TradFi's Credit Spectrum

When we draw Credit from TradFi, we need to consider the following variables to determine the nature of the loan:

• The interest rate on the loan

• The purpose of the loan (what the borrowed funds can be used for)

• How the loan is secured (recourse)

For example:

• In the case of a mortgage:

  • A homebuyer might provide 20% of the purchase price as a down payment and receive the other 80% from the bank, resulting in a 4:1 debt-to-equity ratio (purpose of loan).

  • This loan is secured, or collateralized, by a claim on the house itself. If the buyer stops making payments, the bank will repossess the house to recover the value of the loan (recourse).

• Other loans are secured not with direct collateral, but instead with a senior claim on assets or future income.

  • In the case of credit card purchases and corporate bonds, loans are not secured by direct collateral but instead the lender has recourse to the borrower’s other assets, which partially compensate for the lack of direct collateral.

  • In case of nonpayment, outstanding claims are resolved through a collections process (individual) or bankruptcy (for companies).

Both directly and indirectly collateralized credit are critical to the operation of the modern economy, as they provide the capital that powers consumption and investment.

Consider every loan as occupying some point on the spectrum from

1. over-collateralized to under-collateralized,

2. specific-purpose to general-purpose.

And it becomes clear that traditional finance supports all quadrants.