Insecure about securities?

We established in my last article what financial institutions are and the fact that they invest in bonds, stocks and other securities. So what are these other securities?

There are three categories of securities: debt, equity and derivative contracts. Debt and equity are the easier to understand and most commonly used but fear not, I will simplify those futures, options and other exotic securities.

Let’s start with debt. Debt securities mainly consist of bonds and debentures. In the last article we defined a bond as effectively an IOU in which the amount borrowed, interest rate and maturity (date the initial money is repaid) are fixed.

A debenture is similar but by no means the same. Debentures are typically used by large companies looking to expand. They tend to be based on the reputation and creditworthiness of the company. The better the company’s reputation and ability to repay the bond the lower the interest they will pay. This is where they differ from bonds; a debenture isn’t backed by collateral (assets – money) but by reputation. There are two main types of debentures: convertible and non-convertible. A convertible debenture can be converted to equity shares at a future point. Conversely, non-convertible debentures do not have this conversion option so they tend to have higher interest rates.

Are there any other differences between debentures and bonds? Well, debentures, particularly non-convertible ones, offer a higher interest rates than bonds due to their lack of security. Bonds are more secure as they are backed by company assets. If a company goes bankrupt then bondholders are paid before debentures holders, making them a safer investment.

The final debt securities we shall discuss are collateralised debt obligations (CDOs), which shot to fame during the financial crisis. In 2004 there were only $157.4 billion of CDOs being issued, but by 2007 the amount grew to $481.6 billion. You may have heard of CDOs in light of the banking crisis but like many of us, including financial ‘experts’, had no idea what they are.
Think of it this way a CDO is essentially a very large bond formed from a pool of bonds. The CDO is broken into tranches (slices) that are of different investment grade before being sold on to institutional investors such as investment banks. This is where the problems arose. These CDOs were rated by credit rating agencies (S&P, Fitch and Moody’s), the riskier the CDO the higher the interest rates and the more money an investor could make. But many of these CDOs contained sub-prime mortgages (mortgages to first time buyers/people with poor credit histories) and the rating agencies still rated these bundles at an incorrectly low risk due confusion between them and less risky mortgages.

CDOs kept being ‘sliced up’ and sold on, moving from balance sheet to balance sheet which made it difficult to calculate the risk of the underlying mortgages. When the underlying sub-prime borrowers finally defaulted, due incredibly high interest rates, investors of CDOs didn’t get the return they’d expected. The overvaluations meant that those who’d invested heavily in CDOs, famously including Lehman Brothers and Bear Stearns, suffered huge losses and holes in their balance sheets.

This is where the nifty and controversial Credit Default Swaps (CDSs) came into the action, bought in order to act as ‘insurance’ so to speak. Goldman Sachs covered themselves using CDS protection, buying it from AIG. After the Sub-prime market collapsed so too did the CDO market meaning AIG was left with massive losses and ultimately bankruptcy.

We shall quickly look at equity securities, which refer to the ownership of a company. There are two main types of stocks an investor can invest in: common stock and preferred stock. Common stock entitles shareholders to voting rights on certain company issues. Preferred stock holders, however, receive dividends when a company profits and is paid before common stock holders if the company goes into liquidation.

Now moving swiftly on to the more exotic securities. Firstly futures, these are basically contracts to deliver a commodity, bond, stock or currency at a specific price at a specific future date. The two parties are pledging to do a transaction in the future; a margin (percentage of the price agreed) is paid on the day of the deal to ensure the price is paid. Investors often invest in futures to reduce the risk of future price fluctuations. Futures are traded at futures exchanges like the DTB (Deutsche Boerse) in Europe and the CME Group in the US.

An option is a contract between two parties on the transaction of an asset at a set price before a given date. There are two types of options: call and put. A call option is when the buyer has the right to buy the asset at a specific price. A put option is when a seller has the right to sell an asset at a specific price. If the option isn’t sold before the set date it is void and worthless. Options differ from futures mainly because there is a right for the seller and buyer but no obligation. An investor must pay a premium when entering an options contract which is seen as the price they pay for the privilege of no obligation.

These are simplified definitions but hopefully you shall now be able to tackle those financial pages and understand the jargon used.