CREDIT



In the fields of commerce and finance, credit is essentially a "buy now, pay later" transaction. In other words, credit refers to transactions between two parties in which one, acting as creditor or lender, supplies the other (the debtor or borrower) with money, goods, services, or securities in return for the promise of future payment instead of immediate payment. Credit and debt, therefore, describe the same transaction—only from opposite perspectives. In modern economies the use of credit is pervasive and the volume enormous.

Consumers and businesses use credit to purchase everything from home appliances, computers, and even money to purchase automobiles, homes, or other companies. While debtors can purchase items such as stoves, ovens, and computers on credit from retailers, usually by providing a down payment and making monthly payments until the balance is paid off, they cannot do this when purchasing things with substantially higher prices, such as automobiles or houses. Instead buyers become debtors to banks or finance companies and essentially purchase cash through loans, which they use to purchase higher priced goods.

HISTORICAL PERSPECTIVE

Credit dates back to the beginning of recorded history. Evidence of credit transactions from approximately 4000 B.C. has been found in Mesopotamia. Archaeologists have discovered a plethora of credit receipts in the form of stone tablets along the Tigris and Euphrates Rivers. With the rise of private property and international trade, credit became necessary. Almost all credit came from individuals or singular institutions that had excess reserves of money or a desired commodity.

In bartering economies, commodities of value to the trading parties, such as corn, constituted commodity money. The transportation costs of commodity money, however, hampered trade. This led to the use of bills of exchange in which one party would promise to pay the holder of the bill a certain amount of a commodity. Traders used bills of exchange in a manner similar to modern paper currency. The person demanding settlement of the bill most likely was not the original recipient.

The almost universal minting of coins gave rise to money changers and a small banking system in Greece by the late fifth century B.C. Banks functioned primarily to settle bills of exchange and make credit money loans. With the fall of the Roman Empire in 476 A.D., a feudal system arose in Europe that had little need for money and credit. By the eleventh and twelfth centuries, however, privatization and trade exploded. The need for credit drained the available reserves of traditional lenders. To fill the gap, money traders and lenders developed new sources of funds. They accepted deposits entrusted to them for safekeeping and for interest. From these funds they, in turn, made loans. Thus, banking spread over Europe.

The overextension of credit and poor business practices repeatedly brought down banks all over Europe. By 1300 the first laws concerning bankruptcy and fraud were enacted. The principality of Catalonia, Spain, instituted a municipal bank that systematized and centralized banking activities and regulation.

Chronic cash shortages, excessive interest rates, and bank failures forced governments to enact legislation and form their own banking systems to regulate private banking. In 1694 the Bank of England was formed to provide the government with loans to finance its war with France. The government chartered only the Bank of England with the power to issue bank notes acceptable to the government for taxes and taxation and other debts. By the mid-1800s, the Bank of England had a virtual monopoly on banking. As a result, the Bank of England became the central bank, accepting reserve deposits from other banks and savings from the citizenry. As a consequence, the era modern banking began with banks functioning as major providers of credit.

TYPES OF CREDIT

Discussion of credit often involves distinguishing among trade or commercial credit, consumer credit, and credit cards. Trade credit covers deferred payments where businesses are the buyers, whereas consumer credit includes deferred payments where individuals are the buyers. Credit cards, on the other hand, refer to lines of credit consumers and businesses access via magnetic cards, which they receive from banks and credit institutions. Credit transactions use documents called credit instruments such as bills of exchange, bonds, checks, money orders, and promissory notes. Credit instruments generally are negotiable, which means they can be transferred in the same manner as money.

COMMERCIAL CREDIT.

Commercial credit covers a variety of business transactions involving deferred payment. Companies offer credit to other companies, allowing debtor companies to produce and distribute goods prior to making full payment for the materials and equipment needed to manufacture them. Through this kind of commercial credit, businesses can manufacture their products without immediately paying the substantial costs for the materials and equipment needed to produce them and bring them to market. Businesses also obtain credit by issuing corporate bonds, using the money received from their sale to expand operations or upgrade equipment.

CONSUMER CREDIT.

Consumer credit includes the personal consumption debts acquired by individuals to meet expenses or to make purchases via deferred-payment plans. Credit cards constitute one of the largest and most common sources of consumer credit. In addition, consumer credit refers to the home and auto loans of individual consumers. With lower price items, consumers generally obtain credit from the seller. With high priced items, however, consumers rely on banks and finance companies to provide them with credit.

CREDIT CARDS.

By the late 1990s credit cards had become one of most pervasive forms of credit—especially consumer credit—in the United States, and the use of credit cards around the world continued to grow. With credit cards, cardholders receive a maximum credit limit, which they cannot exceed. Cardholders must make monthly payments if they have a balance, but they have the option of paying only part of the balance each month and rolling the remainder of the balance over to the next month.

The credit card industry consists of credit card companies or associations such as Visa and MasterCard as well as credit card issuers such as Citigroup or MBNA America. In addition, some companies such as American Express issue their own credit cards.

CREDIT AND ECONOMICS

Credit conditions generally reflect the overall economic conditions of a country. For example, credit expands during times of strong business growth, while credit diminishes during times of slow business growth and depressions. Moreover, credit transactions infuse substantial sums of money into the economy. By 1986, loans, investments, and government securities accounted for about 85 percent of the total assets of 14,000 insured U.S. banks. In addition, consumer credit transactions rose to over $575 billion the same year.

Furthermore, credit uses excess property and money that otherwise would go unused and credit facilitates complex business transactions and operations without the frequent exchange of money. In a production economy, credit bridges the time gap between the commencement of production and the final sale of goods in the marketplace. In order to pay labor and secure materials from vendors, manufactures secure a constant source of credit to fund production expenses, i.e., working capital. The promise or expectation of continued economic growth motivates businesses to expand production facilities, increase labor, and purchase additional materials. These create a need for long-term financing.

To accumulate adequate reserves from which to lend large sums of money, banks and insurance companies act as intermediaries between those with excess reserves and those in need of financing. These institutions collect excess money (short-term assets) through deposits and redirect it through loans into capital (long-term) assets.

REASONS FOR OBTAINING CREDIT

In a production economy, credit is widely available and extensively used. Because credit includes a promise to pay, the credit purchaser accepts a certain amount of financial and personal risk. The three following strategies highlight the primary reasons for obtaining credit.

  1. The lack of investments and assets convertible to cash prevents profitable investments in prosperous times. Consequently, to acquire goods, services, or money needed, people or corporations must obtain credit. The advantage of obtaining credit may rest in a future income stream more than adequate to outweigh the debt.
  2. Favorable borrowing costs make it less expensive to borrow in the present than in the future. Borrowers may have expectations of rising rates, tight credit supplies, growing inflation, and decreasing economic activity. Conversely, profit expectations may be sufficiently favorable to justify present investments that require financing.
  3. Tax incentives, which expense or deduct some interest costs, decrease the cost of borrowing and assist in capital formation. Borrowing extends one's purchasing power and ability to invest in capital assets to build wealth.

USES OF CREDIT

A debtor accepts the risks of borrowing to secure something of value, whether perceived or real, profitable, or neutral. The need or desire for credit also may be necessitated by psychological and cultural factors.

ENJOYMENT.

Credit has come to finance the enhancement of one's lifestyle or quality of life through activities and purchases for enjoyment. Activities beneficial to one's well-being may translate into a more productive economic life. Enjoyment includes the financing of a boat, an education, a vacation, a health-club membership, a retreat, as well as other products and activities.

UTILITARIAN CONSUMPTION.

The introduction of credit cards in the 1950s and the increase of home equity debt in the 1980s has greatly expanded the financing of daily consumption. Consumer credit in 1990 was four times that of 1975, while that of consumer goods only doubled. Much of this debt was for convenience purchases, consumer goods and services with a life of less than one year.

PROFIT AND WEALTH BUILDING.

Businesses can increase their profits through credit transactions, using credit to make profitable investments and to receive tax benefits. Credit allows businesses to maximize their profits by spreading the cost of their investment out over a series of months or years. In addition, home buyers achieve similar benefits from credit when buying a house. They expect the purchase of a certain house in a certain location to be more "profitable" than renting or purchasing another house elsewhere.

PROMISE TO PAY

Credit contracts define the terms of the agreement between lender and borrower or creditor and debtor. The terms of the contract delineate the borrower's obligation to repay the principal according to a schedule and at a specified cost or interest rate. The lender reserves the right to require collateral such as homes, cars, or real estate to secure a loan and to enforce payment through the courts.

The lender may levy a small charge for loan origination or for acting as the lender. This charge, measured in percentage points, covers administrative costs. This immediate cash infusion decreases the costs of the loan to the lender, thereby reducing the risk. The lender may also require the borrower to provide protection against nonpayment or default by securing insurance, establishing a repayment fund, or assigning collateral assets.

A promissory note is an unconditional written promise to pay money at a specified time or on demand. The maker of the note is primarily liable for settlement. No collateral is required. A lien agreement, however, holds property as security for payment of debt. A specific lien identifies a specific property, as in a mortgage. A general lien has no specific assignment.

CREDIT TERMS

The terms associated with credit and credit contracts include assets, net worth, repayment schedule, interest rate, collateral, and various credit instruments.

ASSETS.

Assets refer to a person's, organization's, or corporation's entire collection of things of value, such as property, businesses, investments, and cars. Assets include all items subject to or applicable to the payment of debt.

NET WORTH.

The value of corporation is the amount left after its liabilities —the amount it owes—have been subtracted. Net worth is determined by subtracting all current debts from a company's current total assets. The remaining amount is the company's net worth.

REPAYMENT SCHEDULES.

Credit contracts—such as loans—vary in length or maturity. Short term debt is from overnight to less than one year. Long-term debt is more than one year to 30 or 40 years. Payments may be required at the end of the contract or at set intervals, usually on a monthly basis. The payment is generally comprised of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, repaid little by little, until completely retired. As the principal balance diminishes, the interest on the remaining balance also declines.

Interest on loans does not reduce the principal. The borrower pays interest on the principal loan amount and is expected to pay the principal at the end of the contract through a balloon payment or through refinancing.

Revolving credit such as the credit offered by credit card companies has no fixed date for retirement. The lender provides a maximum line of credit and expects monthly payment according to an amortization schedule. The borrower decides the degree to which to use the line of credit. The borrower may increase debt at anytime the outstanding amount is below the maximum credit line. The borrower may retire the debt at will, or may continue a cycle of paying down and increasing the debt.

INTEREST RATES.

Interest is the fee charged for the use of credit or borrowing. The interest rate charged by lending institutions must be sufficient to cover operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of three, five, and ten years. Lenders also charge rates proportional to the risk involved: the more risk involved, the higher the interest rate.

COLLATERAL.

Assets such as property and businesses pledged as security for the payment of loans are collateral. Credit backed by collateral is secured. The asset purchased by the loan often serves as the only collateral. In other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land collateralizes mortgages.

CREDIT INSTRUMENTS.

Unsecured debt relies on the earning power of the borrower. A debenture is a written acknowledgment of a debt similar to a promissory note in that it is unsecured, relying only on the full faith and credit of the issuer. Corporations often issue debentures as bonds. With no collateral, these debentures are subordinate to mortgages.

A bond is a contract held in trust obligating a borrower to repay a sum of money. A debenture bond is unsecured. A mortgage bond holds specific property in lien or as collateral. A bond may contain safety measures to provide for repayment. An indenture is a legal document specifying the terms of a bond issue, including the principal, maturity date, interest rates, any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders. Corporations and government entities issue bonds in a form attractive to both public and private investors. Overnight funds are lent among banks to temporarily lift their reserves to mandated levels.

A special commitment is a single purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a one-time increase in current assets, such as a special inventory purchase, an unexpected increase in money owed, or a need for interim financing.

Trade credit is extended by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment.

A seasonal line of credit of less than one year is used to finance inventory purchases or production. The successful sale of inventory repays the line of credit.

A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Creditors expect future earnings to be sufficient to retire the loan.

Commercial papers are short-term, unsecured notes issued by corporations in a form that can be traded in the public money market. Commercial paper finances inventory and production needs.

A letter of credit (LC) is a financing instrument that involves three parties: the bank, the customer, and the beneficiary. The bank issues, based on its own credibility, an LC on behalf of its customer, promising to pay the beneficiary upon satisfactory completion of some predetermined conditions. An LC is used to facilitate a transaction, especially in trade, by guaranteeing payment at a future date.

A bank's acceptance is another short-term trade financing vehicle. A bank issues a time draft promising to pay on or after a future date on behalf of its customer. The bank rests its guarantee on the expectation that its customer will collect payment for goods previously sold.

Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year and less than five. A large equipment purchase may have longer terms, matched to its useful production life.

Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run 10 to 40 years. When creditors provide a mortgage to finance the purchase of a property without retiring an existing mortgage, they wrap the new mortgage around the existing debt. The interest payment of the wraparound mortgage pays the debt service of the underlying mortgage.

U.S. Treasury bills (T-bills) are short-term debt instruments of the U.S. government issued weekly and on a discounted basis with the full face value due on maturity. T-bill maturities range from 91 to 359 days and are issued in denominations of $10,000.

U.S. Treasury notes (T-notes) are intermediate-term debt instruments ranging in maturity from one to ten years. Issued at par, full face value, in denominations of $5,000 and $10,000, T-notes pay interest semiannually.

U.S. Treasury bonds (T-bonds) are long-term debt instruments. Issued at par values of $1,000 and up, T-bonds pay interest semiannually and may have call dates (retirement) prior to maturity.

CREDITWORTHINESS

The granting of credit depends on the confidence the lender has in the borrower's creditworthiness. Generally defined as a debtor's ability to pay, creditworthiness is one of many factors defining a lender's credit policies.

Creditors and lenders utilize a number of financial tools to evaluate the creditworthiness of a potential borrower. Much of this relies on the analyzing of balance sheets, cash flow statements, inventory movement rates, debt structure, management performance, and market conditions. Creditors favor borrowers who generate net earnings in excess of debt obligations and contingencies that may arise.

INTEREST RATES AND RISK

Lenders use subjective and objective guidelines to evaluate risk and to establish: (a) a general rate structure reflective of market conditions, and (b) borrower-specific terms based on individual credit analysis. To be profitable, lenders charge interest rates that cover perceived risks as well as the costs of doing business. The risks calculated into the interest rate are the following.

FINANCIAL INTERMEDIATION

Financial intermediation is the process of channeling funds from financial sectors with excesses to those with deficiencies. The primary suppliers of funds are households, businesses, and governments. They are also the primary borrowers. Financial intermediaries—such as banks, finance companies, and insurance companies—collect excess funds from these sectors and redistribute them in the form of credit. Financial intermediaries accumulate reserves of funds through investment and savings instruments.

Banks provide savings and checking accounts, certificates of deposit and other time accounts for customers willing to lend the bank their funds for the payment of interest. Insurance companies gather funds through various investments and through the collecting of premiums. Banks, finance companies, and insurance companies also raise cash by selling equity positions or borrowing money from private or public investors. Pension funds utilize available funds from participant contributions and from investment earnings. Federally sponsored credit intermediaries capitalize themselves in a manner similar to banks. For example, Fannie Mae sells securities in the national capital markets.

Financial intermediation provides an efficient and practical method of redistributing purchasing power to qualified borrowers. Banks aggregate many small deposits to finance a single-family home mortgage. Finance companies break large pools of cash down to sizes appropriate for the purchase of an automobile. The pooling of funds from many sources and the distribution of credit to a large number of creditors spreads the risks. Managers of financial intermediaries also reduce risk by qualifying borrowers, thereby funneling funds to creditworthy borrowers. Furthermore, financial intermediation increases liquidity or assets convertible to cash in the system, acting as a buffer against cash shortages resulting from unexpected increases in deposit withdrawals.

CREDIT SECURITIZATION

Credit securitization is one of the most recent and important developments in the fields of finance and investment. Underwriters of financial investments gather together a large number of outstanding credit instruments and other debts, and repackage them in the form of securities that are similar to closed-end mutual funds. Underwriters sort the credit instruments into homogeneous groups by maturity, purpose, interest rates, and so forth, and market them to investors. These investment packages are known as "asset backed securities."

In many instances the underlying debt is mortgages, secured by real estate, and guaranteed by some agency or insurance company. For example, an underwriter may place into securitization only mortgages guaranteed by the Veterans Administration with maturities of no less than 20 years, interest rates of not less than 9 percent, and a cumulative principal (face) value of $10 million. The underwriter sells shares in this pool of mortgages to the public. Other credit instruments securitized are commercial mortgages, auto loans, credit card debts, and trade debts.

Credit securitization supports the viability of financial intermediaries by: (a) spreading the risk over a broader range of investors who purchase the securities, and (b) increasing liquidity through an immediate cash infusion for the securitized debt. This process is also helpful to investors and borrowers alike. The large volume and efficiency of the system put downward pressure on interest rates. The pooling of loans into large, homogeneous securities facilitates the actuarial and financial analysis of their risks.

Investors may participate in a portion of the cash flow generated by the interest and/or principal payments made by borrowers of the underlying debt. Investor participation may be limited to the cash flow of a set number of years, or to a portion of the principal when the underlying debt is retired. Investors also choose to participate at a point suitable to their risk/reward ratio. Hence, investors have the opportunity to derive different benefits from one package of credit instruments.

SEE ALSO : Banking Act of 1933 ; Consumer Credit Reporting ; Corporate Finance ; Credit Approval ; Factoring ; Incubators, Business ; Negotiable Instruments ; Opportunity Cost

[ Roger J. AbiNader ,

updated by Karl Heil ]

FURTHER READING:

Board of Govenors of the Federal Reserve System. The Federal Reserve System: Purposes and Functions. 7th ed. Washington: Federal Reserve System, 1984.

Davies, Glyn. "Credit: 6,000 Years Old and Still Evolving Vigorously." Business Credit, June 1996, 16.

Guttman, Robert. How Credit-Money Shapes the Economy: The United States in a Global System. M.E. Sharpe, 1994.

McNeil, Jane H., and Edward T. O'Leary. Introduction to Commercial Lending. American Institute of Banking, American Bankers Association, 1983.

Rosenthal, James A., and Juan M. Ocampo. Securitization of Credit: Inside the New Technology of Finance. New York: Wiley, 1988.

Wray, L. Randall. Money and Credit in Capitalist Economies: The Endogenous Money Approach. Edward Elgar, 1990.



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