Is there a difference between bank loans and bonds?

I realize this may be a bit of a contentious question, but what I want to get at is the proposition made by Warren Buffett in this article

He basically says that stocks and other productive assets beat currency or commodity assets because stocks and such can grow, whereas currency assets like bonds must beat inflation and the tax burden on them in order to even come out even, and commodity assets usually rely on greater fools.

Do banks make the bulk of their money off loans? Are their rates calculated to beat inflation plus taxes on the payments?

Thanks,
Rob

Erm, have you been paying attention for the last few years? :wink:

A great deal of bank loans ARE bonds in all but name, when they are collatoralized in to things like CDOs and what have you.

Buffett obviously prefers stocks, but his rejection of bonds is somewhat less unequivocal than you imply.

From the article (with my emphasis and parenthetical):

Buffett is saying stocks are better than bonds for normal investors. Banks aren’t normal investors. Essentially, banks borrow money at a very low interest rate (by taking deposits and paying for stuff that gets the deposits, like bank tellers and ATMs) and then lend it out at a higher interest rate. There may not be a huge spread between the two rates, but when you are talking about a few billion dollars, even a few fractions of a percentage point means a lot of dough.

Typically when a person uses the term bonds, they are talking about loans arranged or underwritten by banks and sold to investors. When a person is talking about bank loans, they are talking more about loans made by banks to be held for their own account. Therefore, there would be a difference. Bank loans usually have shorter maturity dates (3-5 years) and many of them are floating rate loans (using prime or LIBOR as the benchmark rate). Bonds are usually a little longer maturity (5-12 years) and many of them are a fixed rate.

Home mortgages are usually made by banks and sold off. There is a big secondary market for mortgages. Certain types of banks (savings and loans) are more likely to hold mortgages on their books. Also, certain types of mortgages (usually jumbo or super jumbo) are more likely to be held on the books of the banks as there is not an active secondary market. The agency qualified loans (fit Fannie Mae, Freddie Mac, Ginnie Mae guidelines) are the most likely to be packaged and sold off.

It depends on the bank and from year to year as well. Some are big commercial/retail lenders, some make more money from capital markets.

As others have noted, banks often hedge their investments in a way that private investors don’t (e.g. by repackaging and selling their loans). But any investment that a bank makes will be compared to a benchmark rate or return or hurdle rate which would take into account taxes, cost of capital, etc.

Bank loans are not calculated to beat inflation. The alternative to making loans is not making them, in which case the income (from not making loans) is zero. Banks will make loans so long as the income from doing it is more than zero, regardless of inflation.

The lower limit on the rate of interest banks charge is their cost of funds. So long banks can lend funds at a rate that’s more than what it costs to obtain them, they’ll make loans to credit-worthy borrowers.

I have often thought that the value added by banks is their financial intermediation and their information processing. That would be the service they provide. One performance measurement for a bank is to compare what it did make against a low risk investment of its capital balance. (Net assets) If, a government Note pays 2% and the bank makes 8% on its capital, then the bank is a winner. If it makes less than the 2%, it’s a loser.

Are bank stocks worthy investments? Not in my estimation, but I’m certainly no expert.

No, the alternative to making loans is investing money in something else that produces a return. Although there may be restrictions on a what a retail bank can invest in, of course.

A bank loan is a simple two-party loan agreement. A bond is a standardized two-party loan agreement which is packaged for easy transfer from one lender to another and is often tradeable in a secondary market.

Basically this. A bond is essentially a ‘standardized’ loan agreement that makes it easier to compare one ‘loan’ to another, which in terms makes it easier to trade ‘loans’ on a secondary market.