Jamaican interest rates are on the decline and are expected to maintain this trend if the implementation of the IMF conditions continue according to plan. As a result, the traditional reverse repurchase agreement is becoming less attractive. Our financial industry will soon be forced to create new ways to deliver higher risk adjusted returns to investors and shareholders and also, to facilitate growth in our economy.

One interesting characteristic of many developed economies is an active secondary market for loans. This prospect of “loan trading” (i.e. the purchase and sale of loans as an investment instrument) can be profitable and beneficial for both the investor and the broader economy. Let’s take a look at this activity.

What is loan trading?

Bank lending traditionally involves the extension of credit that is held by a bank until maturity. Loan sales involve the transference of loans, in part or in entirety, from one balance sheet, to that of another institution. Typically, loan traders buy and sell loans as an investment instrument. Understanding the motives of loan traders is a good starting point for the introduction to this concept. Loans have a number of attractive features that stimulate this activity.

1 Loans provide the investor with a steady stream of cash flows during the tenor of the investment. Due to the strong legal obligations governing repayment from the ultimate borrower, loans provide a consistent and identifiable stream of cash flows.

2 Compared to bonds, loans have higher recovery rates, with similar probabilities of default (i.e. for the same issuer). The higher recovery rate for loans is primarily the result of seniority, collateral, covenants and the provisions of credit agreements.

3 Loan sales also provide a viable source of liquidity for cash strapped institutions. This is particularly relevant in the Caribbean where many financial institutions suffer from a drastic asset-liability mismatch whereby the majority of their funding sources are short term while the lion’s share of their assets is placed in long term investments.

4 The secondary loan market also facilitates the sale of impaired assets. Sellers of distressed debt benefit from the removal of the non-performing assets which increases capital available to extend new loans. It also improves profits by reducing provisions and administrative costs associated with restructuring, negotiating and collecting.

This activity is dominated primarily by institutional investors. However there are many benefits to the individual investor and the economy.

Benefits of loan trading

Increased access to financing

As banks sell loans, they obtain more liquidity which in turn permits them to increase lending and further finance economic activity. The increased liquidity in the economy produces a “multiplier effect”. New loans directly facilitate economic activity. In turn, that particular activity further stimulates other segments of the economy. For example, the proceeds of a loan granted for a construction project is often distributed among laborers, contractors and suppliers who in turn use these funds to purchase additional goods and services, thereby bolstering activity within other sectors of the economy. This compounds the effect of the new loan on economic growth.

Better terms for borrowers and higher returns to investors

The ability to sell (and purchase) loans, ultimately allows a bank to use its capital more efficiently. This in turn may enable banks to make funding available to borrowers under better terms. In fact, research indicates that borrowers with liquid trading loans are able to borrower at lower interest rates after the onset of the trading of their loans (Santos and Nigro 1998). The authors go on to argue that borrowers with liquid loans trading in the secondary market experience an improvement in their bargaining position since the bank garners additional benefits from their business.

The development of the secondary market for loans has also led to the creation of a new asset class with greater returns per unit of risk than many other Þxed income assets and has exhibited low correlations with most other asset classes (Yago and Mcarthy 2004). These considerations increase the attractiveness of investment products which utilize loans as the underlying security.

Loan trading has clear benefits, and is a relatively easy step to a deeper financial market and more sustainable economic growth. How can we make Jamaica ready for loan trading?

Marian Ross is a business development officer with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

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