Banks make loans to individuals and companies who then pay back the amount of the loan plus interest. Since banks make money from loans, those loans are considered the bank’s assets. However, those assets also come with liability. What if someone defaults on a loan the bank has given them and is unable to pay back the money they owe to the bank? This presents a risk or liability for the bank. While the bank stands to make money by collecting the interest on a loan, they also could potentially lose money if a person is unable to repay the loan.
Sometimes banks will decide they no longer wish to service individual loans. They will then gather a large number of these loans and clump them together with other similar type loans to create a reference portfolio. This portfolio can subsequently be sold to an issuer. At that point, the bank no longer owns those loans. Selling the loans allows the bank to use the profits to make more loans. This is one fundamental way that banks make money.
Issuers can be investment trusts, corporations, or even domestic and foreign governments. Issuers take these reference portfolios and use them to create securities that they then sell to investors. Issuers aggregate the securities into smaller pools based on the level of risk. These are called tranches.
Investors can then choose tranches based on their risk tolerance. Some may be more risk-averse than others, and they will select tranches with lower risk and a corresponding more moderate rate of return. In contrast, other investors may seek higher returns and therefore take on riskier securities.
Investors buying securities at varying levels of risk ensures liquidity in the market. The investors are paid back as loans are paid off over time, so it provides them with a steady source of income. Securities have other benefits beyond just turning illiquid assets into liquid ones and making money for investors, though. Since they free up capital for banks and other financial institutions, those banks and institutions are then able to make more loans to individuals and companies – thus growing the economy.
Along with the good, though, there are some drawbacks to securities. Though most loans included in securities are backed by some tangible asset such as a house or a car, there is no guarantee that the asset will still be as valuable as it originally was if debtors are unable to repay their loans. If the debtors default and the asset is no longer as valuable, investors can be left holding the bag. As such, investors must have an understanding of the debt that is underlying the product they’re buying. It is incumbent on them to do their due diligence and research their investments. Since the debts have been bundled in securities, transparency can be limited. Investors are also at risk if debtors pay their debts off early or refinance their loans as they won’t receive as high a return on investment without the interest the loan would have accrued over time.