Once a loan is initiated between a lender and the borrower, the lending institution has the option of keeping the loan in-house. By choosing to keep the loan, the lender accepts the responsibility of servicing the loan and collecting payments from the borrower for the lifetime of the loan. The lender also accepts the full risk associated with the loan, including situations where the borrower fails to make payments. If the borrower cannot or will not pay back the loan, the lender is then placed in a position of having to pursue collection against the borrower. In extreme cases, the lender may be forced to write off the loan.
To avoid these types of situations, lenders often seek to avoid the entanglements accompanying the lending of loans by reselling the loans on the secondary market.
The secondary market is made up of multiple players that work in concert to achieve their individual financial goals. These operators include mortgage originators (responsible for loan creation), mortgage aggregators (party responsible for purchasing and securitizing mortgage loans), dealers/brokers (sellers of the loans), and investors (buyer of the securitized loans).
By reselling loans on the secondary market, lenders can mitigate financial risk, generate liquidity, or deleverage their balance sheets for regulatory reasons. Additionally, lenders who trade loans on the secondary market are given the ability to fund more loans. In alleviating risk, the lender is also able to still generate income from fees.
The secondary market is used for a variety of different loans to include syndicated loans. The syndicated loans process involves a group of financial institutions (a syndicate) providing a loan to a single entity. These syndicates are generally made up of both banks and non-banking institutions. Upon origination of the syndicated loan, shares of the loan can then also be traded on the secondary market. Many syndicated loans are designed with a transferability clause allowing for the transfer of shares of the loan to another institution or creditor.
Another form of loan trading is loan participation predominantly employed by Credit Unions, defined as a sharing or selling of interests in a loan. Depository institutions use loan participations as an integral part of their lending operations. Banks may sell participations to enhance their liquidity, interest rate risk management, capital, and earnings. They may also sell participations to diversify their loan portfolio and serve the credit needs of borrowers. Commonly, a lead bank is responsible for originating and closing a loan. At this point, the lead bank sells interests to one or more financial institutions. Even with the distribution of these shares to other financial institutions, the lead bank remains borrower-facing, retains all loan documentation, and services the loan.
While there are similarities between syndicated and participation loan trading, there are enough differences to distinguish the two. With loan participation, the existing relationship among the participants is broken down into a three-tiered system where the lead bank acts as a facilitator: initially between the borrower and the lead bank, and then between the lead bank and the loan participants. This method of loan trading runs counter to a syndicated loan because the relationship in a syndicated loan is one where financing is provided by each member of the syndicate to the borrower, based on the pre-defined agreement between all parties. Additionally, whereas the borrower may be unaware their loan was participated out to other lenders, the borrower is acutely aware of all lenders in a syndicated loan relationship.