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A daily selection of business terms and their definitions / application.

Term: Stuffing

What Is Stuffing?

Stuffing is the act of selling unwanted securities from a broker-dealer’s account to client accounts. Stuffing allows broker-dealer firms to avoid taking losses on securities that are expected to decline in value. Instead, client accounts take the losses. Stuffing can also be used as a means to raise cash quickly when securities are relatively illiquid and difficult to sell in the market.

KEY TAKEAWAY

  • While stuffing is widely regarded as unethical, it can be difficult to prove whether such transactions constitute fraud. Often, broker-dealers are given the power to buy and sell without client consent for discretionary accounts.
  • Stuffing may also refer to when a broker loses a price or quotes a price incorrectly and is obligated by another party to honor and complete a transaction at the quoted or promised price.

How Stuffing Works

While stuffing is widely regarded as unethical, it can be difficult to prove whether such transactions constitute fraud. Often, broker-dealers are given the power to buy and sell without client consent for discretionary accounts. Furthermore, the legal standard for broker-dealers buying securities for these accounts is “suitability,” which can be broadly interpreted. Since discretionary accounts provide so much power to broker-dealers, many financial advisors suggest that customers insist on providing consent for all transactions in their accounts.

Clearly you can assume that stuffing can cause issues as it relates to brokers and customers. This is why stuffing can be quite troublesome for all parties involved. The push to have discretionary accounts give consent to all transactions is a safety protocol that is in the best interest of the client. As the world of Wall Street moves towards openness – procedures in place to avoid stuffing is widely considered a good thing.

Stuffing vs. Quote Stuffing

The stuffing of customer accounts differs from the better-known form of stock market manipulation “quote stuffing.” Quote stuffing is the practice of quickly entering and then withdrawing large orders in an attempt to flood the market with quotes—causing competitors to lose time in processing them.

Quote stuffing is a tactic by high-frequency traders (HFT) in an attempt to achieve a pricing edge over their competitors. In practice, quote stuffing involves traders fraudulently using algorithmic trading tools that allow them to overwhelm markets by slowing down an exchange’s resources with buy and sell orders.

Other Forms of Stuffing

Stuffing may also refer to when a broker loses a price or quotes a price incorrectly and is obligated by another party to honor and complete a transaction at the quoted or promised price. In general, the price to cover the agreed-to transaction is a disadvantage to the individual who quoted it. However, the cost of fulfilling the order is borne by the broker, or the “stuffed” party.

In channel stuffing, salespeople and companies attempt to inflate their sales figures—and earnings—by deliberately sending buyers (such as retailers) more inventory than they are able to sell. Channel stuffing tends to happen closer to the end of quarters or fiscal years to help influence sales-based incentives. This activity can cause an artificial inflation of accounts receivable. When retailers are unable to sell the excess inventory, the surplus goods are then returned and the distributor is required to readjust its accounts receivable (if it adheres to GAAP procedure). As a result, its bottom line suffers after the fact—and after bonuses are paid. In other words, channel stuffing will eventually catch up with a company that fails to prevent it.

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Term: Liquidation Preference

What Is a Liquidation Preference?

A liquidation preference is a clause in a contract that dictates the payout order in case of a corporate liquidation. Typically, the company’s investors or preferred stockholders get their money back first, ahead of other kinds of stockholders or debtholders, in the event that the company must be liquidated. Liquidation preferences are frequently used in venture capital contracts to clarify what investors get paid and in which order in a liquidation event, such as the sale of the company.

KEY TAKEAWAYS

  • The liquidation preference determines who gets paid first and how much they get paid when a company must be liquidated, such as the sale of the company.
  • Investors or preferred shareholders are usually paid back first, ahead of holders of common stock and debt.
  • The liquidation preference is frequently used in venture capital contracts.

Understanding Liquidation Preference

Liquidation preference, in its broadest sense, determines who gets how much when a company is liquidated, sold, or goes bankrupt. To come to this conclusion, the company’s liquidator must analyze the company’s secured and unsecured loan agreements, as well as the definition of the share capital (both preferred and common stock) in the company’s articles of association. As a result of this process, the liquidator is then able to rank all creditors and shareholders and distribute funds accordingly.

The liquidation preference determines who gets their money first when a company is sold, and how much money they are entitled to get.

How Liquidation Preferences Work

The use of specific liquidation preference dispositions is popular when venture capital firms invest in startup companies. The investors often make it a condition for their investment that they receive liquidation preference over other shareholders. This protects venture capitalists from losing money by making sure they get their initial investments back before other parties.

In these cases, there does not need to be an actual liquidation or bankruptcy of a company. In venture capital contracts, a sale of the company is often deemed to be a liquidation event. As such, if the company is sold at a profit, liquidation preference can also help venture capitalists be first in line to claim part of the profits. Venture capitalists are usually repaid before holders of common stock and before the company’s original owners and employees. In many cases, the venture capital firm is also a common shareholder.

Liquidation Preference Examples

For example, assume a venture capital company invests $1 million in a startup in exchange for 50% of the common stock and $500,000 of preferred stock with liquidation preference. Assume also that the founders of the company invest $500,000 for the other 50% of the common stock. If the company is then sold for $3 million, the venture capital investors receive $2 million, being their preferred $1M and 50% of the remainder, while the founders receive $1 million.

Conversely, if the company sells for $1 million, the venture capital firm receives $1 million and the founders receive nothing.

More generally, liquidation preference can also refer to the repayment of creditors (such as bondholders) before shareholders if a company goes bankrupt. In such a case, the liquidator sells its assets, then uses that money to repay senior creditors first, then junior creditors, then shareholders. In the same way, creditors holding liens on specific assets, such as a mortgage on a building, have a liquidation preference over other creditors in terms of the proceeds of sale from the building.

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Term: Foreclosure Crisis

What Was the Foreclosure Crisis?

The foreclosure crisis was a period of drastically elevated property seizures in the U.S. housing market between 2007 and 2010. The foreclosure crisis was one aspect of the financial crisis and Great Recession that developed during this period. The excessive extension of mortgage credit, complicated schemes of mortgage debt securitization, and rapid increase in the number of foreclosures (in an industry ill prepared to process them all) each contributed to the crisis.

KEY TAKEAWAYS

  • The foreclosure crisis was a period of drastically elevated property seizures in the U.S. housing market between 2007 and 2010.
  • Prior to and during the crisis, mortgage servicing companies processed large numbers of loans without adequate review of the information accompanying them.
  • This messy process sometimes led banks to foreclose on the wrong property, miscalculate home values, and, in some cases, give lawyers for homeowners facing foreclosure the chance to throw the case out entirely.
  • Excessive credit expansion during the housing boom, mortgage debt securitization, and a financial system unprepared to cope with a widespread increase in defaults all contributed to the crisis.

Understanding the Foreclosure Crisis

Foreclosure is the legal process that occurs when a homeowner fails to make full principal and interest payments on his or her mortgage. If this issue is not rectified within a specified grace period, the lender has the right to evict the homeowner, take control of the property, and then sell it off.

The foreclosure crisis peaked in Sept. 2010, when approximately 120,000 homes were repossessed in a one-month period. However, its roots lay in a downturn in the housing market that began early in 2007 and blossomed into a crisis when Lehman Brothers declared bankruptcy in Sept. 2008.

Excess Mortgage Credit

Excessively low interest rates due to expansionary monetary policy at the U.S. Federal Reserve, coupled with pro-housing policy by the executive branch, in the 2000’s created a boom in home buying and the extension of credit for home mortgages. This led to generally sketchy or nonexistent oversight of underwriting processes as commission-hungry lenders recklessly dished out hordes of riskier subprime mortgages on sometimes predatory terms to people with low income and creditworthiness. This process was facilitated by the innovation of mortgage debt securitization that allowed lenders to pass the risks of these loans on to investors and continue lending.

The volume of mortgage debt relative to the economy’s ability to repay rose rapidly. Total mortgage debt in the U.S. surpassed U.S. Gross Domestic Product (GDP) beginning in the 1st quarter 2008. Previously this ratio (total mortgage debt to GDP) had ranged between about 30–60% for most of the 20th century.

Debt Securitization

Mortgage banks frequently pocketed fees and then promptly sold the loans on to often inattentive financial institutions, which failed to do appropriate due diligence on the loans. The mortgages were securitized into Mortgage Backed Securities and more complex instruments, which were believed at the time to be an adequate tool to manage the default risk of any one mortgage by combining it with other loans to effectively pool the risk and then distribute it across all holders of the issued security. In addition to not ultimately being an adequate risk management tool (particularly when virtually all home prices fell and defaults became widespread) the securitization of the loans in many cases obscured the links between who held the loans and the borrowers.

Increase in Foreclosures

As the Federal Reserve began to hit the monetary brakes and slow down the massive flow of credit expansion in 2006, problems started to become visible in the industry. Tighter credit conditions made it harder for lenders to continue to extend risky mortgages and made existing mortgages with adjustable interest rates less affordable for existing borrowers. Between 2006 and 2008, delinquency rates on home loans more than doubled and would continue to climb through 2010 as the crisis spread.

When defaults rose, banks suddenly found themselves facing so many foreclosure events that they could not process them efficiently. Prior to and during the crisis, mortgage servicing companies processed large numbers of loans without adequate review of the information accompanying them. It was generally believed that defaults on home loans and the subsequent foreclosures would be individual or at most local events, which could easily be processed and liquidated in the course of lenders’ and loan servicers’ normal operations.

Hasty securitization during the housing boom had, in any cases, led to poor record keeping of the actual ownership of any given mortgage loan. In some cases, banks failed to initiate foreclosures on homes for months after homeowners had ceased to make payments. Record-keeping processes had become so sloppy that banks could not always be sure they actually owned mortgages for properties being foreclosed, and even in some cases foreclosed on mortgage loans that they did not legally own.

Many bank employees simply signed everything that came across their desks, assuming all paperwork to be legitimate. Once the volume of foreclosures rose significantly, robo-signers created significant problems when they signed off on improper paperwork, either because they had no idea what they were signing or because they had to process far too many documents to do the proper work to authenticate them.

Employees that signed off foreclosure documents without reviewing them properly became known as robo-signers.

The effects of inaccurate and obscure paperwork combined with a run up in the number of home loans going into default nationwide created widespread problems. Some banks foreclosed on the wrong properties, miscalculated home values, or, in some cases, gave lawyers for homeowners facing foreclosure the chance to throw foreclosure cases out entirely.

Resolution of the Foreclosure Crisis

The government eventually reached a settlement with the nation’s five largest mortgage servicers, Ally, formerly known as GMAC; Bank of America; Citi; JPMorgan Chase; and Wells Fargo, in 2009. The agreement, known as the National Mortgage Settlement, cost the servicers over $50 billion in penalties and consumer relief payments.

Affected borrowers received principal reductions or refinances for underwater loans, allowing them to avoid foreclosure and stay in their homes. In addition, the settlement required an overhaul of the loan servicing systems overseen by the banks.

Borrowers who lost homes due to foreclosure by these banks in states party to the settlement agreement became eligible for payments of approximately $1,480. The total settlement pay-out amounted to roughly $1.5 billion.

Real estate information company RealtyTrac estimated that one out of every 248 households in the U.S. received a foreclosure notice in Sept. 2012.

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Term: Unamortized Bond Discount

What Is an Unamortized Bond Discount?

An unamortized bond discount is an accounting methodology for certain bonds. The unamortized bond discount is the difference between the par value of a bond—its value at maturity—and the proceeds from the sale of the bond by the issuing company, less the portion that has already been amortized (written off in gradual increments) on the profit and loss statement.

KEY TAKEAWAYS

  • An unamortized bond discount represents a difference between the face value of a bond and the amount actually paid for it by investors—the proceeds reaped by the bond’s issuer.
  • The bond issuer amortizes—that is, writes off gradually—a bond discount over the remaining term of the associated bond as an interest expense. The amount of the bond discount that has not yet been written off is the unamortized bond discount.
  • The flip side or an unamortized bond discount is an unamortized bond premium, which comes into play when the bond is selling for more than its face value.

How Unamortized Bond Discount Works

The discount refers to the difference in the cost to purchase a bond (its market price) and its par, or face, value. The issuing company can choose to expense the entire amount of the discount or can handle the discount as an asset to be amortized. Any amount that has yet to be expensed is referred to as the unamortized bond discount.

A bond discount to par value occurs when the current interest rate associated with a bond is lower than the market interest rate of issues of similar credit risk. If on the date a bond is sold, the listed bond’s coupon or interest rate is below current market rates; investors will only agree to purchase the bond at a “discount” from its face value.

Because bond prices and interest rates are inversely related, as interest rates move after bond issuance, bond’s will be said to be trading at a premium or a discount to their par or maturity values. In the case of bond discounts, they usually reflect an environment in which interest rates have risen since a bond’s issuance. Because the bond’s coupon or interest rate is now below market rates, and investors can get better deals (and better yields) with new issues, those selling the bond have to, in effect, mark it down to make it more appealing to buyers. So the bond will be priced at a discount to its par value.

Accounting for the Unamortized Bon Discount

The bond’s issuer can always elect to write off the entire amount of a bond discount at once, if the amount is immaterial (e.g., has no material impact on the financial statements of the issuer). If so, there is no unamortized bond discount, because the entire amount was amortized, or
written off, in one gulp. Usually, though, the amount is material, and so is amortized over the life of the bond, which may span a number of years. In this latter case, there is nearly always an unamortized bond discount if bonds were sold below their face amounts, and the bonds have not yet been retired.

A bond’s unamortized discount to par will:

  1. turn into a recognized capital loss if the bond is sold before its stated maturity; or,
  2. shrink as the bond’s market price rises with the passage of time as the bond nears its maturity date, which the bond will then be priced at its par value.

Unamoritzed Bond Premium

The flip side or an unamortized bond discount is an unamortized bond premium. A bond premium is a bond that is priced higher than its face value. Unamortized bond premium refers to the amount between the face value and the higher amount the bond was sold at, minus the interest.The unamortized bond premium is the part of the overall bond premium that the issuer will amortize—that is, write off incrementally against expenses in the future. The amortized amount of this bond is credited as an interest expense.

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Term: Central Registration Depository—CRD

What Is the Central Registration Depository (CRD)?

The Central Registration Depository (CRD) is a database maintained by the Financial Industry Regulatory Authority since 2007 for all firms and individuals involved in the U.S. securities industry. It is used to store and maintain information on registered securities and broker firms, as well as individuals who dispense investing and financial advice.

The data within the Central Registration Depository can be used like a background check on brokers and financial advisers, showing any complaints that may have been filed against them, enforcement actions, education, as well as licensing and professional certifications.

Understanding the Central Registration Depository (CRD)

The data found in the Central Registration Depository (CRD) is put in use in FINRA’s BrokerCheck program, which provides background information on more than 6,800 registered broker-dealers and more than 660,000 active registered individuals to potential investors.

KEY TAKEAWAYS

  • The Central Registration Depository (CRD) is a database the Financial Industry Regulatory Authority (FINRA) maintains of all entities in the U.S. securities industry.
  • FINRA’s BrokerCheck program uses CRD information to provide background information on more than 6,800 registered broker-dealers and more than 660,000 active registered individuals.
  • CRD data can be used like a background check on brokers and financial advisers, showing any complaints, enforcement actions, education, as well as licensing and professional certifications.
  • Central Registration Depository data is available on the internet as Web CRD.

Interested parties can also access CRD data by calling BrokerCheck toll-free at (800) 289-9999. Investors can also find such information through their state’s securities regulator or via the North American Securities Administrators Association.

Central Registration Depository (CRD) and BrokerCheck

BrokerCheck offers the following information on brokerage firms:

  • A summary report that provides an overview of the firm
  • A profile of the firm’s ownership
  • A firm history, including any mergers, acquisitions or name changes
  • A description of the firm’s operations, listing its active licenses and registrations, the types of businesses it conducts and other details
  • Arbitration awards and any regulatory or disciplinary events on the firm’s records

BrokerCheck offers the following information on individual brokers:

  • A summary report that provides an overview of the broker and his or her credentials
  • A listing of the broker’s qualifications, including current registrations or licenses and industry exams that the broker has passed
  • Previous employment data for the past 10 years, both in and outside the securities industry, as reported by the broker
  • Any customer disputes or regulatory and disciplinary events on the broker’s record.

Central Registration Depository (CRD) on the Web

FINRA makes the Central Registration Depository available on the web as Web CRD. According to FINRA, “the system contains the registration records of more than 3,700 registered broker-dealers, and the qualification, employment, and disclosure histories of more than 634,000 active registered individuals.”

“Web CRD also facilitates the processing and payment of registration-related fees such as form filings, fingerprint submissions, qualification exams, and continuing education sessions. Web CRD is a secure system for entitled users only. Firms must complete FINRA’s entitlement process noted below to request access to use Web CRD.”

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Term: Commission House

What is a Commission House?

A commission house provides services for buying and selling all kinds of assets, including stocks, mutual funds and bonds — and charges fees for doing so.

KEY TAKEAWAYS

  • A commission house provides services for buying and selling all kinds of assets, including stocks, mutual funds and bonds — and charges fees for doing so.
  • Unlike self-directed brokerages that allow customers to place trades on their own and pay nominal fees, the commissions charged by these full-service providers are often steep and unnecessary.
  • This is especially true with respect to load mutual funds and annuities — two products that already come with high fees. Tack on commissions of up to 10 percent on the principal amount, and investors wind up paying a big chunk to a commission house.

Understanding a Commission House

This is especially true with respect to load mutual funds and annuities—two products that already come with high fees. Tack on commissions of up to 10 percent on the principal amount, and investors wind up paying a big chunk to a commission house.

For example, annuities include a mortality and expense charge, fund management fees and fees to ensure your principal. The annual cost for a variable annuity can range from about 1 percent to as much as 3 percent. Plus, some annuities come with what are known as “back-end surrender charges.” This means if you cash out the annuity, you pay an exit fee typically during the first seven years of ownership.

Load mutual funds work this way: An A-load fund, requires that you pay a transaction fee when you buy it. For example, if you invest $10,000 in one with a 5 percent front-end load, $500 goes to pay the commission and $9,500 is invested.

A B-load fund, on the other hand, penalizes you if you sell it within a certain period. A 6 percent back-end load may be required if you sell in the first year and decreases a percentage each year until it reaches zero.

Finally, a C-fund neither imposes a back- or front-end load, but adds a sales charge into the expense ratio that is much higher than most no-load funds.

These types of fees can eat into principal. For example, two mutual funds that are nearly identical in holdings, but one charges an expense ratio of 0.60% and the other 1.60%, your $10,000 investment in the lower-fee fund grows 10% over 20 years, for a total of $60,300. That same investment in the more expensive fund will grow to only $50,200, applying the same time period and interest rate.

Services might include transactions such as buying and selling bonds, stocks or commodities. More specifically, a commission house gets paid for executing orders, arranging settlement or servicing margin accounts on behalf of their clients. They typically use omnibus accounts to do this.

Example of a Commission House Trade

For example, let’s assume an investor is looking to buy a U.S. growth stock mutual fund. She has the option of buying an A, B, or C-fund. Because she is looking to hold the investment for 10+ years, she decides to go with the B-fund because of the longer time horizon. Because her investment amount is not large, she will not receive a break point with the B-fund, but after a long period of time, like 6 years, the B-fund converts to an A-fund.

Another example would be if another investor has a large amount of money to invest in the above scenario. Because he has $250,000 to invest, he decides to go with an A-fund because he gets a break on the load fees. Additionally, he is a long-term investor and is planning to hold this investment for 10+ years.

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Term: Lipstick Entrepreneurs

What are Lipstick Entrepreneurs?

Lipstick entrepreneurs is a slang term that refers to independent, self-employed businesswomen who sell makeup or other female-oriented products and services. Lipstick entrepreneurs are viewed as leaders of the “femterprise” movement. In periods of economic crises there is often a surge of female-owned start-up businesses or “female enterprises,” due in large part to the perceived job security, income potential and flexibility to accommodate a busy family schedule.

KEY TAKEAWAYS

  • Lipstick entrepreneurs is a slang term that refers to independent, self-employed businesswomen who sell makeup or other female-oriented products and services.
  • Mary Kay, Avon, Rodan + Fields, Tupperware, and Arbonne are among some of the most well-known female-oriented businesses that target lipstick entrepreneurs.
  • Many of these businesses operate as multi-level marketing (MLM) schemes – meaning that individuals not only sell products but also recruit new saleswomen to sell as well.
  • While these opportunities do provide women with a sense of autonomy and extra income, many of the business platforms rely on multi-level marketing schemes that have come under scrutiny by regulators and the public.

    Understanding Lipstick Entrepreneurs

    Mary Kay, Avon, Rodan + Fields, Tupperware, and Arbonne are among some of the most well-known female-oriented businesses that target lipstick entrepreneurs. Many of these businesses operate as multi-level marketing (MLM) schemes – meaning that individuals not only sell products but also recruit new saleswomen to sell as well. Those recruits then may recruit ever more individuals. All along the way, recruited members forfeit some of their sales commissions to pay those that recruited them and those that recruited their own recruiter, etc. Regulators and public revelations have criticized such platforms for making more income off of recruiting salespeople rather than selling actual goods or services. Nonetheless, these platforms remain popular, and there are several success stories of women doing very well and who are quite happy in this line of business.

    Avon U.K. has identified eight primary types of lipstick entrepreneurs:
    1. The Meritocrat—a formerly successful career woman who has chosen self-employment.
    2. The Rescuer—a woman who pursues self-employment as a way to provide for her family, often as a result of her husband’s job or income loss.
    3. The Horizontal Juggler—most often a middle-aged woman who begins her own business in addition to managing childcare duties.
    4. The Double Hitter—a woman who is able to compress a full-time job into part-time hours and run her own business on the side.
    5. The Domestecutive—most often a woman already caring for young children at home who begins a home-based business to provide additional income for her family without having to incur costs for full-time childcare.
    6. The Passionista—a woman who chooses to turn a hobby into her full-time personal business.
    7. The Fledgling—a young woman, typically still in college or recently graduated, who opts to launch her own business either full-time or part-time to earn income and pay off student debt.
    8. The Freewheeler—a woman nearing, or in, retirement who chooses to start a business.

    Example of a Lipstick Entrepreneur

    Let’s assume a mother of young children is looking to get into a side hustle that involves her network of other mothers. She knows that cooking is a huge part of her network’s daily lives, so she decides to get started with Tupperware because their products are known for their durability and quality. Additionally, she knows that throwing a Tupperware party is likely an easy way to get her network together and have fun, all while she capitalizes on the potential commission it’ll bring.

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Term: Trust Indenture

What Is a Trust Indenture?

A trust indenture is an agreement in a bond contract made between a bond issuer and a trustee that represents the bondholder’s interests by highlighting the rules and responsibilities that each party must adhere to. It may also indicate where the income stream for the bond is derived from.

KEY TAKEAWAYS

  • A trust indenture is legal and binding bond contract made between a bond issuer and a trustee to protect the bondholder’s interests.
  • A trust indenture describes the bond’s characteristics and the terms of its callability. It also delineates the amount of additional debt the issuer can assume, and the circumstances and procedures in case of issuer default.
  • Most corporate bond issues over $5 million are required to include a trust indenture, and to file a copy of it with the SEC.

How a Trust Indenture Works

Bonds are issued to lenders or investors to raise money for a corporation or governmental body. To issue a bond, the issuer hires a third-party trustee, usually a bank or trust company, to represent investors who buy the bond. The agreement entered into by the issuer, and the trustee is referred to as the trust indenture.

A trust indenture is a legal and binding contract that is created to protect the interests of bondholders. The trustee’s name and contact information is included in the document, which highlights the terms and conditions that the issuer, lender, and trustee must adhere to during the life of the bond. The section on the trustee’s role is important, as it gives a clear indication of how unforeseen incidents will be dealt with. For example, if a conflict of interest comes up involving the trustee’s role as a fiduciary, in certain trust indentures, the issue must be resolved within 90 days. Otherwise, a new trustee will be hired.

A trust indenture also includes the characteristics of the bond, such as maturity date, face value, coupon rate, payment schedule, and purpose of the bond issue. One section of the trust indenture dictates the circumstances and processes surrounding a default. The indenture establishes a collective action mechanism under which creditors or bondholders can collect in a fair, orderly manner if default by the issuer takes place. A bondholder should be aware of and understand the proper sequence of events, allowing them to take the proper course of action should such a situation occur.

Special Provisions of a Trust Indenture

Protective or restrictive covenants are highlighted in a trust indenture. For example, a trust indenture may indicate whether an issued bond is callable. If the issuer can “call” the bond, the indenture will include call protection for the bondholder, which is the period during which the issuer cannot repurchase the bonds from the market. After the call protection period, the indenture may list the first call dates and any subsequent call dates that the issuer may exercise its right to call. The call premium, that is, the price that will be paid if the issuer repurchases the bond is also indicated on the trust indenture.

Almost all indentures include subordination clauses that limit the amount of additional debt that the issuer can incur, and that dictate that all subsequent debts are subordinated to prior debts. Without such restrictions, an issuer would theroretically be allowed to issue an unlimited amount of debt, increasing bondholders’ exposure to default risk.

Which Bonds Have Trust Indentures?

Trust indentures may not be included in every bond contract, given that some government bonds disclose similar information (the duties and rights of the issuer and bondholders) in a document called the bond resolution.

Many of the current rules regarding trust indentures were established by the Trust Indenture Act (TIA), a piece of legislation passed in 1939 to protect bondholders and investors.

However, most corporate offerings must include a trust indenture. A copy of it must be filed with the Securities and Exchange Commission (SEC) for corporate bonds with aggregate principal issues of at least $5 million. Corporate issues for less than $5 million, municipal bonds, and bonds issued by the government are not required to file trust indentures with the SEC. Of course, these exempted entities may choose to create a trust indenture to reassure prospective bond buyers, if not to adhere to any federal law.

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Term: Cash Per Share

What Is Cash Flow Per Share?

Cash flow per share is the after-tax earnings plus depreciation on a per-share basis that functions as a measure of a firm’s financial strength. Many financial analysts place more emphasis on cash flow per share than on earnings per share (EPS). While earnings per share can be manipulated, cash flow per share is more difficult to alter, resulting in what may be a more accurate value of the strength and sustainability of a particular business model.

KEY TAKEAWAYS

  • Cash flow per share functions as a measure of a firm’s financial strength and is calculated as the after-tax earnings of a company plus depreciation on a per-share basis.
  • By adding back expenses related to amortization and depreciation, a cash flow per share valuation keeps a company’s cash flow numbers from being artificially deflated.
  • Because cash flow per share represents the net cash a company produces, some financial analysts view it as a more accurate measurement of a company’s financial health.

Understanding Cash Flow Per Share

Cash flow per share is calculated as a ratio, indicating the amount of cash a business generates based on a company’s net income with the costs of depreciation and amortization added back. Since the expenses related to depreciation and amortization are not actually cash expenses, adding them back keeps the company’s cash flow numbers from being artificially deflated.

The calculation to determine cash flow per share is:

Cash Flow Per Share = (Operating Cash Flow – Preferred Dividends) / Common Shares Outstanding

Cash Flow Per Share and Free Cash Flow

Free cash flow (FCF) is similar to cash flow per share in that it expands on the attempt to avoid artificial deflation of a company’s cash flow. The free cash flow calculation includes the costs associated with one-time capital expenditures, dividend payments, and other non-reoccurring or irregular activities. The company accounts for these costs at the time they occur as opposed to spreading them out over time.

Free cash flow provides information about the amount of cash that a company actually generates during the time period being examined. Because they view free cash flow as providing a more accurate snapshot of a company’s finances and profitability, some investors prefer to evaluate a stock on its free cash flow per share instead of its earnings per share.

Earnings Per Share vs. Cash Flow Per Share

A company’s earnings per share is the portion of its profit that is allocated to each outstanding share of common stock. Like cash flow per share, earnings per share serves as an indicator of a company’s profitability. Earnings per share is calculated by dividing a company’s profit, or net income, by the number of outstanding shares.

Since depreciation, amortization, one-time expenses, and other irregular expenses are generally subtracted from a company’s net income, the outcome of an earnings per share calculation could be artificially deflated. Additionally, earnings per share may be artificially inflated with income from sources other than cash. Non-cash earnings and income can include sales in which the purchaser acquired the goods or services on credit issued through the selling company, and it may also include the appreciation of any investments or selling of equipment.

Since the cash flow per share takes into consideration a company’s ability to generate cash, it is regarded by some as a more accurate measure of a company’s financial situation than earnings per share. Cash flow per share represents the net cash a firm produces on a per-share basis.

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Term: Employers’ Liability Insurance

Term: Employers’ Liability Insurance

What Is Employers’ Liability Insurance?

Employers’ liability insurance, sometimes known as employment practices liability insurance (EPLI), protects employers from financial loss if a worker has a job-related injury or illness not covered by workers’ compensation. Employers’ liability insurance can be packaged with workers’ compensation insurance to further protect companies against the costs associated with workplace injuries, illnesses, and deaths. Employers’ liability insurance is also called “part 2” of a workers’ compensation policy.

KEY TAKEAWAYS

  • Employers’ liability insurance protects the employer if a worker is not covered by workers’ compensation or if they decide to sue the employer.
  • A company purchases employers’ liability insurance when it buys workers’ compensation.
  • Employers’ liability insurance places limits on the amounts paid out per employee, per injury, or per illness.

How Employers’ Liability Insurance Works

Most employees are covered by workers’ compensation laws established at the state level (federal employees work under federal workers’ compensation laws). States require most employers to carry workers’ compensation insurance.

Workers’ compensation provides some level of coverage for medical expenses and lost wages for employees or their beneficiaries when an employee is injured, falls sick, or is killed as a result of their job. There is no need for the employee to sue the employer to establish fault to qualify for workers’ compensation. However, if an employee feels that workers’ compensation does not adequately cover their loss—perhaps because they feel their employer’s negligence caused their injury—they may decide to sue their employer for punitive damages such as pain and suffering.

Employers’ liability coverage is designed to cover expenses not covered by workers’ compensation or general liability insurance. In the event of a payout under an employers’ liability insurance policy, an employer can help limit their losses by including, as a condition of the payout, a clause that releases the employer and their insurance company from further liability related to the incident in question.

Because workers’ compensation laws don’t cover all workers or injuries, an injured worker may sue their employer for work-related injuries; employers’ liability coverage provides protection for the employer.

The Limits of Employers’ Liability Insurance Policies

Even with adequate employers’ liability insurance coverage, claims can become complicated and costly for employers, particularly in the case of a lawsuit. The cost of defending against such a suit itself can be a major financial loss.

For this reason, many organizations choose to carry employers’ liability insurance to help cover the costs of defending the organization from a lawsuit. A claim may be legitimate or not, but even so, many businesses cannot accept that level of risk, and they take measures to ensure against it.

Employers’ liability insurance covers employers against employee claims alleging discrimination (for example, based on sex, race, age, or disability), wrongful termination, harassment, and other employment-related issues such as failure to promote.

If an employer intentionally aggravates an employee’s work-related injury or illness, employers’ liability insurance will not cover the employers’ financial obligations to the employee, and the employer will have to pay the employee if the employee wins in court.

Employers’ liability insurance policies also place limits on what they must pay out per employee, per injury, and per illness. These limits might be as low as $100,000 per employee, $100,000 per incident, and $500,000 per policy. This insurance does not cover independent contractors.

Special Considerations: Policy Exclusions

Employers’ liability insurance coverage does not cover every situation. Exclusions include criminal acts, fraud, illegal profit or advantage, purposeful violation of the law, and claims arising out of downsizing, layoffs, workforce restructurings, plant closures or strikes, mergers, or acquisitions.

However, many employers’ liability insurance policies provide punitive damages through the “most-favored jurisdiction” clause.

The clause specifies that punitive damages coverage will be regulated by the state law that favors insuring against punitive damages. For example, take a company that has business operations in many states and a claim arises in the state where punitive damages coverage is excluded. If the company was established in a state that supports punitive damages coverage, then the company can get coverage under its employers’ liability insurance policy.

According to the 2017 Hiscox Guide to Employee Lawsuits, an employer without additional liability protection would have to pay an additional $110,000 out of pocket to settle a case.

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Term: Guaranteed Bond

Term: Guaranteed Bond

What Is a Guaranteed Bond?

A guaranteed bond is a debt security that offers a secondary guarantee that interest and principal payments will be made by a third party, should the issuer default due to reasons such as insolvency or bankruptcy. A guaranteed bond can be of either the municipal or corporate variety. It can be backed by a bond insurance company, a fund or group entity, a government authority, or the corporate parents of subsidiaries or joint ventures that are issuing bonds.

KEY TAKEAWAYS

  • A guaranteed bond is a debt security which promises that, should the issuer default, its interest and principal payments will be made by a third party.
  • Corporate or municipal issuers of bonds turn to guarantors—which can be financial institutions, funds, governments, or corporate subsidiaries—when their own creditworthiness is weak.
  • On the upside, guaranteed bonds are very safe for investors, and enable entities to secure financing—often on better terms—than they’d be able to do otherwise.
  • On the downside, guaranteed bonds tend to pay less interest than their non-guaranteed counterparts; they also are more time-consuming and expensive for the issuer, who has to pay the guarantor a fee and often submit to a financial audit.

How a Guaranteed Bond Works

Corporate and municipal bonds are financial instruments used by companies or government agencies to raise funds. In effect, they are loans: The issuing entity is borrowing money from investors who buy the bonds. This loan lasts for a certain period of time—however long the bond term is—after which the bondholders are repaid their principal (that is, the amount they . originally invested). During the life of the bond the issuing entity makes periodic interest payments, known as coupons, to bondholders as a return on their investment.

Many investors purchase bonds for their portfolios due to the interest income that is expected every year.

However, bonds have an inherent risk of default, as the issuing corporation or municipality may have insufficient cash flow to fulfill its interest and principal payment obligations. This means that a bondholder loses out on periodic interest payments, and—in the worst-case scenario of the issuer defaulting—may never get their principal back, either.

To mitigate any default risk and provide credit enhancement to its bonds, an issuing entity may seek out an additional guarantee for the bond it plans to issue, thereby, creating a guaranteed bond. A guaranteed bond is a bond that has its timely interest and principal payments backed by a third party, such as a bank or insurance company. The guarantee on the bond removes default risk by creating a back-up payer in the event that the issuer is unable to fulfill its obligation. In a situation whereby the issuer cannot make good on its interest payments and/or principal repayments, the guarantor would step in and make the necessary payments in a timely manner.

The issuer pays the guarantor a premium for its protection, usually ranging from 1% to 5% of the total issue.

Advantages and Disadvantages of Guaranteed Bonds

Guaranteed bonds are considered very safe investments, as bond investors enjoy the security of not only the issuer but also of the backing company. In addition, these types of bonds are mutually beneficial to the issuers and the guarantors. Guaranteed bonds enable entities with poor creditworthiness to issue debt when they otherwise might not be able to do so, and for better terms. Issuers can often get a lower interest rate on debt if there is a third-party guarantor, and the third-party guarantor receives a fee for incurring the risk that comes with guaranteeing another entity’s debt.

On the downside: Because of their lowered risk, guaranteed bonds generally pay a lower interest rate than an uninsured bond or bond without a guarantee. This lower rate also reflects the premium the issuer has to pay the guarantor. Securing an outside party’s backing definitely increases the cost of procuring capital for the issuing entity. It can also lengthen and complicate the whole issuing process, as the guarantor naturally conducts due diligence on the issuer, checking its financials and creditworthiness.

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Term: Private Company

What Is a Private Company?

A private company is a firm held under private ownership. Private companies may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an initial public offering (IPO). As a result, private firms do not need to meet the Securities and Exchange Commission’s (SEC) strict filing requirements for public companies. In general, the shares of these businesses are less liquid, and their valuations are more difficult to determine.

KEY TAKEAWAYS

  • A private company is a firm that is privately owned.
  • Private companies may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an IPO.
  • The high costs of an IPO is one reason companies choose to stay private.

How a Private Company Works

Private companies are sometimes referred to as privately held companies. There are four main types of private companies: sole proprietorships, limited liability corporations (LLCs), S corporations (S-corps) and C corporations (C-corps)—all of which have different rules for shareholders, members, and taxation.

All companies in the U.S. start as privately held companies. Private companies range in size and scope, encompassing the millions of individually owned businesses in the U.S. and the dozens of unicorn startups worldwide. Even U.S. firms such as Cargill, Koch Industries, Deloitte, and PricewaterhouseCoopers with upwards of $25 billion in annual revenue fall under the private company umbrella.

Remaining a private company, however, can make raising money more difficult, which is why many large private firms eventually choose to go public through an IPO. While private companies do have access to bank loans and certain types of equity funding, public companies can often sell shares or raise money through bond offerings with more ease.

Types of Private Companies

Sole proprietorships put company ownership in the hands of one person. A sole proprietorship is not its own legal entity; its assets, liabilities and all financial obligations fall completely onto the individual owner. While this gives the individual total control over decisions, it also raises risk and makes it harder to raise money. Partnerships are another type of ownership structure for private companies; they share the unlimited liability aspect of sole proprietorships but include at least two owners.

Limited liability companies (LLCs) often have multiple owners who share ownership and liability. This ownership structure merges some of the benefits of partnerships and corporations, including pass-through income taxation and limited liability without having to incorporate.

S corporations and C corporations are similar to public companies with shareholders. However, these types of companies can remain private and do not need to submit quarterly or annual financial reports. S corporations can have no more than 100 shareholders and are not taxed on their profits while C corporations can have an unlimited number of shareholders but are subject to double taxation.

Advantages and Disadvantages of Private Companies

The high costs of undertaking an IPO is one reason why many smaller companies stay private. Public companies also require more disclosure and must publicly release financial statements and other filings on a regular schedule. These filings include annual reports (10-K), quarterly reports (10-Q), major events (8-K), and proxy statements.

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Term: Pro-Rata Tranche

What Is a Pro-Rata Tranche?

A pro-rata tranche is a portion of a syndicated loan that is comprised of two features: a revolving credit facility, and an amortizing term loan. Pro-rata tranches are common within the leveraged loan market or in loans to companies with existing high debt loads.

Within the pro-rata tranche, the revolving credit line will typically have the same ending or maturity date as the term loan. Pro-rata tranches have historically been much larger than institutional tranches in terms of their dollar size.

Syndicated Loans

A syndicated loan, also known as a syndicated bank facility, is financing offered by a group of lenders—referred to as a syndicate—who work together to provide funds for a single borrower. The borrower can be a corporation, a large project, or a sovereign government. The loan can involve a fixed amount of funds, a credit line, or a combination of both. Syndicated loans arise when a project requires too large a loan for a single lender or when a project needs a specialized lender with expertise in a specific asset class.

The Leveraged Loan

A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or a poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and so a leveraged loan is more costly to the borrower. Default occurs when a borrower cannot make any payments for an extended period. Leveraged loans for companies or individuals with high levels of debt tend to have higher interest rates than typical loans; the increased interest reflects the greater level of risk involved in issuing the loans.

Structuring a Leveraged Loan

Most leveraged loans are structured and syndicated to accommodate two primary types of lenders: banks (domestic and foreign) and institutional investment companies. So, leveraged loans consist of pro-rata debt (the pro-rata tranche), and institutional debt.

Investors in pro-rata loans are primarily banks and other financing companies. Loans in the pro-rata tranche allow borrowers to draw down funds, repay them, then draw down again. Investors in institutional loans—which, for the most part, are term loans—include structured finance products, collateralized loan obligations (CLOs), and mutual funds, among other investment vehicles.

Characteristics of the Pro-Rata Tranche

In business and finance pro rata translates from Latin to mean “in proportion.” In this context, pro rata refers to a process where whatever is being allocated will be distributed in equal portions. So, the pro-rata tranche distributes the debt among a number of banks proportionately, thereby greatly reducing each lender’s potential loss or credit risk. This is seen as being favorable toward the syndication of lending institutions.

The pro-rata tranche is usually comprised of working-capital lenders that hold a pro-rata share of the revolving credit facility and the shorter-maturity amortizing term loan. As a general rule, these investors are actively engaged in the business of lending, and the sizes (dollar amount) they hold in any particular loan are relatively significant compared to those of their institutional counterparts.

KEY TAKEAWAYS

  • A pro-rata tranche is a portion of a syndicated loan that contains a revolving credit facility, and an amortizing term loan.
  • Pro-rata tranches are common within the leveraged loan market.
  •  The pro-rata tranche distributes the debt among a number of banks, which greatly reduces each lender’s potential credit risk.

Inherent Risk of the Pro-Rata Tranche

Investing in leveraged loans has more inherent risk than many other investments, including equities. Because of this risk potential, the pro-rata tranche is characterized by a hands-on approach, which often subjects the borrower to tighter monitoring and oversight. An economy that’s experiencing a contraction in its institutional markets would tend to have a somewhat risk-averse lending mentality. So, investors in this economy—particularly in the middle market—might feel more comfortable with a smaller, more active lending group, as opposed to the widely syndicated, large institutional-investor driven leveraged loan market of the 1990s, for example.

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Term: Block House

What is a Block House?

A block house is a particular type of brokerage firm that deals in large trades. In particular it specializes in locating potential buyers and sellers for the large trades. A block house typically deals with institutional clients rather than individual investors, since a single large trade may represent millions of dollars.

KEY TAKEAWAYS

  • A block house, like any brokerage firm, facilitates transactions between buyers and sellers, who pay the firm commissions and other transaction fees. Unlike most brokerage firms, block houses deal primarily in so-called block trades, which, by definition, exceed $200,000 worth of bonds, or 10,000 shares of stock, not including penny stocks.
  • Because of the potential impact that large-volume trades can have on the market value of the securities being traded, block trades usually go through block houses. Block houses can break up the trade into several smaller chunks and channel them through separate brokers to keep market volatility to a minimum.
  • Block houses’ institutional clients include corporations, banks and insurance firms, as well as mutual funds and pension funds that assume significant security positions.

How a Block House Works

A block house, like any brokerage firm, facilitates transactions between buyers and sellers, who pay the firm commissions and other transaction fees. Unlike most brokerage firms, block houses deal primarily in so-called block trades, which, by definition, exceed $200,000 worth of bonds, or 10,000 shares of stock, not including penny stocks. In practice, block trades tend to be much larger. These transactions occur off exchange, or outside of the open market.

Because of the potential impact that large-volume trades can have on the market value of the securities being traded, block trades usually go through block houses. Block houses can break up the trade into several smaller chunks and channel them through separate brokers to keep market volatility to a minimum. That said, even well-executed block trades can significantly impact the market, and some analysts watch block trade activity to anticipate market trends.

Block houses’ institutional clients include corporations, banks and insurance firms, as well as mutual funds and pension funds that assume significant security positions.

The Block House Alternative

Institutions seeking to avoid brokerage fees and commissions also may conduct block trades directly, without employing a block house as an intermediary, on the fourth market. While primary, secondary and third markets are public markets accessible to every kind of investor, the fourth market is more exclusive and less transparent. Fourth-market trades are restricted to institutions and are only made public after the transaction is complete.

It’s this last feature of the fourth market that offers another advantage to institutions initiating block-size trades besides low transaction fees. Because the trade is conducted with less transparency, there is less risk that the market will shift before the transaction is complete.

The fourth market also precludes the possibility that a block house trader will use knowledge of an impending block trade in a fraudulent practice known as front running. In 2013, a senior equity trader at Dallas-based Cushing MLP Asset Management, was caught conducting his own trades just before block trades from his firm’s clients that were likely to boost the stock’s price. Not only did his scheme unethically benefit him by at least $532,000 over the course of 132 transaction; it set his own interests in opposition to those of his clients, who specifically relied on him to manage price exposure.

Example of Block House Trading

Let’s assume a hedge fund is long 1,000,000 shares of ABC stock and they are looking to sell a block through Cantor Fitzgerald (a block house). They want to use a block house because ABC typically trades 200,000 shares a day on average. So, a large trade of this size would greatly impact the price of ABC.

The trader at the hedge fund will call up or send an instant message to their dedicated saleswoman at Cantor Fitzgerald looking for buyers of ABC. The hedge fund will not divulge that they are looking to sell 1 million shares, instead they will say 100,000 shares in an attempt to bring out buyers. The saleswoman will alert the other sales traders that she is a seller of 100,000 shares of ABC. The other salespeople will reach out to their relationships and even those that hold positions in ABC, in an attempt to see if they are interested in buying shares of ABC. Because ABC is rather illiquid, it trades by appointment.

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Term: Economic Tsunami

What Is an Economic Tsunami?

An economic tsunami is a widespread set of economic troubles caused by a single significant event. The downstream effects of economic tsunamis generally spread to broad geographic areas, multiple industry sectors, or both.

KEY TAKEAWAYS

  • An economic tsunami is a widespread set of economic troubles caused by a single significant event.
  • The downstream effects of economic tsunamis generally spread to broad geographic areas, multiple industry sectors, or both.
  • Globalization is one of the main reasons why the shockwaves of an economic downturn in one part of the world can be felt on the other side of the globe.

Understanding Economic Tsunamis

Economic tsunamis take their name from natural tsunamis, which are abnormally large waves triggered by a disturbance to the ocean floor, such as an earthquake. The resulting wave causes widespread destruction once it reaches the shore and floods low-lying coastal areas, and it can even cross oceans in their effects.

Likewise, economic tsunamis generate destructive effects beyond the geographic area or industry sector in which the triggering event takes place. These consequences can illustrate previously undetected connections between parts of the global economy that create a ripple effect only under extreme stress.

Depending on the severity of the consequences and the mechanism by which they spread, economic tsunamis can lead to new regulations as markets attempt to adapt to or prevent a future recurrence under similar conditions.

Example of an Economic Tsunami

The 2008 global financial crisis sits among the most prevalent recent examples of an economic tsunami. The subprime mortgage market in the U.S. acted as a trigger in this case, with large investment banks (IBs) miscalculating the amount of risk in certain collateralized debt instruments.

Unexpectedly high default rates led to large financial losses in portfolios with high credit ratings, which triggered massive losses for highly leveraged investments made by financial institutions (FIs) and hedge funds. The resulting liquidity crunch spread rapidly beyond the subprime mortgage market. In response, the U.S. government took over secondary mortgage market giants Fannie Mae and Freddie Mac, while Lehman Brothers filed for bankruptcy. Losses at Bear Stearns and Merrill Lynch led to acquisitions of those companies by JPMorgan Chase & Co. and Bank of America, respectively.

Foreign banks also suffered losses through investments affected by the economic crisis. Iceland’s banking sector suffered a nearly complete collapse following the subprime crisis, tanking the nation’s economy. Meanwhile, in the United Kingdom, the British government stepped in to bail out its banking sector.

The U.S., the U.K., and Iceland all undertook varying degrees of regulatory reform following the crisis. Iceland’s economy essentially reinvented itself to rely more heavily upon tourism than on international banking. The U.S. introduced a range of regulatory controls via the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 as well as the Housing and Economic Recovery Act of 2008. Many of these regulations strengthened oversight of mortgage lending. The U.K. response included the introduction of the Financial Services Act in 2012.

Special Considerations

Globalization is one of the main reasons why an economic downturn in one part of the world can be felt on the other side of the globe. Without widespread economic interdependence between markets across the world, economic tsunamis, along with their associated costs, would essentially cease to exist. Free trade agreements (FTAs) between different countries have made companies more competitive and helped to lower the prices that consumers pay for various goods and services, but the benefits of globalization come with important caveats.

Closer economic and financial relations also lead to increased transmission of economic shocks. The increased interconnectedness of national economies means that an economic downturn in one country can create a domino effect through its trading partners. Nations now depend on each other to stay afloat. If the economy of a key buyer or seller of goods and services experiences turbulence, this could be expected to have a knock-on effect, impacting exports and imports in other countries.

Increasing interconnectedness of global financial markets over time has also become a major factor in the propagation of economic tsunamis. This can be seen above in the example of the global financial crisis and the Great Recession as well as in other prior events such as the Asian currency crisis and the Long Term Capital Management incident.

In the first six months of 2019, the United States’ biggest trade partners were, in the following order: Mexico, Canada, China, Japan, and Germany.

Trade Wars

Growing calls from some quarters to unwind globalization are also stirring up threats of economic tsunamis while possibly also mitigating the risk posed by economic tsunamis by reducing dependence on foreign supply chains.

An example of this is the trade war between China and the United States. A bitter standoff between the world’s two biggest economies is hurting companies from both countries, weighing on equity markets, investments, the labor market, and consumer spending. U.S. exports to China fell from $64 billion in the first six months of 2018 to $51 billion in the first half of 2019. According to the Federal Reserve, President Donald Trump’s protectionist tariffs are indirectly costing the average American household over $1,000 a year while admittedly creating thousands of American jobs.

Other countries have been caught in the crossfire, too. The International Monetary Fund (IMF) warned that America’s trade spat with China could cost the global economy roughly $700 billion by 2020.

On the other hand, to the extent that increasingly protectionist trade policies achieve their stated goals of increasing reliance on domestic supply chains and decreasing dependence on foreign markets, they may reduce the danger of economic tsunamis being transmitted between economies and increase the overall resilience of the domestic economy to economic shocks.

Financial Crises

Globally connected financial markets represent a major transmission mechanism for economic tsunamis. Stocks, bonds, commodities, currencies, and derivatives are all traded across effectively global markets in the modern economy. A disruption to trading or collapse in the value of an asset in any one market can very quickly spread across the planet. Moreover, the major financial institutions whose rise and fall has the power to move markets are interconnected around the world with investors and governments in a complex web of financial obligations and counterparty risk.

This increases the risk of economic tsunamis originating in or traveling through international financial networks as seen in the financial crisis of 2008 and the Great Recession. Indeed several economists, including Kenneth Rogoff and Carmen Reinhart in their 2009 book, This Time It’s Different, have documented clear, persistent links between the degree of international capital mobility and financial crises.

Since the Great Recession, total global capital flows, which peaked in 2007, have fallen somewhat, as documented by a 2017 IMF study, “Global Financial Resets.” However, other measures of financial globalization have steadily risen, such as foreign direct investment and foreign holdings of equity and credit instruments. In addition to conventional financial arrangements, the global shadow banking system (which was so heavily implicated in the 2008 financial crisis) has surged, increasing in total assets by 75% between 2010 and 2017, according to the international Financial Stability Board based in Basel, Switzerland. This all suggests that global financial transmission of economic tsunamis will remain a substantial risk to the world economy.

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Term: Consumer Credit

What Is Consumer Credit?

Consumer credit is personal debt taken on to purchase goods and services. A credit card is one form of consumer credit.

Although any type of personal loan could be labeled consumer credit, the term is usually used to describe unsecured debt that is taken on to buy everyday goods and services. It is not usually used to describe the purchase of a house, for example, which is considered a long-term investment and is usually purchased with a secured mortgage loan.

Consumer credit is also known as consumer debt.


Important: The average American had a credit card balance of $5,700 in early 2019.

Understanding Consumer Credit

Consumer credit is extended by banks, retailers, and others to enable consumers to purchase goods immediately and pay off the cost over time with interest. It is broadly divided into two classifications: installment credit and revolving credit.

Installment Credit

Installment credit is used for a specific purpose and is issued at a defined amount for a set period of time. Payments are usually made monthly in equal installments. Installment credit is used for big-ticket purchases such as major appliances, cars, and furniture. Installment credit usually offers lower interest rates than revolving credit as an incentive to the consumer. The item purchased serves as collateral in case the consumer defaults.

Revolving Credit

Revolving credit, which includes credit cards, may be used for any purchase. The credit is “revolving” in the sense that the line of credit remains open and can be used up to the maximum limit repeatedly, as long as the borrower keeps paying a minimum monthly payment on time.

It may, in fact, never be paid off in full as the consumer pays the minimum and allows the remaining debt to accumulate interest from month to month. Revolving credit is available at a high interest rate because it is not secured by collateral.

KEY TAKEAWAYS

  • Installment credit is used for a specific purpose and is issued for a set period of time.
  • Revolving credit is an open-ended loan that may be used for any purchase.
  • The disadvantage of revolving credit is the cost to those who fail to pay off their entire balances every month and continue to accrue additional interest charges.
  • The average American had a credit card balance of $5,700 as of early 2019.

Special Considerations

Consumer credit use reflects the portion of a family or individual’s spending that goes to goods and services that depreciate quickly. It includes necessities such as food and discretionary purchases such as cosmetics or dry cleaning services.

Consumer credit use from month to month is closely measured by economists because it is considered an indicator of economic growth or contraction. If consumers overall are willing to borrow and confident they can repay their debts on time, the economy gets a boost. If consumers cut back on their spending, they are indicating concerns about their own financial stability in the near future. The economy will contract.

Advantages of Consumer Credit

Consumer credit allows consumers to get an advance on income to buy products and services. In an emergency, such as a car breakdown, that can be a lifesaver. Because credit cards are relatively safe to carry, America is increasingly becoming a cashless society in which people routinely rely on credit for purchases large and small.

Revolving consumer credit is a highly lucrative industry. Banks and financial institutions, department stores, and many other businesses offer consumer credit.

Disadvantages of Consumer Credit

The main disadvantage of using revolving consumer credit is the cost to consumers who fail to pay off their entire balances every month and continue to accrue additional interest charges from month to month. The average annual percentage rate on new offers of credit cards was 19.24% as of April 2019. Department store credit cards averaged 25.74%. A single late payment can boost the cardholder’s interest rate even higher.

In early 2019, the average American had a credit card balance of $5,700, according to Federal Reserve data. Overall, Americans owed a total of $1.04 trillion to credit card issuers.

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Term: Crude Oil

What Is Crude Oil?

Crude oil is a naturally occurring, unrefined petroleum product composed of hydrocarbon deposits and other organic materials. A type of fossil fuel, crude oil can be refined to produce usable products such as gasoline, diesel, and various other forms of petrochemicals. It is a nonrenewable resource, which means that it can’t be replaced naturally at the rate we consume it and is, therefore, a limited resource.

KEY TAKEAWAYS

  • Crude oil is the raw natural resource that is extracted from the earth and refined into products such as gasoline, jet fuel, and other petroleum products.
  • Crude oil is a global commodity that trades in markets around the world, both as spot oil and via derivatives contracts.
  • Many economists agree that crude oil was and remains the single most important commodity in the world as it is the primary source of energy production.

Understanding Crude Oil

Crude oil is typically obtained through drilling, where it is usually found alongside other resources, such as natural gas (which is lighter and therefore sits above the crude oil) and saline water (which is denser and sinks below). It is then refined and processed into a variety of forms, such as gasoline, kerosene, and asphalt, and sold to consumers.

Although it is often called “black gold,” crude oil has ranging viscosity and can vary in color from black to yellow depending on its hydrocarbon composition. Distillation, the process by which oil is heated and separated in different components, is the first stage in refining.

History of Crude Oil Usage

Although fossil fuels like coal have been harvested in one way or another for centuries, crude oil was first discovered and developed during the Industrial Revolution, and its industrial uses were first developed in the 19th century. Newly invented machines revolutionized the way we do work, and they depended on these resources to run. Today, the world’s economy is largely dependent on fossil fuels such as crude oil, and the demand for these resources often spark political unrest, as a small number of countries control the largest reservoirs. Like any industry, supply and demand heavily affect the prices and profitability of crude oil. The United States, Saudi Arabia, and Russia are the leading producers of oil in the world.

In the late 19th and early 20th centuries, however, the United States was one of the world’s leading oil producers, and U.S. companies developed the technology to make oil into useful products like gasoline. During the middle and last decades of the 20th century, however, U.S. oil production fell dramatically, and the U.S. became an energy importer. Its major supplier was the Organization of the Petroleum Exporting Countries (OPEC), founded in 1960, which consists of the world’s largest (by volume) holders of crude oil and natural gas, reserves. As such, the OPEC nations had a lot of economic leverage in determining supply, and therefore the price, of oil in the late 1900s.

In the early 21st century, the development of new technology, particularly hydro-fracturing, has created a second U.S. energy boom, largely decreasing OPEC’s importance and influence.

Adverse Effects of Relying on Oil

Heavy reliance on fossil fuels is cited as one of the main causes of global warming, a topic that has gained traction in the past 20 years. Risks surrounding oil drilling include oil spills and ocean acidification, which damage the ecosystem. Many manufacturers have begun creating products that rely on alternative sources of energy, such as cars run by electricity, homes powered by solar panels, and communities powered by wind turbines.

Investing in Oil

Investors may purchase two types of oil contracts: futures contracts and spot contracts. People may invest in oil as a speculative asset, as a portfolio diversifier, or as a hedge against related positions.

Spot Contracts

The price of the spot contract reflects the current market price for oil, whereas the futures price reflects the price buyers are willing to pay for oil on a delivery date set at some point in the future. The futures price is no guarantee that oil will actually hit that price in the current market when that date comes; it is just the price that, at the time of the contract, purchasers of oil are anticipating. The actual price of oil on that date depends on many factors.

Commodity contracts bought and sold on the spot markets take effect immediately: Money is exchanged, and the purchaser accepts delivery of the goods. In the case of oil, the demand for immediate delivery versus future delivery is small, because in no small part of the logistics of transporting oil to users. Investors, of course, don’t intend to take delivery at all (although there have been situations where an investor’s error has resulted in this), so futures contracts are more common, among both end-users and investors.

Futures Contracts

An oil futures contract is an agreement to buy or sell a certain number of barrels set amount of oil at a predetermined price, on a predetermined date. When futures are purchased, a contract is signed between buyer and seller and secured with a margin payment that covers a percentage of the total value of the contract. End-users of oil purchase on the futures market to lock in a price; investors buy futures to essentially gamble on what the price will actually be down the road, and profit by guessing correctly. Typically, they will liquidate or roll over their futures holdings before they would have to take delivery.

There are two major oil contracts in which oil market participants are most interested. In North America, the benchmark for oil futures is West Texas Intermediate (WTI) crude, which trades on the New York Mercantile Exchange (NYMEX). In Europe, Africa, and the Middle East, the benchmark is North Sea Brent crude, which trades on the Intercontinental Exchange (ICE). While the two contracts move somewhat in unison, WTI is more sensitive to American economic developments, and Brent responds more to those overseas.

While there are multiple futures contracts open at once, most trading revolves around the front-month contract (the nearest futures contract); for this reason, it’s is known as the most active contract.

Spot vs. Future Oil Prices

Futures prices for crude oil can be higher, lower or equal to spot prices. The price difference between the spot market and the futures market says something about the overall state of the oil market and expectations for it. If the futures prices are higher than the spot prices, this usually means that purchasers anticipate the market will improve, so they are willing to pay a premium for oil to be delivered at a future date. If the futures prices are lower than the spot prices, this means that buyers expect the market to deteriorate.

“Backwardation” and “contango” are two terms used to describe the relationship between expected future spot prices and actual futures prices. When a market is in contango, the futures price is above the expected spot price. When a market is in normal backwardation, the futures price is below the expected future spot price.

The prices of different futures contracts can also vary depending on their projected delivery dates.

Forecasting Oil Prices

Economists and experts are hard-pressed to predict the path of crude oil prices, which are volatile and depend on various situations. They use a range of forecasting tools and depend on time to confirm or disprove their predictions. The five models used most often are:

  • Oil futures prices
  • Regression-based structural models
  • Time-series analysis
  • Bayesian autoregressive models
  • Dynamic stochastic general equilibrium graphs

Oil Futures Prices

Central banks and the International Monetary Fund (IMF) mainly use oil futures contract prices as their gauge. Traders in crude oil futures set prices by two factors: supply and demand and market sentiment. However, futures prices can be a poor predictor, because they tend to add too much variance to the current price of oil.

Regression-Based Structural Models

Statistical computer programming calculates the probabilities of certain behaviors on the price of oil. For instance, mathematicians may consider forces such as behavior among OPEC members, inventory levels, production costs, or consumption levels. Regression-based models have strong predictive power, but scientists may fail to include one or more factors, or unexpected variables may step in to cause these regression-based models to fail.

Bayesian Vector Autoregressive Model

One way to improve upon the standard regression-based model is by adding calculations to gauge the probability of the impact of certain predicted events on oil. Most contemporary economists like to use the Bayesian vector autoregressive (BVAR) model for predicting oil prices, although a 2015 International Monetary Fund working paper noted these models work best when used on a maximum 18-month horizon and when a smaller number of predictive variables are inserted. BVAR models accurately predicted the price of oil during the years 2008-2009 and 2014-2015.

Time-Series Models

Some economists use time-series models, such as exponential smoothing models and autoregressive models, which include the categories of ARIMA and the ARCH/GARCH, to correct for the limitations of oil futures prices. These models analyze the history of oil at various points in time to extract meaningful statistics and predict future values based on previously observed values. Time-series analysis sometimes errs, but usually produces more accurate results when economists apply it to shorter time spans.

Dynamic Stochastic General Equilibrium (DSGE) Model

Dynamic stochastic general equilibrium (DSGE) models use macroeconomic principles to explain complex economic phenomena; in this case, prices of oil. DSGE models sometimes work, but their success depends on events and policies remaining unchanged since DSGE calculations are based on historical observations.

Combining the Models

Each mathematical model is time-dependent, and some models work better at one time than another. Since no one model alone offers a reliably accurate prediction, economists often use a weighted combination of them all to get the most accurate answer. In 2014, for instance, the European Central Bank (ECB) used a four-model combination to predict the course of oil prices to generate a more accurate forecast. There have been times, however, when the ECB has used fewer or more models to capture the best results. Even so, unforeseen factors like natural disasters, political events or social upheavals may derail the most careful of calculations.

Where to Find Breaking News About Oil

Because the crude oil market is so liquid (no pun intended)—with positions and prices changing by the second—staying on top of the industry (and events that might affect it, like those mentioned above) is crucial for investors and traders. There are many websites that report crude oil news, but only a few broadcast the breaking news and current prices. The following three offer the most current information.

MarketWatch

MarketWatch provides “business news, personal finance information, real-time commentary, investment tools, and data.” Due to this diversity, it might not necessarily stand out as targeting oil, but it is always one of the first to break stories, putting out headlines as soon as news hits. These headlines can be found at the top center of its home page under the tab “Latest News.” MarketWatch also provides details when necessary, posting stories, sometimes only a paragraph or two, to elaborate on its headlines, and updating them throughout the day.

The site provides current oil price information, stories detailing oil’s price path—including pre-market and closing bell commentary—and multiple feature articles. The company has an active link on its landing page showing the price of WTI. Within most articles, MarketWatch also includes an active link to the price of oil, so when you read an article the price quote included is current.

In addition, MarketWatch offers a more in-depth analysis of the economic news driving oil prices.

Reuters Commodities Page

Reuters has a commodity-specific portion of its website that releases breaking oil news, background stories and current prices. It also offers more recent in-depth stories on, and analysis of, the sector as a whole, including price-driving sector updates (it’s superior to MarketWatch in this regard) and is good at releasing any imperative news as it is made public. Reuters also publishes frequent pieces detailing oil’s price movements and factors behind those movements.

CNBC

CNBC has an online page dedicated to oil news. During U.S. market hours, it publishes relevant oil-specific pieces. This works out to be about every hour when you look at its main page. CNBC frequently updates its articles when there is a price movement in oil, but it does not provide a live feed to oil prices like MarketWatch. It makes up for this, though, by providing a good breadth of oil sector stories including all major price movers and price-driving developments.

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Term: At Par

Term: At Par

What is At Par?

The term at par means at face value. A bond, preferred stock, or other debt instruments may trade at par, below par, or above par.

Par value is static, unlike market value, which fluctuates with market demand and interest rate fluctuations. The par value is assigned at the time the security is issued. When securities were issued in paper form, the par value was printed on the face of the security, hence face value.

Understanding At Par

Due to the constant fluctuations of interest rates, bonds and other financial instruments almost never trade exactly at par. A bond will not trade at par if current interest rates are above or below the bond’s coupon rate, which is the interest rate that it yields.

KEY TAKEAWAYS

  • Par value is the price at which the bond was issued.
  • Its value then fluctuates based on prevailing interest rates and market demand.
  • The owner of a bond will receive its par value at its maturity date.

A bond that was trading at par would be quoted at 100, meaning that it traded at 100% of its par value. A quote of 99 would mean that it is trading at 99% of its face value.

A New Bond

When a company issues a new bond, if it receives the face value of the security the bond is said to have been issued at par. If the issuer receives less than the face value for the security, it is issued at a discount. If the issuer receives more than the face value for the security, it is issued at a premium.

The coupon rate, or yield, for bonds, and the dividend rate for preferred stocks, have a material effect on whether new issues of these securities are issued at par, at a discount, or at a premium.

Common stocks have a par value, usually a penny a share. This is an anachronism and has no relationship with its market value.

A bond that trades at par has a yield equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer.

Example of At Par

If a company issues a bond with a 5% coupon, but prevailing yields for similar bonds are 10%, investors will pay less than par for the bond to compensate for the difference in rates. The bond’s value at its maturity plus its yield up to that time must be at least 10% to attract a buyer.

If prevailing yields are lower, say 3%, an investor is willing to pay more than par for that 5% bond. The investor will receive the coupon but have to pay more for it due to the lower prevailing yields.

Par Value for Common Stock

Par value for common stock exists in an anachronistic form. In its charter, the company promises not to sell its stock at lower than par value. The shares are then issued with a par value of one penny. This has no effect on the stock’s actual value in the markets.

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Term: Double Irish With a Dutch Sandwich

What Is the Double Irish With a Dutch Sandwich?

The double Irish with a Dutch sandwich is a tax avoidance technique employed by certain large corporations, involving the use of a combination of Irish and Dutch subsidiary companies to shift profits to low or no-tax jurisdictions. The technique has made it possible for certain corporations to reduce their overall corporate tax rates dramatically.

KEY TAKEAWAYS

  • The double Irish with a Dutch sandwich is a tax avoidance technique employed by certain large corporations.
  • The scheme involves sending profits first through one Irish company, then to a Dutch company and finally to a second Irish company headquartered in a tax haven.
  • The legislation passed in Ireland in 2015 ends the use of the tax scheme for new tax plans. Companies with established structures were able to benefit from the old system until 2020.

Understanding Double Irish With a Dutch Sandwich

The double Irish with a Dutch sandwich is just one of a class of similar international tax avoidance schemes. Each involves arranging transactions between subsidiary companies to take advantage of the idiosyncrasies of various national tax codes.

These techniques are most prominently used by tech companies because these firms can easily shift large portions of profits to other countries by assigning intellectual property rights to subsidiaries abroad.

The double Irish with a Dutch sandwich is generally considered to be an aggressive tax planning strategy used by some of the world’s largest corporations. In 2014, it came under heavy scrutiny, especially from the U.S. and the European Union, when it was discovered that this technique facilitated the transfer of several billion dollars annually tax-free to tax havens.

Special Considerations

Due largely to international pressure and the publicity surrounding the use of double Irish with a Dutch sandwich, the Irish finance minister passed measures to close the loopholes in the 2015 budget. The legislation effectively ends the use of the tax scheme for new tax plans. Companies with established structures were able to benefit from the old system until 2020.

Requirements for Double Irish With a Dutch Sandwich

The first Irish company would receive large royalties from sales sold to U.S. consumers. The U.S. profits and therefore taxes are dramatically lowered and the Irish taxes on the royalties are very low. Due to a loophole in Irish laws, the company can then transfer its profits tax-free to the offshore company, where they can remain untaxed for years.

The second Irish company is used for sales to European customers. It is also taxed at a low rate and can send its profits to the first Irish company using a Dutch company as an intermediary. If done right, there is no tax paid anywhere. The first Irish company now has all the money and can again send it onward to the company in the tax haven.

Example of the Double Irish With a Dutch Sandwich

In 2017, Google reportedly transferred 19.9 billion euros or roughly $22 billion through a Dutch company, which was then forwarded to an Irish company in Bermuda. Companies pay no taxes in Bermuda. In short, Google’s subsidiary in the Netherlands was used to transfer revenue to the Irish subsidiary in Bermuda.

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Term: Asset

What Is an Asset?

An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit. Assets are reported on a company’s balance sheet and are bought or created to increase a firm’s value or benefit the firm’s operations. An asset can be thought of as something that, in the future, can generate cash flow, reduce expenses, or improve sales, regardless of whether it’s manufacturing equipment or a patent.

KEY TAKEAWAYS

  • An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.
  • Assets are reported on a company’s balance sheet and are bought or created to increase a firm’s value or benefit the firm’s operations.
  • An asset can be thought of as something that, in the future, can generate cash flow, reduce expenses or improve sales, regardless of whether it’s manufacturing equipment or a patent.

Understanding Assets

An asset represents an economic resource for a company or represents access that other individuals or firms do not have. A right or other access is legally enforceable, which means economic resources can be used at a company’s discretion, and its use can be precluded or limited by an owner.

For an asset to be present, a company must possess a right to it as of the date of the financial statements. An economic resource is something that is scarce and has the ability to produce economic benefit by generating cash inflows or decreasing cash outflows.

Assets can be broadly categorized into short-term (or current) assets, fixed assets, financial investments, and intangible assets.

Current assets are short-term economic resources that are expected to be converted into cash within one year. Current assets include cash and cash equivalents, accounts receivable, inventory, and various prepaid expenses.

While cash is easy to value, accountants periodically reassess the recoverability of inventory and accounts receivable. If there is evidence that accounts receivable might be uncollectible, it’ll become impaired. Or if inventory becomes obsolete, companies may write off these assets.

Assets are recorded on companies’ balance sheets based on the concept of historical cost, which represents the original cost of the asset, adjusted for any improvements or aging.

Fixed Assets

Fixed assets are long-term resources, such as plants, equipment, and buildings. An adjustment for the aging of fixed assets is made based on periodic charges called depreciation, which may or may not reflect the loss of earning powers for a fixed asset.

Generally accepted accounting principles (GAAP) allow depreciation under two broad methods. The straight-line method assumes that a fixed asset loses its value in proportion to its useful life, while the accelerated method assumes that the asset loses its value faster in its first years of use.

Financial Assets

Financial assets represent investments in the assets and securities of other institutions. Financial assets include stocks, sovereign and corporate bonds, preferred equity, and other hybrid securities. Financial assets are valued depending on how the investment is categorized and the motive behind it.

Intangible Assets

Intangible assets are economic resources that have no physical presence. They include patents, trademarks, copyrights, and goodwill. Accounting for intangible assets differs depending on the type of asset, and they can be either amortized or tested for impairment each year.

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