August 31, 2015
Surely one of the oldest professions is being a lender of money. As far back as 9,000 BC there is evidence of money lending. The Babylonian civilization which thrived around 1750 BC had rules that governed the lending and paying back of debt, as laid out in the Hammurabi Code. From the money changers in the Temple of Jerusalem at the time of Christ, to today’s global mega banks, the history of lending money is very long. Lending money today is changing, and we investors should examine how the ancient act of lending continues to evolve.
There are essentially two main ways to deploy or invest money. I can buy and own an asset, or I can lend money. When I buy a stock, a piece of art or gold, I own the asset. As the owner I make money if the value of the asset goes up. Lending money can be accomplished in a number of ways. If you opened a savings account as a child you were lending money to the provider of the account, which was typically a bank. They paid you a rate of interest with a promise to return your money when you wanted it. If you invest in a bond or a fixed income product in actuality you are lending money. The borrower just happens to be a government, a municipality, or a corporation. When I loan money I am merely providing my capital to someone who needs it, and who promises to do two things, pay me back and pay me a little extra known as interest.
The world of lending is enormous and includes all the governments and companies in the world that borrow money. The bulk of this lending is done in what is called the public market, where securities represent the loan. A large and growing private lending market is now emerging. Today’s innovative borrowers and enterprising capitalists are changing long-established approaches to lending money. Potential borrowers are looking beyond traditional ‘intermediaries’ like banks. Instead borrowers and investors have developed ways to conduct business directly with one another. Private lenders have found they can lend money to credit worthy borrowers (both individuals and companies) and earn attractive rates of interest. In the past several years pools of capital have been created to help diversify the major risk of lending, defaulting borrowers. The old school approach of an investor lending to one borrower provides for a binary return, the investor makes money if the loan is repaid, or loses if the borrower defaults. With the right lending vehicle, the loan risk can be spread among many different borrowers. Not all will default and, just like an investor in the stock market who attempts to diversify their stock portfolio risk, the loan portfolio has diversified risk.
Low interest rates have caused investors with capital to seek new ways to deploy their money. The private lending markets offer potentially attractive opportunities to suitable investors but of course the risk, and any illiquidity, have to be properly understood. Private lending to creditworthy borrowers is a market that is growing, and worthy of further understanding.