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We have been talking as though a loan involved a supplier of money meeting a demander in person and handing over cash. That would be direct finance in its purest form. However, that is not how loans generally work. More commonly, direct financing involves stocks or bonds.
Bonds
One thing that commonly happens, when the borrower is a firm, is that the lender purchases one or more bonds issued by the borrower. The $10,000 loan discussed earlier might be made through the purchase of 11 bonds, each with a face value, or par value, of $1,000 and a maturity date one year from the date of purchase. Note that the face value is not the purchase price. It is the bond’s value at maturity—the amount paid to the holder at that time. The agreement between buyer and seller that 11 bonds whose par values add up to $11,000 can be purchased for $10,000 a year earlier is, in essence, an agreement that the nominal interest rate will be 10 percent.
Once a bond is issued, it can be bought and sold on the secondary market, at prices that fluctuate based on current economic conditions. This is in fact where the vast majority of bond purchases take place. Suppose that a person who just paid $10,000 for those bonds decides to unload them the very next day. Meanwhile, in the last 24 hours, news reports have come out that the economy is slowing down and the inflation rate is falling. By the Fisher equation, a lower inflation rate means that the same real interest rate can be achieved with a lower nominal rate. The buyer of those 11 bonds will therefore be willing to pay somewhat more than $10,000 for them. The market price of the bonds will also go up simply with the passage of time. In late December, as the maturity date approaches, the value of the bonds will approach $11,000, since that is how much the holder is guaranteed to receive in a few days.
One type of bond deserves special mention. Treasury bonds (“T-bonds”) are issued by the U.S. government. In times when the government is spending more than it brings in (which unfortunately is nearly all the time), selling treasury bonds is how the government borrows money to fund ongoing operations. For savers, treasury bonds are considered an extremely safe, conservative investment. They do not earn a high rate of interest, but the chance that the government will fail to honor its obligation when the bond reaches maturity has long been assumed to be negligible. In recent years, concerns about possible default have risen slightly, but T-bonds are still considered safer than almost any other form of saving.
Stocks
Whereas a bondholder has made a loan to a firm, someone who buys stock in a firm becomes, technically speaking, one of the owners. Together, stocks and bonds are called securities. Like bonds, stocks can in theory be bought directly from the issuing firm but in practice are almost always bought on the secondary market, at prices that change constantly. Unlike a bond, however, a stock has no “anchoring” price at a future maturity date. Stock prices therefore tend to fluctuate much more than bond prices do. The buyer earns a return—interest by another name—by (hopefully) selling the stock at a higher price than it was bought at. (With mature, securely established issuing firms, the holder of a stock may also collect quarterlydividend payments.) The upshot is that although a stock purchase isn’t technically a loan, practically speaking it works like one: the buyer forgoes use of the money for a while, in order to get the money back, plus profit, at a later date. Like a bond, in short, a stock is a way to save.
Indirect Finance
Small businesses don’t issue bonds or stocks. When they need a loan, they go to a bank and apply for one. On the savers’ side, households that want to save money routinely keep a good deal of it on deposit at a bank. The bank, working with savers on one hand and with borrowing firms on the other, acts as a financial intermediary. Savers deposit money with the bank and earn interest paid by the bank. Firms take out loans from the bank and pay the bank interest. (So do households that need to fund major purchases, such as a house.) The bank makes money by charging higher interest rates on the loans than it is paying its depositors. This arrangement is called indirect finance, because the supplier of the money being lent and the demander borrowing it never deal with each other directly.
