1 category it can be designated with a plus sign (+). This indicates that the issuer’s commitment to meet its obligation is very strong. Country risk and currency of repayment of the obligor to meet the issue obligation are factored into the credit analysis and reflected in the issue rating.

• A-1 : obligor’s capacity to meet its financial commitment on the obligation is strong
• A-2 : is susceptible to adverse economic conditions however the obligor’s capacity to meet its financial commitment on the obligation is satisfactory
• A-3 : adverse economic conditions are likely to weaken the obligor’s capacity to meet its financial commitment on the obligation
• B : has significant speculative characteristics. The obligor currently has the capacity to meet its financial obligation but faces major ongoing uncertainties that could impact its financial commitment on the obligation
• C : currently vulnerable to nonpayment and is dependent upon favorable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation
• D : is in payment default. Obligation not made on due date and grace period may not have expired. The rating is also used upon the filing of a bankruptcy petition.

Stock market indices

Standard & Poor’s publishes a large number of stock market indices, covering every region of the world, market capitalization level, and type of investment (e.g. indices for REITs and preferred stocks)

These indices include:

• S&P 500 — value weighted index of the prices of 500 large-cap common stocks actively traded in the United States.
• S&P 400 MidCap Index^{[citation needed]}
• S&P 600 SmallCap Index^[2]

Publications

Standard & Poor’s publishes a near-weekly (48 times a year) stock market analysis newsletter called The Outlook which is issued both in print and online to subscribers.

Criticism

See also: Credit rating agency#Criticism

Credit rating agencies such as Standard & Poor’s have been subject to criticism in the wake of large losses beginning in 2007 in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the CRAs.

Credit ratings of AAA (the highest rating available) were given to large portions of even the riskiest pools of loans. Investors, trusting the low risk profile that AAA implies, loaded up on these collateralized debt obligations (CDOs) that later became unsellable. Those that could be sold often took staggering losses. For instance, losses on $340.7 million worth of collateralized debt obligations (CDOs) issued by Credit Suisse Group added up to about $125 million, despite being rated AAA by Standard & Poor’s.

It is also worth mentioning that Standard & Poor’s apparently failed to predict the bankruptcy of all the largest Icelandic banks and a weaker position of the Icelandic Government in 2008, a country that had a very high rating until its economy suddenly collapsed.

In April 2009 Standard & Poor’s called for “new faces” in the Irish Government, which was seen as interfering in the democratic process.  In a subsequent statement they said they were “misunderstood.”

Standby letter of credit (conditional guarantee): In English writings, traditionally the term “guarantee” denotes an accessory (secondary) or “conditional” type of obligation. The essence of the instrument is the promise to answer for the duty of another should the other default. The beneficiary of such a promise will not be entitled to payment unless it can adduce evidence of the occurrence of the event, which the guarantee secures. Thus the issuer’s liability to pay arises only in cases of actual default of the principal and not by a mere demand. In addition the issuer in cases of litigation can raise any defenses available for the principal.

Thus if it later appears that the contract between the principal and the beneficiary was void, the guarantor may raise this defense to avoid paying the beneficiary. In addition the surety could raise defenses which are not available to the principal, these include (i) materially increasing the risk of the issuer without consent of the issuer by contract changes (ii) alterations (iii) improper payments. For further analysis on the defenses available to the issuer.

Major differences distinguish this instrument from “demand guarantees”; in the latter instrument the obligation to pay is conditioned within the terms of the bank’s promise, therefore if the demand guarantee is payable upon the beneficiary’s written first demand he is assured payment notwithstanding any defense related to any other underlying transactions. Proof of default is not needed and issuers are not concerned with the underlying contract nor can they raise any defense available to the underlying contracting party.

This type of guarantee is usually used in a wide range of different and often complex transactions. These transactions include: payment upon the seller’s default in a sale of goods transaction; security for service contracts or construction contracts; paying the fee of a solicitor in case he secures a divorce for a client; underwriting the liability of partners in joint venture agreements; and they have even been used to secure the payment of a ransom. Each type of business or transaction may require the issuance of a certain type of guarantee. The typical demand guarantee is simply used to provide financial security against default in performance of a non-money obligation, in which case the guarantee is usually given by the seller/contractor (the account party) to the buyer/employer (the beneficiary).

There is much terminological confusion when distinguishing between demand guarantees and accessory guarantees. Indeed the issue has been disputed in some recent cases. No precise term has yet been adopted to distinguish between the two types of instruments. English courts, however, have agreed that the decisive factor in determining the type of the guarantee is to be found in the terms of the guarantee itself and not in how the guarantee is referred to in a particular transaction.

In the United States, demand guarantees are referred to as standby letters of credit and English courts give standby credits the same legal status that is given to demand guarantees.

Role of demand guarantees in international trade

Demand guarantees developed to replace money deposits, which sellers had to provide to buyers in order to secure the latter against the former’s default under the contract. The substitution of money deposits by demand guarantees helped account parties to maintain their liquidity: they were no more forced to tie up their money for a considerable period of time pending completion of the underlying contracts, and where the account party had no sufficient money to pay an upfront deposit it was relieved from the expense of borrowing cash from a banker and paying interest on the loan during its life. The account party also benefits from the low cost of demand guarantees compared to other instruments such as accessory guarantees.

The account party might not trust the beneficiary enough to agree to provide him with a cash deposit; similarly the beneficiary might doubt the account party’s solvency and therefore ability to fulfill the underlying contract or its ability to rectify defaults in performance. The demand guarantee bridges the “gap of distrust” that exits between the parties. When the bank issues the demand guarantee, the beneficiary deals with a party whose financial strength he can trust and a party which would pay upon first demand regardless of an existing dispute between the parties on the performance of the underlying contract.^[7] More importantly, however, the demand guarantee is also used to reallocate the risks between the parties. In this regard, the demand guarantee is used to avoid three types of risk: judgment risks, execution risks and jurisdictional risks. Judgment risks include, inter alia, risks involved in taking the dispute to court, losing on a procedural issue, the risk of an unfriendly court, evidentiary problems and the threat of political uncertainty that could prevent an action being brought against a party. Execution risks include the risk that a plaintiff could not execute a judgment against the defendant. This is often due to defendant insolvency or due to the unenforceability of one country’s court judgments in another country. Finally jurisdictional risks are part of both the above risks: they revolve mainly around the costs and difficulty that a party would endure when bringing an action against the defendant who is usually located in another jurisdiction. Where the beneficiary is issued a demand guarantee by a bank in his own locality, the guarantee aims “to shifting of risks and the cost of bearing them from [the beneficiary to the account party]”. Should the beneficiary find the contractor in default, he can immediately seek compensation by demanding on the guarantee and it is the account party who is forced to bring an action to recover any disputed amount. The premise in such transactions is that by agreeing to provide a demand guarantee both the account party and the beneficiary agree that the latter should not be deprived of his money (money due under the guarantee) by litigation against him at the suit of the account party.