Template:M intro pb lending and financing

What is the difference between “lending” — the outright extension of credit to a borrower — and “financing” — providing money to a counterparty against its existing assets? Is there one? Is the latter just a special case of the former?

We tend to see “lending” and “financing” as alternative forms of indebtedness, to be contrasted with “equity investment”. On this view financing is a sort of safer type of lending, with recourse to the asset should the borrower fail, but still, in essence, a time-bound loan of a resource for a fee as opposed to a permanent disposition of capital in return for a share of profits.

I want to make the case that this is a miscategorisation. If there is a fundamental divide, it is between outright capital allocation on one hand, whether in the form of equity or debt, and asset optimisation on the other — which includes all forms of financing. The split should look like this:

Investments	Financing
Credit risk	Asset risk
Equity Unsecured Loan Guaranteed loan Bond Guaranteed Bond	Mortgage lending Margin lending Securities financing Swaps Exchange traded derivatives Securitisations

Unsecured lending

Unsecured lending is a form of outright capital allocation: the lender contributes fresh capital to the borrower’s business against just the borrower’s promise to pay it back. In terms of its risk profile this is similar to equity injection: repayment depends on the continued existence of the borrower. Hence, a borrower needs good credit standing to be able to take an unsecured loan: the lender must make an assessment of the borrower’s existing assets and likely outstanding liabilities. It will only lend if it is reasonably satisfied there are more assets than liabilities, by an amount significantly greater than the size of the loan. A bank may lend unsecured to a well-established business; it is not likely to lend unsecured to a new business.

Secured lending

Where a company does not have good enough credit standing to raise an unsecured loan, it can offer its assets as security: thereby giving the lender a first claim on those assets ahead of any other creditor in the borrower’s bankruptcy.

This might be a general claim over its assets (an all-obligations debenture) or a specific claim over a designated asset. The classic case is a security interest over the asset acquired with the loan: a mortgage over real estate, for example. Here, the lender's main credit assessment will be on the value of the mortgaged asset rather than the general credit standing of the borrower.

For that to work the borrower will have to contribute a significant portion of the asset purchase price from its own funds: this maybe as much as thirty or forty percent.

Mortgage financing is suitable for assets like real estate that tend not to depreciate, or alternatively, assets which depreciate at a rate comparable to the repayment schedule of the loan.

While sophisticated borrowers may be subject to loan-to-value covenants which require additional collateral or even acceleration rights, in a standard mortgage arrangement, a lender cannot require further security should the value of the mortgage asset fall below its loan value, so the amount of buffer the borrower is required to contribute will be great.

Margin lending

A variation on secured lending is “margin lending”: here, there are two further enhancements: firstly, the borrower must always ensure there is a minimum buffer between the market value of the purchased asset and the outstanding loan value: this is the “margin”. If the asset’s market value declines against the loan, the lender may “call for margin”: this means the borrower must pay a cash amount back to the lender to restore that buffer.

This is quite a lot riskier for the lender as it is vulnerable to market fluctuations in the value of the asset. It is therefore only suitable for assets which are relatively “liquid” in that they can be sold quickly and the loan repaid with the sale proceeds, thereby taking the borrower “off risk”.

A couple of implications here:

Firstly, assets of sufficient liquidity to be suitable for margin loans tend to be financial instruments (bonds, shares, transferable instruments) which do not depreciate, are not consumed or used as such — rather held — and are easily transferable. Capital assets which do depreciate and are consumed or used (real property, plant and machinery and so on) tend to be less suitable for margin lending as they are much less liquid and more likely to sell at a significant discount.

Secondly, Because the assets are not needed for consumption or practical use, they can be delivered outright to the lender, who can in turn raise money against them in the market. This changes the funding implications of a margin loan dramatically.

Finally, whereas normal secured loans tend to be fixed duration, long-term arrangements — a mortgage might run for twenty-five years — margin loans tend to be undated arrangements (from the lender’s perspective) but callable from the borrower’s: they can be repaid at will. Because the lender can raise money against the margin assets and is entitled to call for further margin from the borrower should the loan-to-value drop, it has no particular reason to terminate the loan. The borrower on the other hand, will typically be a financial market investor and will only want financing for as long as the asset is performing and otherwise suitable for its portfolio so we wish to have the right to end the arrangement without notice.

Interest rates for margin loans, whilst floating, will tend to be significantly cheaper than the fixed interest rates one would expect on a mortgage of equivalent size.

Asset financing distinguished from lending

we can regard “asset financing” as the transformation of an asset the financing counterparty already owns into something more liquid — cash. As long as the asset covers the notional financed, as generally it will, the financing party has no risk to the borrower itself. Nor does the beneficiary increase its capital.

We draw this distinction in part because of a linguistic looseness around the word “borrow”, and in part because we are accustomed to thinking of capital investment chiefly in terms of its return and not risk. The return of an equity investment is very different to the return of a loan.

But their risk profiles of a loan and a share are similar, and closely correlated. And, from a legal eagle’s perspective, it is the risk of a investment that will cause us trouble, not its return.

First, some terminology:

In an outright, unsecured loan, the lender allocates capital to the borrower, apropos nothing, against an expectation of a payment by the borrower of a return. A lender assumes the borrower’s bare credit risk.

In a financing, the financier provide assumes the market risk of a third-party asset, against the payment of a financing rate. If the financed asset declines in value, the loan value is adjusted by means of a margin mechanism. As long as the asset doesn’t suddenly collapse, the borrower’s prospects don’t come into the risk assessment of a financing arrangement.

Linguistics looseness about borrowing

Bankers use the word “borrow” in a strange way. In ordinary usage, “borrowing” implies possession but not ownership:

“May I borrow your car for the weekend?”
“I have borrowed this book from the library.”

We have possession of what we borrow but the lender always owns it.

Borrowing is different when it comes to banking. Firstly, because money is an unownable anti-asset, you cannot “borrow” it in this ordinary sense.

Cash is special: as long as you hold it, no one, including the person who “lent” it to you, has any proprietary claim on that money. This follows because money cannot be owned, only held. To “lend” money is to give it away absolutely against an enforceable promise from the recipient to pay not the same money, but an “equivalent” amount of any fungible money, back.

If we were talking about anything other than money, we would not call this “borrowing”.

Why mention this now? Because it rubs out one of the fundamental differences between a “loan” and an “investment”: the lender does not “lend” “her” money to the borrower, the same way she might lend her car. Rather, she gives money to the borrower on terms that the borrower will later pay back an equal sum, plus interest.

Return metrics

The expected returns at maturity from lending and financing are similar. We calculate them by reference to an independent index that has nothing to do with the borrower: an interest rate.

By contrast an equity investment has no term, no “par value” and pays a variable return. The rising or falling share price measures how the market values the business: that is the share’s “return metric”. A failure to beat a benchmark, reach a target or meet analyst’s expectations is still a return, just a disappointing one. It is correlated with the risk of business failure but is still not a “risk metric”. It is not a “default” on the contractual obligation the share represents. Only the company’s bankruptcy would be that and — well — too late.

The redemption value of a “performing” equity at any time is n, where n can be any number above zero, and while bankrupt is zero.

The redemption value at maturity of a “performing” unsecured loan is n where n is the loan’s stated principal amount, and is less than n at any time when the company is bankrupt.

This is simply a function of the different investment profiles of the loans and equities. They are designed with different payoffs and different exit mechanisms. A loan has a predictable payoff and a determined exit point; an equity has an unpredictable payoff and no determined exit point.

You could — and I do — make an argument that outright lending and owning are more like to each other, and less like asset financing. Asset financing is more like the kind of capital market activity we do not usually think of as lending — prime brokerage, swap trading, securities financing and futures trading.

Interlude: isn’t all lending a subcategory of financing?

But, JC, by your own logic, therefore, every loan is extended against delivery of an asset: the legal debt claim against the borrower. It does not matter whether it takes the shape of an abstract contractual claim visible only to the law and provable only in court, or a tangible instrument representing indebtedness, freely transferable on its own terms. In each case the lender can, more or less easily, raise money against the asset represented by its loan. Indeed, in the broadest sense, that is all banks do.

Does this not prompt a warping of swaptime: does it not, instead, say that rather than financing being a subspecies alone, alone is a subspecies of a financing?

In one sense, yes; in another, no. The key difference is the measure of performance: in one case, the borrower provides a legal claim only against itself; in the other, it provides a margined claim against an unrelated asset. Buy the margin mechanism it adjusts the size of its claim to the prevailing size of the asset. Unless there is a sudden extreme crash, the lender’s claim is only to the present value of the asset. The borrower keeps all the risk of the asset. It's ultimate sanction is to sell it and return the proceeds to the lender.

Where the “asset” is only the legal obligation to repay of the borrower, the lender cannot defray its credit risk unless it sells the instrument absolutely, in which case it is no longer financier or lender at all.

To be sure, in a financing there is always a “second-loss” risk exposure to the borrower if the asset does collapse in value between margin calls — so there is residual credit risk — but it remains fully contingent on that asset failure, and is in turn a failure of the financier’s market risk management rather than credit risk management per se.

Financing as asset transformation

We can distinguish between financing, as a bilateral transformation of asset values between parties on the one hand — I give you cash in return for an asset you give me, with the expectation that we will reverse this exchange at a later date: this is an exchange of equivalent values — and investment, as an outright transfer of capital on the other — I give you cash in return for your promise to pay me a return on my investment, which may be interest and an agreement to repay principal at a later date (if debt) or a proportional share the return on your business (if equity).

Oil>uWhile they are different in some regards, these are both outright investments of capital: where they sit in the borrower’s capital structure is a second-order distinction which, at the limit, breaks down: in an insolvent/distressed credit, shareholders are wiped out so the bondholders are effectively in the same position as shareholders — hence the concept of the debt-for-equity swap.)

Characteristics

The key difference between financing and lending arrangements is collateral: a financing arrangement involves the upfront exchange of money for goods of equal or even greater value and thereafter margin adjustments to take account of fluctuations in the value of the asset exchanged. Under a securities financing, for example, there will be a margin flow each day reflecting the move in the value of the financed assets. Done

Originally, swap transactions were something of a hybrid in that there was an initial exchange albeit synthetic but there was not necessarily any margining arrangement thereafter. Therefore a financing arrangement could morph into a lending arrangement if the underlying asset appreciated or depreciated enough in value.

It was not long before collateralisation was introduced to the ISDA — credit support annexes were published a couple of ears after the 1992 ISDA in the mid 1990s and while these were optional arrangements, often structured as one-way margining obligations in favour of the swap dealer, after the global financial crisis of 2008 bilateral variation margining became a regulatory requirement. Most swaos these days are fully margined both ways. This is not always a good thing.

Examples of lending

• Deposit taking
• Traditional lending
• Uncovered bond investments
• Equity investments

Examples of financing

• Repo
• Securities lending
• Swaps
• Securitisation
• Prime brokerage
• Project finance

On this view most capital markets activity (repos, securities lending, derivatives, securitisation and structured financing) is fundamentally financing — while the traditional banking book (corporate lending, consumer credit) represents true capital allocation. Notably initial public offerings — also a form of capital injection — tend to be managed and underwritten by banks, but placed into the market.

Note that bonds and stocks themselves, as they are “securitised” can in turn be financed. This is what the prime broker does.