The Mathematics of Money

(Darren Dugan) #1

Copyright © 2008, The McGraw-Hill Companies, Inc.


2.3 Secondary Sales of Promissory Notes


Suppose that you borrow $1,000 from Friendly Neighborhood National Bank (FNNB).
You sign a 1-year note with a simple interest rate of 8%. By now, it is a simple matter for
us to calculate that this means that you will be required to pay back the original $1,000 plus
$80 simple interest for a total of $1,080 one year from the loan date.
But now suppose that 1 month after you sign the note, the bank decides that it wants
to be repaid early. Maybe it realized that it made more loans than it should have, maybe
it needs the cash for some other purpose, or maybe it just wants to take advantage of an
opportunity to loan that $1,000 to someone else at a better rate. Whatever the reason, the
bank wants its cash back 11 months sooner than originally agreed. Does it have the right to
demand that you repay the loan before the maturity date?
In most cases, the answer to this question would be no.^4 Unless the terms of the loan
specifically allow the lender to demand early payment, you would not normally be obli-
gated to pay up so much as a single day sooner than the maturity date. (Of course, there
is nothing to prevent a lender from asking for early payment, maybe even offering some
incentives to entice you to pay early.) But in the end, if the note says you have to pay up
3 weeks from next Tuesday, then you are under no obligation to pay until 3 weeks from
next Tuesday.
The lender does have other options, though. A key fact about notes is that they are
negotiable. This term can be misleading—it does not mean that the terms of the note can
be negotiated (that may well be true, but that is not what is meant by this term). The term
negotiable means that notes can be bought and sold.^5 Friendly Neighborhood National
Bank may not be able to collect from you before the maturity date, but it probably can sell
your note to someone else. Such a transaction is often referred to as a secondary sale of the
note. (Notes can be sold again and again and again, but no matter how many times a note
has changed hands any such sale is still called secondary.)
Here is how it works. Suppose FNNB sells your note to Cheery Community Savings
and Trust (CCST). On the maturity date your $1,080 will go to Cheery Community instead
of Friendly National. This really makes no difference to you. The sale does not affect the
maturity value or date, so you will still cough up the same $1,080 on the same maturity date
as before. At worst, this may require you to make your payment check out to CCST instead
of FNNB, and send it to a different address than you originally would have. And actually
it may not even require that, since sometimes the original lender simply agrees to pass on
your payment to the note’s new owner. In that case, you might not even be aware that the
note has been sold at all.
If FNNB does sell the note to CCST, how much should CCST pay? FNNB would
certainly be quite happy if it could get the full $1,080 maturity value, but then CCST
would make no profit on the deal. There is nothing to prevent CCST from paying $1,080
(or, for that matter, even more), but it is hard to imagine why it would willingly do that. In
all likelihood, CCST will pay something less than the $1,080 that it will receive at maturity.
For example, the two banks might agree to take $60 off the maturity value. The note would
then change hands for $1,080  $60  $1,020.
Notice that when FFNB and CCST decide on a selling price for this note, they are likely
to think of that price in terms of subtracting something from the maturity value. In other
words, they are likely to think in terms of discount. When you first borrowed the money,
the situation looked like simple interest, but matters look different when a note that already

(^4) Sometimes a loan may include the provision that the lender can demand early repayment. Bank certifi cates of
deposit are an example; though the term of the CD is fi xed, you (as the lender) typically can withdraw your money
sooner, though doing so usually will involve a signifi cant fi nancial penalty, such as forfeiting some of the interest
earned. Loans that can require early payment are not common for most situations, but such loans do exist. You
should always read the fi ne print of any agreement. Since you are the type of person who reads footnotes in math
books, you probably knew that already.
(^5) It is possible for a note to have a provision that the lender can not sell it, or can sell it only under certain
circumstances, but that would be unusual.
2.3 Secondary Sales of Promissory Notes 71

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