Heard from Phiten today that there was a long queue of people at the AIA Customer Service and the GE Building during lunch as people rushed to surrender their insurance policies in light of the bad patch AIG is going through. Gosh. I suppose if a person isn’t really involved in the financial industry, the person would easily assume that AIG is going to collapse overnight. If someone drew that conclusion after sound analysis, that’s ok. Unfortunately, I think it’s just mass hysteria that’s kicking in.
Anyway, here’s in layman language some of the common terms that are flying around now…
Qn: What does it mean to be "insolvent"?
Ans: Insolvency is when your liabilities (i.e. debts) exceed your assets (i.e. things you can sell to clear your debt).
Qn: When you file for bankruptcy, does it mean you have no more money left?
Ans: No. When someone or a company files for bankruptcy, it means that person/company has applied to the courts to be declared legally insolvent. The court will then appoint an administrator aka the Official Assignor (an officer of the court) to liquidate as much assets as possible to pay off the debts.
Qn: What is Chapter 11?
Ans: A company filing of Chapter 11 in the US is similar to a company going for judicial management in Singapore. The court can appoint competent persons (quite often independent auditors) to take over the running of the company, instead of letting creditors take full control over the remaining assets of the distressed company. This sometimes allow distressed companies to work out their debt (debt restructuring, rescheduling of repayment schedules with creditors, etc) instead of winding up completely. However, in cases where it is decided that it is best for the company to be wound up, the appointed judicial managers will liquidate the remaining assets in the best way possible so as to repay as many creditors as possible.
Qn: What is CDO?
CDO stands for Collateralised Debt Obligation. CDO is a credit product that is backed by a host of securities ranging from assets, loans, bonds, etc. In the case of the recent sub-prime meltdown, banks and insurers that were hit were those who held CDOs that were backed by sub-prime loans. A sub-prime loan is a high risk mortgage made to debtors who were of poor than usual credit standing.
Qn: What is CDS?
A CDS (Credit Default Swap) is a credit derivative contract used typically by banks (and sometimes insurers) to hedge risk. There are 3 parts to a CDS – the Buyer, the Seller and the Reference Entity. The Buyer of the CDS pays periodic payments to the Seller in exchange for indemnity compensation in the event the Reference Entity suffers a default (aka a credit event).
The CDS is a competing product to a Credit Insurance Policy where the Insured would pay premiums to the Insurer for compensation payment by the latter in the event of a default under the insured Debt Instrument.
Qn: What is Standard & Poor’s or Moody’s?
Ans: These are credit rating agencies that evaluate the financial strength of companies, government, etc. Entities rated BBB and above are considered "investment grade".
Qn: Why did a downgrade of AIG’s rating trigger a collateral call?
Ans: When lenders extend loans to borrowers, it is based on the assumption that their financial rating is able to support the repayment of the loan. Loans typically have conditions in them requiring borrowers to maintain certain Debt to EBITA ratio, etc. In the event a borrower’s financial strength is deemed to have deproved, under the loan agreements, lenders are usually allowed to require the borrower to provide more collateral for the loan.
OK… I think that’s all I can cover for today… does this help anyone understand the terms you see in the news better? I guess there’s a need to delve deeper into the issues behind the financial meltdown we’re seeing in the US now… but… it’s really too much to type in one post!
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