I am wondering how the loan market works, why are people willing to buy a company’s loan and why would an aggregate pool of loans be used as a collateral for asset backed securities.
How can this be sustainable?
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It isn’t clear why such a system isn’t sustainable.
Person A borrows from Person B. Now Person B needs some cash and offers to sell this loan payment stream to Person C who has some extra cash and wants to earn some interest for it. From Person A’s perspective, a loan is a liability – a promise of future payments. From Person B and C’s perspective the loan is an asset – it is a promise to receive future payment, ie it has value. Since the loan has value to the lender, it can be traded.
A bank might make many loans, this means it gives out cash now in return for a promise of future cash inflows. Making loans reduces a banks capacity to make new loans (ie they’ve lent out their cash). Depending on the bank’s strategy, they might not want to wait years for the loans to be paid back. The bank might believe that it is more profitable for them to originate loans and get upfront fees. These fees could be more desirable because they fund the salary and costs of the bank.
The bank then decides to package and sell all the loans they made. This package of loans is a security that has an asset (ie loans) backing it. By selling it, they pass on the risk and the (long term) returns of the loans to other parties in return for immediate cash with which they can now use to make new loans.
As long as the system is managed, the rate of loan defaults remain consistent and the economy is reasonably stable, and people/companies want new loans all the time, it is very sustainable.
I’ve got a buddy who started working for an investment bank after finishing Uni in 2001. He was responsible for building an algorithm for trading INTEREST RATES! Not even the monetary interest itself, but the banks started trading rates! I can’t even get my head around how that actually works in practice!
Loans pay interest and return borrowed principal, so investors who want that guaranteed return will buy others’ debt.
It’s sustainable because companies or other entities need to borrow money, and investors want low risk investment opportunities.
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