What investors Should Care About in this New Era of Non Bank Lending

Gordon Gekko: The point is ladies and gentlemen that greed, for lack of a better word, is goodWall Street (1987)

 

Think about the two main risks an investor who buys a security accepts: credit risk and operational risk. When I buy a bond as an investor, I am buying some future cash flows - the bond’s interest stream and principal repayment.  With Alternative Finance, I am usually buying receivables with they hope I will be repayed.

So let’s look at Credit Risk first.  My concern should be on the counterparty to the transaction.  I buy some right to that stream and repayment and as an investor I could add protection in the form of credit insurance, which comes in many flavors – puts, credit default swaps, credit insurance, etc.  In essence I could add a derivative that is conditional on some event.

When you add credit insurance to a cash flow, where the cash flow is an asset and you have a contractual right to repayment, the insurance is a derivative of the cash flow.  It’s conditional. It’s no different than the conditions on the cash flow itself.  This is why Investors who care get under the details.  Just like not all bonds are the same in terms of their cash flow conversions, not all receivable and alternative investments are either.

Then there is Operational Risk. I buy a bond, that must go through a Clearing System, money goes through brokers, the bond goes through the Custody system, banks are involved, settlement and paying agents are involved, any potential failure here is operational risk.  There are very low probabilities of failure here, but for those of us without bad memories, institutions can fail, and stuff happens.

Why does all this matter? Because the current economic environment leads me to believe there is a likelihood of some credit failure.  It you look at some leading global banks price to book ratios, you would see markets are deeply discounting either the assets valued by these banks, or believe they are underestimating liabilities, or both.

Alternative investments have these risk as well. To really understand this you have to know it.  Yes it’s an invoice, it may or may not be confirmed, every one of those factors are part of the contractual agreements, just like the service provisions in a bond prospectus.

As I mentioned in a prior post, we have been living in a world where everything is a “Put on the US Government.” Everybody wants to believe in a Free  Market – but the government influences and ultimately controls who fails and who doesn’t.  Why?  Because left to our own devices, the Gordon Geckos of the world would drive institutions to failure.

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