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Glossary of Finance and Economic Terms (A-F)

Please Note: All definitions used in this glossary were derived from the Freddie Mac Seller/Servicer Guide glossary. For specific information governing the use of material presented on this website, see our Terms & Conditions.

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A3 Rating. Credit rating indicating a relatively low level of default risk that is awarded by Moody’s Investors Services; other companies provide ratings expressed in slightly different terms. The highest rating conferred by Moody’s is AAA, given to a security with the greatest margin of investor safety against credit loss, even under severe economic conditions. The lowest rating, C, is assigned to a bond with a high probability of defaulting. Bonds rated from BAA to just short of Aaa are considered "investment grade." Those rated BA and below are "speculative grade." Moody’s provides a finer gradation of credit risk with numerical modifiers, such as A3 and BAA1.

Adjustable-Rate Mortgage (ARM). Mortgage repaid at a rate of interest that increases or decreases over the life of the loan based on market conditions. The interest charged is recalculated on predetermined dates by adding the current value of a specified financial index to a fixed amount--or margin.

Adverse Selection. With respect to mortgage pricing, a process that results in lenders obtaining only the "worst" loans. For example, a lender using average-cost pricing is taking a risk that the best loans will go to a competing firm that uses risk-based pricing to offer those borrowers a lower interest rate. The remaining business available to the cost-based pricing company represents an "adverse" pool of loans.

Affinity Program. Business partnership in which one company offers special rates or services to another company’s existing clientele and by which both companies expect to increase revenue. For example, an airline may award frequent-flyer miles to customers who sign up for telecommunications services with a designated company.

Affordable Gold. Freddie Mac’s family of mortgage products designed specifically to meet the needs of lower-income borrowers who typically earn 100 percent or less of area median income.

Analytics. Computer-based tools that evaluate cash flows under a variety of assumptions and scenarios.

Appreciation. Increase in the value of a property or other asset.

Arrearage. Amount borrower owes to lender for missed payments and the associated costs of collecting the debt.

Area Median Income. Midpoint in the family-income range for a metropolitan statistical area or for the non-metro parts of a state. The figure often is used as a basis to stratify incomes into low, moderate and upper ranges.

Asset-Backed Security (ABS). Debt obligation repaid from the future cash flows of different types of property or rights. This type of security often carries credit enhancements that limit investor exposure to the credit risk of the seller.

Auto-Dialer. Automated dialing capability used by debt collectors to save on the time and expense of manually dialing phone numbers. If, after entering a phone number, the dialing system detects an answering machine, busy signal or no answer, it automatically dials the next number on a programmed list. The system’s user sets calling frequencies. Call is connected to agent only if someone answers. When connection is made, the system also provides the agent with the account’s status.

Average-Cost Pricing. Method of pricing mortgages that charges identical interest rates for a set of loans despite differences in their anticipated risks.

Backtesting. With respect to capital-adequacy practices, a statistical test to determine risk-evaluation model accuracy that compares a company’s actual losses with loss estimates predicted by the firm’s internal Value-at-Risk model.

Balloon. Type of fixed-rate mortgage that becomes due in full after, typically, five or seven years, although the monthly mortgage payments in those first years are amortized according to a 30-year repayment plan.

Basis Point. One one-hundredth of a percent; for example, 100 basis points equals 1 percentage point. Often used as a unit of measurement to convey differences in mortgage-interest rates.

Basle Accord. Agreement reached in 1988 by central-banking authorities from 12 countries, including the U.S., to establish consistency among international capital standards. The resulting risk-based capital standards originally focused on default-risk exposure, but subsequent amendments have incorporated minimum capital standards for market-risk exposure. The landmark meeting was sponsored by the Bank for International Settlements located in Basle, Switzerland.

Bid Price. Specified amount a prospective buyer is ready to pay for a security, to which the seller responds by accepting, rejecting or countering the offer.

Bond. Obligation by a borrower to eventually repay money obtained from a lender. The bondholder buying the investment is entitled to receive both principal and interest payments from the borrower. A bond may be issued for $1 million or more but generally trades in smaller denominations of $1,000 increments.

Book Value. In accounting terms, the value of an asset as recorded on a company’s balance sheet. Book value is usually the same as the acquisition price, but may be the market value when an asset, like that held in a bank’s trading book, is Marked-to-Market. 

Business Risk. Generic term that refers to the chance of significant loss to a company whenever the actual value of an outcome falls short of its expected value. Business-risk losses can arise from a variety of events including natural disasters, credit events--such as loan default or corporate default--or market changes in interest rates, exchange rates, commodity prices or stock prices.

Call Option. The right, but not the obligation, to buy something at a specified price in the future. A mortgage essentially gives the borrower a call option because the homeowner can refinance at any time without triggering a prepayment fee, unless the loan is a prepayment- protection mortgage.

Callable Debt. Liability that gives the issuer the right to redeem the debt before the scheduled maturity date by paying the investor a predetermined price.

Cap. Provision in a debt contract or option agreement that protects the owner of a variable interest-rate instrument from interest-rate risk. The cap locks in the maximum interest rate for which the owner is responsible, even if prevailing rates climb higher.

Capital. Difference between a firm’s assets and liabilities. Also known as net worth or owners’ equity. Regulators--overseeing the safety and soundness of financial institutions for the protection of deposit-insurance funds and, potentially, taxpayers--typically require these firms to maintain a minimum level of capital to offset their risks that could result in a loss of asset value.

Capital Market Line. Linear depiction of the risk and reward tradeoffs associated with various securities traded in the capital markets. Typically, as the level of risk increases, the return expected also rises.

Capital Reserves. Difference between a firm’s assets and liabilities, also known as net worth or owner’s equity. These reserves are earmarked as a cushion against a firm’s unexpected losses, as well as those anticipated in the normal course of business.

Capital-to-Assets Ratio. Form of leverage ratio expressed as shareholder equity divided by total assets, often used as a capital-adequacy measure.

Cash-Out Refinance. As defined for the April 1999 issue of SMM, a refinance transaction resulting in a new mortgage at least 5 percent larger than the outstanding balance of the old mortgage. Presumably, this will eliminate cases in which the financing of transactional costs alone accounts for the higher balance. Excess loan proceeds above 5 percent are assumed to indicate the amount of equity against which the owner has borrowed to free up funds for other purposes.

Catastrophic Risk-Transfer Bonds (CAT Bonds). Investment instrument, usually issued by an insurance company, to serve as a hedge against losses a firm must pay out on a portfolio of property or casualty insurance contracts. The more severe the losses, the lower the return to the investor. A catastrophic loss, perhaps caused by a storm or earthquake, could result in a reduction or loss of interest payments, investor principal or both interest and principal. A lower-than-anticipated loss rate may lead to above-market interest payments.

Collateral. In mortgage finance, the property that secures or guarantees the discharge of a mortgage obligation.

Collateralized Mortgage Obligation (CMO). Type of bond that divides cash flows from a pool of mortgages into multiple classes with different maturities or risk profiles. Although similar to Real Estate Mortgage Investment Conduits (REMICs), CMOs count as balance-sheet assets that issuers must capitalize against default, whereas REMICs do not.

Collections. Referral of a past due account to an intermediary that specializes in enlisting a delinquent borrower’s cooperation in bringing a debt current. In the mortgage industry, a successful intervention averts foreclosure of the collateral backing the loan while keeping to a minimum the lender’s resulting expenses caused by the delay or foreclosure proceedings. Common collections practices include increasingly frequent phone and written contact with the borrower until a resolution is reached.

Common Equity. Stock ownership in a firm that gives common shareholders a lower claim than preferred share-holders on the assets of a firm in the event of bankruptcy. A firm cannot pay common dividends until after it has paid its creditors and made dividend payments to preferred stockholders. Shareholders cannot redeem their stock through the firm but can sell the shares privately.

Community Reinvestment Act (CRA). 1977 federal law requiring depository institutions to serve the credit needs of the communities in which they do business, including low- and moderate-income communities. Regulators’ approval of mergers and expansions is determined partly by assessments of CRA compliance.

Conditional Default Rate. Proportion of all loans outstanding in a pool at the beginning of a time period that are expected to default during that period.

Conditional Prepayment Rate (CPR). Measure of the proportion of outstanding mortgages in a security that pre-pay in a month, extrapolated out to a year. The higher the CPR, the faster the mortgages in the pool are prepaying.

Conforming Jumbo Mortgage. Conventional mortgages originated between July 1, 2007 and December 31, 2008 with original unpaid principal balances (UPB) that exceed Freddie Mac's base conforming loan limits ($417,000 for a 1-unit property). The original UPB of a conforming jumbo mortgage may not exceed the lesser of (i) 125 percent of the “area median house price” (as determined at a county level) of a residence of applicable size or (ii) 175% of the base conforming loan limit - $729,750 for a 1-unit property (except in Alaska, Hawaii, Guam and the U.S. Virgin Islands, where the original UPB of each newly conforming jumbo mortgage may not exceed $1,094,625). The conforming jumbo loan limits were enacted as part of the Economic Stimulus Act of 2008 and these mortgages remain eligible for sale to Freddie Mac in perpetuity. However, these mortgages are eligible for sale only on a negotiated basis.

Conforming Mortgage. Loan eligible for sale to Freddie Mac or Fannie Mae because the original mortgage amount does not exceed an annually adjusted dollar threshold. In 2009, for example, the conforming-loan limit for a one-family home is $417,000. Higher limits apply in Alaska, Hawaii, Guam and the U.S. Virgin Islands and to multi-unit properties.

Conservator (Conservatorship). In mortgage finance, an entity appointed by a government agency or the courts to assume control of a critically undercapitalized or otherwise weakened firm in an effort to nurse it back to financial health then turn back the firm’s management to its owners.

Contract Rate. Actual interest rate, as specified in the mortgage note, that the borrower has agreed to pay.

Conventional Mortgage. Residential loan neither insured nor guaranteed by the federal government through its Federal Housing Administration (FHA Department of Veterans Affairs (VA) or Rural Housing Service (RHS) programs. See also Government-Backed Mortgage. 

Conventional Mortgage Home Price Index (CMHPI). Index jointly developed by Freddie Mac and Fannie Mae to track changes in the prices of detached, one-unit, single-family homes that serve as collateral for mortgages funded by the two secondary-mortgage-market firms. The index is constructed using regression techniques and observations of actual sales prices or appraised values for the same homes over time. After identifying consecutive transactions by matching street addresses, price changes are calculated for each set of consecutive events pertaining to the same property. The CMHPI database contains records of more than 11.4 million repeat-transactions.

Convexity Risk. Chance of loss to an investor due to a decline in a financial instrument’s value characterized by larger and larger losses for each 1-percentage-point change in interest rates.

Core Capital. For purposes of meeting Freddie Mac’s and Fannie Mae’s minimum capital standards, the component of a firm’s capital that consists of common- and preferred-shareholder equity. Excludes Subordinated Debt, Loan-Loss Reserves and other reserves counted by a regulator as part of the firm’s total capital.

Correlation. Statistical measure of the degree to which two variables move together in a linear fashion, either positively or negatively, that convertsCovariance to a standard scale ranging from -1 to +1.

Counterparty. Opposing party in a swap or other financial transaction.

Covariance. Statistical measure of the degree to which two variables move together, in a linear fashion, either positively or negatively, that, unlike Correlation, is expressed in the units of measurement of the two variables.

Credit Derivative. Financial instrument with option-like characteristics designed to transfer credit default risk from one party to another.

Credit Enhancement. Measures taken to boost the credit rating of a security. Examples of credit enhancements include overcollateralization, which involves pledging additional assets against default; a letter of credit, which is a document issued by a bank promising to make good on a debt; and subordination. See Subordinated Tranche.

Credit Markets. Marketplace in which investors trade securities on the basis of their respective appetites for default risk.

Credit Risk. Chance of loss to an investor arising from the loan default of a borrower who fails to make promised interest or principal payments when due or the corporate default of a business partner or other counterparty. See Default Risk.

Credit Score. Statistical summary of information contained in an individual’s credit report that serves as a measure of the person's creditworthiness. It is calibrated to predict a certain type of outcome, such as a default on a mortgage or a declaration of bankruptcy.

Credit Spread. Difference between the interest rate on an asset and an analogous risk-free asset, such as a Treasury security. The wider the spread, the greater the investor’s return, or compensation, for taking on the higher credit risk of investment asset. Also considered a measure of relative credit risk.

Credit Union. Cooperative organization of stockholding consumer members joined by a common bond, such as employment, association or residence. The institution serves members only, taking their deposits and extending mortgages and loans to them.

Credit-Rating Agency. One of four recognized firms that support investors by analyzing, reporting and monitoring the credit risk of companies or bonds and other fixed-issue investments. The agency formulates a relative credit rating after collecting and analyzing relevant credit-related information. Investors use the rating to help determine whether to invest in that bond.

Credit-Bureau Score. Statistical summary of information contained in an individual’s credit report that serves as a measure of the person's creditworthiness. When used in the mortgage-lending industry, the score is calibrated to predict the likelihood of a loan going into default. For example, Fair, Issac and Co., one of the country’s more prominent scoring-system developers, employs a spectrum of "FICO" values that range from a high-default-risk score of around 400 to a low-default-risk score of around 800.

Critical Capital Level. Capital-adequacy measure considered the trigger point for regulatory intervention and Conservatorship. This measure of capital to assets is defined differently for depository institutions versus Freddie Mac and Fannie Mae.

Cure. When a borrower makes restitution for loan arrearages by repaying missing installments, refinancing the loan or paying off the mortgage by selling the collateral property.

Cure Rate. Of a portfolio of delinquent mortgages, the percentage brought current or repaid. In the first case, the borrower makes missed payments, bringing the mortgage up to date. In the second instance, the borrower pays off the mortgage in full, thereby canceling the loan obligation.  

Currency Swap. Arrangement where two parties sell to each other a currency with a commitment to re-exchange the principal amount at the maturity of the deal, with an adjustment made to compensate for changes in principal value.

Debt Ratio. Measure used by lenders to gauge the ability of a borrower to repay a mortgage. The measure takes two forms. The housing debt-to-income ratio reflects how much of a borrower’s income goes toward paying the mortgage. The total debt-to-income ratio expresses how much income goes toward making payment on all debts owed by a borrower. Generally, lenders prefer to approve borrowers with a housing-debt ratio of 28 percent or less and a total-debt ratio of 36 percent or less, although the growing use of automated underwriting provides greater latitude in these areas.

Debt Restructuring. Term used in commercial real estate lending when a lender agrees to modify the terms of a loan, given the inability of the borrower to repay the debt as agreed. Often, the debt is restructured to include unpaid interest, penalties and other fees, and the borrower is given an extended time to pay. Debt restructuring also can include a new mortgage rate.

Default. When a borrower is in breach of a note or a security instrument--such as a mortgage or deed of trust--thereby entitling a lender to initiate foreclosure proceedings.

Default Risk. Chance of loss to an investor arising from a borrower’s failure to make promised interest or principal payments when due. Also known as Credit Risk. 

Deflation. Decrease in the economy’s general price level, as measured, for example, by the consumer price index.

Delinquency. Delinquency occurs when all or part of the borrower's monthly installment of principal and interest (and possibly the escrow) remain unpaid after the due date.

Department of Veterans Affairs (VA). Federal agency that, among its functions, provides lenders with low- or no-down-payment mortgage financing to offer to eligible veterans. The agency partially guarantees a participating lender against loss upon the foreclosure of a VA loan.

Deposit Insurance. Government-backed insurance of banks, thrifts and credit unions that protects depositors in the event of an organization’s failure. The fund, financed through premiums charged to insured institutions, currently covers losses up to $100,000 per deposit account.

Depreciation. Decline in the value of a property or other asset.

Derivative. Financial instrument with contractual payments indexed to changes in the value of an underlying item without requiring possession of the item.

Discount Point. Unit of measure equal to 1 percent of the principal amount of a loan. Borrowers pay discount points as a means of obtaining a lower mortgage-interest rate.

Disinflation. Deliberate attempt by a government or central bank to arrest an inflationary trend in the economy by decreasing the money supply or raising interest rates.

Diversification Effect. Resulting reduction in the overall risk of a portfolio or firm when its individual component risks do not move together. Also known as Portfolio Effect. 

Dual-Indexed Mortgage. Adjustable mortgage built around two variable indexes; the interest due on the remaining loan balance moves with shifts in market interest rates, and the borrower's monthly payment fluctuates with wage changes.

Due Date. Contractually established date--often the first day of the month--at which time a mortgage borrower must make the scheduled payment, although the loan agreement may give the borrower a grace period to make payment before a late charge is assessed.

Duration. Length of time an asset or liability survives. The duration is shorter than the stated term if the investment is terminated early. The duration of a mortgage and its funding are well-matched if the expected durations are similar and both durations respond similarly to changes in interest rates.  

Duration Analysis. Process for determining overall interest-rate sensitivity of a portfolio’s value based on the durations of individual assets and liabilities. Duration refers to the percentage change in an instrument’s value resulting from a 1-percent change in interest rates. Technically, duration is an instantaneous measure describing the change in price due to a change in yield.

Economic Capital. Amount of capital deemed appropriate by a firm to cover worst-case losses in all but the most extreme economic scenarios. Accordingly, it represents the largest cumulative loss a company can withstand without going bankrupt. Reflects a firm’s internally determined capital needs, as opposed to the capital requirements imposed by external regulators.

Equal Credit Opportunity Act (ECOA). 1974 federal law prohibiting lenders from discriminating based on age, sex, religion, color, national origin or marital status.

Equity. Value that an owner has in real estate over and above liens against it. Equity is measured as the difference between the property’s fair market value and current level of indebtedness. See Capital.. 

Factory-Built Housing. Generic term for the type of housing constructed in a factory and transported to a residential site as opposed to assembled piece by piece at the construction site. Examples of factory-built housing include manufactured, modular and panelized housing.

Federal Deposit Insurance Corporation Improvement Act (FDICIA). Law passed by Congress in 1991 to address the thrift-industry crisis. The statute mandates a series of successively more stringent regulatory actions as the capital of an insured bank or thrift deteriorates by various degrees. The law also gives regulators authority to take more timely action when dealing with troubled institutions.

Federal Financial Institutions Examinations Council (FFIEC). Interagency group devoted to promoting uniformity in the regulatory oversight of many of the country’s banking institutions, as practiced by five federal financial regulators: the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS).

Federal Housing Administration (FHA). Federal agency that provides mortgage insurance for residential loans with very low down payments. The borrower pays the insurance premium and the lender is the beneficiary. In the event of borrower default, FHA pays the lender an amount covering some or all of the outstanding loan balance. Although FHA does not lend the mortgage money, it does set underwriting and construction standards.

FICO Mortgage Credit Score. Statistical credit evaluation score provided by Fair, Issac and Co., one of the country’s leading scoring-system developers. The spectrum of “FICO” values ranges from a high default-risk score of around 400 to a low default-risk score of around 800.

Float. Interest earned on borrower payments between the time the servicer receives the installments and then remits the funds to the investor.

Foreclosure. When used in the mortgage business, a legal proceeding initiated by a lender to take possession of the collateral property to secure a defaulted mortgage.  

Forward Loan Commitment. Legally binding contract to provide a loan at some future point. For example, a lender or funding source might agree to provide a long-term mortgage to replace a short-term building loan once a rental project under construction is completed, occupied and leased.

Forward Transaction. Privately arranged commitment between two parties to make a particular exchange on a specific date at a price determined at the time of the transaction.  

Fully Indexed Rate. Interest rate on an adjustable-rate mortgage that is determined by the value of the underlying index plus the margin before discounts or rate caps, either periodic or lifetime, are applied.

Funding Risk. Probability that interest rates will rise, making it more expensive for investors to fund mortgages or more costly for investors to hold fixed rates of return when higher-yield opportunities become available.

Future. Financial instrument used to arrange the prospective purchase or sale of a commodity on a date and at a price agreed to in advance by the parties. Futures confer on both buyer and seller the obligation to execute the stipulated trade. Futures trade on an organized exchange and are valued daily at market prices.

Futures Contract. Written agreement to buy or sell an item at a future date at price determined when the contract is signed. Unlike an option, a futures contract confers on both parties both the right and the obligation to trade. Futures contracts trade on an organized exchange and are valued daily at market prices.  

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