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How to Crack the Credit Crunch Code

Richard Widows

The unprecedented "credit crunch" ignited by the excesses of the recent housing boom has impacted us all. In addition to the jolts to home prices and securities valuations , we have been bombarded by the business media with new acronyms and abbreviations.

So here is an investment quiz to test your understanding of all this crunch-inspired "code" or "alphabet soup." For any of the terms you are not completely familiar with, explanations will follow the questions to help you get a better grasp on the terminology of the credit crisis.

Feel free to use the many features available on TheStreet.com to help you answer the questions. A great place to start your search for investment knowledge is the "Search" box at the top of TheStreet.com.

Another great resource available on our Web site is a glossary of definitions and explanations of financial and investment terms. Just roll-over the "Portfolio & Tools" tab at the top of the site and select the "Glossary" option.

This investment quiz is a self-test, so you keep your own score. Ready?

Good luck!

Question 1: What is LIBOR?

LIBOR is a term you will see with some regularity in the financial news. Besides having an impact at the highest level of the credit markets, the term appears hidden in documentation that crosses the hands of many financially unsophisticated individuals. Many -- to their subsequent regret -- never bothered to learn more about LIBOR before signing documents with the term sprinkled in inconspicuous places.

Question 2: What are ARMs?

Hint: They are appendages that many would like to remove -- and not ones on the human body.

This term frequently relates to the LIBOR question. The acronym A.R.M. might be appropriate in that this financial instrument has a reach. Specifically, its influence in the credit crunch extends from the basic level of the working stiff to creations of the most supposedly sophisticated financial engineers.

Question 3: What does CMO stand for?

In many cases, this term also relates to the two questions above. It might be described as the adhesive that held the whole credit imbroglio together -- until things became unglued, unleashing the credit crunch!

Question 4: In investment terms, how would you define SWF?

Hint: It does not stand for "single white female."

Finally, we are getting to something that might help us turn the corner and eventually get the world out of this credit mess. SWFs have come to the rescue of firms enmeshed in the credit crunch, such as Citigroup C and Morgan Stanley MS, as well as some notable non-financial companies, such as DellDELL and Rio TintoRTP.

Question 5: What is the TSLC?

Hint: It is not the Taiyuan Satellite Launch Center in China.

This has been one of the big guns in the battle to extricate our financial system from the credit crunch.

Now, answers to questions one through five.

Answer to Question 1: LIBOR stands for London Interbank Offered Rate. It is the interest rate at which banks offer to lend funds to other banks in the highly liquid , highly visible London interbank market.

LIBOR is the cornerstone of one of the most liquid and visible markets for short-term funds outside of U.S. Treasury bills .

Many people are not aware of it, but many "variable" interest rates for individuals are keyed to LIBOR. They range from credit card rates to variable mortgages. Homebuyers who sign mortgages linked to LIBOR do so at their own peril.

Answer to Question 2: ARM stands for "adjustable rate mortgage."

For a homebuyer, a key decision is whether to accept a fixed-rate mortgage whose payments stay level for the entire term of the agreement or to opt for one whose payments will vary because of future changes in interest rates.

Here is the definition of from TheStreet.com's glossary:

An adjustable rate mortgage is a long-term loan you use to finance a real estate purchase, typically a home.

Unlike a fixed-rate mortgage, where the interest rate remains the same for the term of the loan, the interest rate on an ARM is adjusted, or changed, during its term.

The initial rate on an ARM is usually lower than the rate on a fixed-rate mortgage for the same term, which means it may be easier to qualify for an ARM. You take the risk, however, that interest rates may rise, increasing the cost of your mortgage.

The rate adjustments, which are based on changes in one of the publicly reported indexes that reflect market rates, occur at preset times, usually once a year but sometimes less often.

What is the relationship between ARMs and LIBOR? The interest rates of ARMs are frequently tied to the LIBOR interest rate. For example, an adjustable rate mortgage agreement might specify that the interest rate will periodically adjust to the 30-day LIBOR rate plus 2.75 percentage points.

The current credit crunch was caused, in part, because many ARMs were issued to "subprime" (high risk) borrowers who were given extremely low initial "teaser" rates on their mortgages. When the initial rates adjusted sharply higher, many of the homeowners were no longer able to maintain their monthly payments and a wave of defaults and foreclosures followed.

To compare fixed and adjustable rate mortgages, check out TheStreet.com's Calculator section.

Answer to Question 3: CMO stands for collateralized mortgage obligation. Here is the definition of it from TheStreet.com's glossary:

CMOs are fixed-income investments backed by mortgages or pools of mortgages.

A conventional mortgage-backed security has a single interest rate and maturity date. In contrast, the pool of mortgages in a CMO is divided into four tranches, each with a different interest rate and term.

Owners of the first three tranches receive regular interest payments, and principal is repaid to reflect the order in which the tranches mature. The fourth tranche is usually a deep-discount zero-coupon bond on which interest accrues until maturity, when the full face value is repaid.

How does this relate to the other credit crunch-related questions? Defaults on CMOs resulted in huge write-offs (or write-downs) at financial institutions, a major factor in the resulting crisis.

Many of the defaults occurred because low "teaser" rates on ARMs transitioned into higher mortgage charges that homeowners couldn't afford to pay. With housing prices falling, they couldn't sell their homes and pay off their debt. The resulting defaults worked their way up the CMO "pyramid" to the highest levels of finance.

The result of the proliferation of CMOs and then their implosion in value helped trigger a serious need for help by some of the largest financial firms.

Answer to Question 4: SWF stands for sovereign wealth fund.

Nations such as Russia and China that accumulate foreign currency through exports traditionally build up foreign reserve balances. But oil-exporting countries such as Saudi Arabia and Abu Dhabi, in addition to some emerging market exporters of manufactured goods, such as China, have accumulated a huge storage of foreign reserves in recent years.

According the International Monetary Fund, SWF assets currently total an estimated $2 trillion to $3 trillion and based on the likely trajectory of current accounts, could reach $10 trillion by the year 2012.

About 20 such countries, including the Norway and Singapore, feel that portions of their excess reserves can be made available for investment purposes. They have created SWFs to invest in vehicles other than the traditional fixed-income treasury securities that normally serve as parking places for their reserves. These investments include equity , as well as debt convertible into equity in some companies wounded by the credit crunch.

How do SWFs relate to ARMs and CMOs? As mentioned earlier, many ARMs were issued at low "teaser" interest rates that have been ratcheting higher in recent months, resulting in defaults. These defaults have resulted in sudden and severe declines in the value of mortgages that have been "pooled" into CMOs. Some major financial institutions, such as Citigroup, that have suffered losses from involvement in CMOs have turned to SWFs for the financing they need to maintain liquidity .

Answer to Question 5: TSLC stands for Term Securities Lending Facility, a new creation of the Federal Reserve.

The Fed has been using this capability to lend Treasury securities to so-called "primary dealers" (large investment institutions) for 28-day periods in exchange for mortgage-backed securities.

This new Fed tool was created in response to the credit crunch and will allow financial firms, such as Lehman Brothers LEH hard hit by the mortgage crisis to maintain the liquidity and balance sheet stability needed to survive the credit crunch.

There's a reason why your teachers put you through the drudgery of learning definitions. Knowing the meaning of words and terms -- including acronyms and abbreviations -- makes your understanding of situations much more complete.