Tuesday, July 7, 2009


When lenders and borrowers transact voluntarily, both parties perceive gains. Otherwise, they would not make the transaction. Of course in the final analysis, one party may gain more than the other. It is possible, and it is usually the case, for both parties to be better off as a result of a loan. A loan is an extension of credit, and a security is written evidence of the extension of a loan. Securities are exchanged in credit markets, ad such markets facilities economic growth. In fact, variations in the amount of credit in an economy may affect economic activity as much as variations in the money supply.
An extension of credit allows the borrower to make expenditures sooner than otherwise, it also allows the lender to earn interest and to purchase more goods in the future. This transferal of purchasing power is an element that is common to all securities. Because all securities can substitute for each other, interest rates earned on the various securities will move up and down together as market conditions change.
If Mr. Smith wanted to borrow a sizable amount for a very period of time, in principle he could find someone to make him a large loan. It is likely, however, that he would find few willing to make such a loan. Those few that would be willing to external credit would insist on a very high interest rate, because a good deal of uncertainty would exist.
Suppose, however, that it were possible for original lenders to sell individual parts of Mr. Smith is total debt obligation-to transfer the extension of credit-to a third party such as Ms. Johnson. Indeed, suppose further that Johnson could resell an individual part of Mr. Smith is debt obligation- a security- to someone else, and so on. The net result of such sales and resale's of the original securities issued to cover Mr. Smith is original total debt would. Be that many people would be extending smaller amounts of credit to Smith for shorter periods of time. The ability to resell securities, therefore, lowers the risk of credit extension and increase the liquidity of the security. By increasing the liquidity of securities, the ability to resell debt (or transfer credit extension) permits greater quantities of credit extension, facilities trade, and lowers interest rates to borrowers.

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