Bank loans question

[RicoTubbs]

Banks originate loans (lend to borrowers, like people who want to buy a house). The bank then has an asset (the right to get future interest and principal payments from the borrower) but no more cash. So they can't lend out any more money.

Instead of sitting around waiting for the cash to come in from the borrower, they sell the asset (the right to future cash payments) to some outside investor. The outside investor could be another bank, a pension fund, a hedge fund, whoever. Why do they buy it? Presumably because it pays a higher rate than they would get by investing in a money market (but they take on more risk).

In reality, what's happening is that it's not just one that's being sold to the pension funds etc., it's thousands of loans that are bundled up into a giant trust and then the rights to the trust's cash flows are sold off, often times in different pools, called tranches, each of which has a different risk profile and pays a different return.

The originating bank has a business model that is basically:
1. Make a loan to a borrower (where borrower pays x%)
2. Sell (securitize) the loan where the buyer only gets y% (y%<x%)
3. Take the money from the securitization and make another loan.
4. Repeat steps 1-3 and profit.

If the pension funds etc. get spooked and don't believe the securitized assets are actually that valuable, they stop buying them from the originating bank. That means step #3 (making a new loan) can't happen because the bank is sitting on an illiquid asset, rather than cash.

So the fact that investors are scared to buy loans from banks means that the banks are having trouble making new loans.