Someone once told me they did not understand how a loan can be sold or bought. The concept did not make sense to them. Here is how I explained it.
The financial markets are basically risk markets. Risk is constantly exchanged and traded between entities. Now that we got some jargon out of the way, let’s get back to talking like normal people.
Let’s say that Tim, a person you know only vaguely, approached you for a loan of $5000 for a month. He said that he really needed it badly and would repay you $6000 at the end of the month. That is a whopping 20% over just one month! You salivate over the opportunity and promptly lend him the money with dollar signs in your eyes. Never have you been able to make a 20% gain out of an investment in just one month. In fact you are really pleased with yourself and feel a bit like a loan shark and giggle in satisfaction.
Problem is it turns out Tim wanted the money to play the roulette table at the local casino. And he is a very bad gambler and has lost literally all of his money last month and his house is likely going to be foreclosed on by the bank. Suddenly your loan shark feelings dissipate and your heart sinks. You are probably never going to see your $5000 again.
Now, you are essentially a nice guy. So you really don’t know how to handle this. You go to Tim and you beg and plead with him to repay your $5000. However Tim tells you to get lost.
Then you get an idea. You decide to go to a real loan shark with a proposal. So you set up a meeting in a dark alley with the local loan shark bad boy, Fred. Ok, ok that doesn’t sound very loan sharky, but bear with me a little, a little drama goes some way to understanding this. Fred is a true loan shark with bad boy enforcers chasing borrowers and beating the money out of them.
You tell Fred that you have a great way for him to make a quick $400 dollars. All he has to do is pay you $5,600 and then ask Tim to repay the $6,000 which is the value of the loan he owes you plus the agreed on interest.
Of course Fred, although his name might be tame, is himself not that tame or lame. He says, “Do you take me for an idiot?” He glares at you and his henchman appear from behind him with menacing looks. You squirm and squeak, “Ok what would you suggest is a fair number?” Fred proposes paying you $5,100 and that is only because he is feeling generous today. You don’t argue. You collect the $5100 from him and then give him Tim’s full address and the casino he gambles at.
Next thing Tim is receiving a visit from Fred telling him that if he does not pay $6000 by the end of the month, he will get beaten up into a pulp and his car and all his possessions will be taken from him and sold to pay off his loan.
So what have you done here? Let’s stop and look at this in financial market terms. What you have done is transferred your risk. You were willing to accept a lower return in exchange for relieving yourself of the risk. You knew that you were not in a position to handle that risk yourself and therefore you sold it. The individual whom you sold it to was a person who knew he could handle that risk and that’s why he bought it. You made money and he made money.
And such is the story in the financial markets. Financial institutions buy and sell risk based on the status of their portfolios and there likelihood of making money out of them. Now let’s not get ahead of ourselves and think that there are banks with henchmen who take on high risks. More, in reality, banks and other lending institutions have a portfolio with a mix of risks, some high, some low and some in between. For a variety of reasons, they are constantly re-jigging this mix to maximize profit. That is what creates the market. Some lenders are willing to buy certain amounts of risk and others willing to sell it.
In fact in this article, we have touched on the basic understanding of a financial derivative. But that’s the subject of other posts. Stay tuned.