Over the last 20 odd years there has been a burst of financial innovation in the United States. Reduced financial regulation helped stimulate financial innovation and new liquidity models were encouraged. The age of hedge funds, derivatives, and even derided instruments such as securitized mortgage obligations, rose from this impulse to innovate. Indeed, innovation in financing, as in so many other elements of the American economy, has been at the heart of our financial leadership for a very long time, despite its imperfections.
Stock-secured loans and securities-collateralized financing for personal or business applications have also developed during this period, but many of those without financial training or experience still find this a puzzling world to navigate. A stock margin loan might be the extent of their entry into the world of securities finance. So here we attempt to shed some light on the subject in its many forms and types. We will do this in styles, types and definitions.
1) Standard Institutional Loans, generally offering low loan-to-value with very strict call and coverage rules. (These may also be called bank margin loans, stock margin loans, simple margin loans, or margin stock loans.) Examples are available from any major bank or brokerage web site.
Loans of this type are familiar to most securities owners. They will provide up to 50% of the value of the underlying stock in a cash or stock-based loan that typically allows the client to put more shares to work for them on the assumption that the entire portfolio will be worth more over time. If that does not turn out to be the case, a margin call will force the borrower to provide more cash or securities to shore up the value of their portfolio.
2) Transfer-of-Title (ToT) Loans, are those typically provided by private parties where borrower ownership is usually contractually extinguished save for the rights to return of the stock portfolio on repayment of the loan, with all elements provided in the loan contract - what is sometimes referred to as "beneficial ownership." Stock-secured loans of this type may provide higher loan-to-value for securities that are lower priced or with less of a market.
Transfer of title stock loans can be risky if the lending party does not have sufficient capital and/or liquidity to administer their loan portfolios. Verification of capitalization should be in writing, be current, and ensure that the lender has the resources to cover the portfolios under his management in all conditions.
That is because many Transfer of Title lenders sell at least some portion of the shares to fund the stock loan. When they trade/sell all of the shares, they may retain a portion of the difference as part of what they may refer to as a "cash hedge" so as to be better equipped to return all of the shares. Option-based hedging may be used if the shares are marginable and optionable an option is structured into the loan to allow the lender (technically on client's behalf) to exercise the option so as to retire the debt. Many of these loans are advertised as nonrecourse (limited recourse) so that borrower's risk in default is, in theory, potentially limited to the underlying shares alone regardless of drops in price.
The potential problems with these loan programs crop up when a lender has sold all or a significant portion of the client's shares to fund his/her loan, and by loan maturity date, the shares are worth substantially more than they were at inception. The lender must use his own capital to go into the market to buy sufficient quantities of the much more valuable (and expensive) shares to return to the client. Lenders who do not have the financial resources to do so may not be able to return the collateral at loan maturity. .
If the ToT lender does not have the liquidity to buy the shares back and return them, he may have to delay return of his shares until he has the cash to buy the shares up on the market. Some may resort to using the cash proceeds from the sale of another client's stock to buy the securities needed to return the original client's stock upon payoff.
While there may be nothing illegal in this - the clients usually having contractually provided the lender with full rights to do so - it can be a potential risk factor that any borrower should at least understand at the outset. if you are dealing with a Tot lender who cannot produce independently verifiable capital resources, and that lender sells a portion or all of the underlying collateral as part of the funding of the loan, the risk of delays in return of shares can be substantial. In the very worst of cases the company may become insolvent, in which case the shares may not be returned at all. .
If a lender can provide written, third-party (CPA- or attorney-) verified proof that the lender can service all portfolios under management, this may provide the verification you of financial health that we recommend every potential borrower to have beforehand. We suggest lender data that is updated quarterly and extrapolated out over at least a year based on "worst case" pricing scenarios. This level of "stress test" may provide a sufficient yardstick by which to measure your ToT lender's ability to remain solvent and effective.
3) Custom Institutional Facilities. This financing typically takes the form of a stock loan or securities-backed line of credit that the borrower can draw down, repay, and refill repeatedly. Unlike ToT loans, these loans are underwritten, processed, and managed through licensed advisors at fully transparent and regulated U.S. brokerages and their banking divisions. Shares normally remain in the borrower's title and account, opened by and for the borrower in the borrower's own name at the lending brokerage.
The banking division of the brokerage provides the loan contract. Records, data, and if permitted - trading within the collateral account - can be usually handled electronically, by phone, or in person. Some activiities, such as the wholesale swapping of one set of collateral securities for another, may require lender consent.
But unlike Standard Institutional Loans, these programs often come with the participation of private depository relationships that allow improved terms and flexibility. The result is usually higher LTV or advance rates, lower interest rates, and far more flexibility than is normally available. Within the fully licensed and regulated institutional environment, a borrower may, for example, swap one set of securities for another, or request a higher advance rate on the credit line if the collateral performs well.
With a custom institutionally managed loan facility, shares do not change title at all; they remain in the borrower's name, and the borrower's own SIPC-insured account at the lender, which is a major brokerage and/or banking firm.
This means the issue of selling of shares never comes up; shares are not sold to fund these loans. The only circumstance in which the collateral changes hands is if the client defaults on the loan and the lender takes ownership as part of the satisfaction of the borrower's obligation.
What are the chief advantages of an institutional securities loan? Most people would probably cite security. Rather than the typically personal capital resources of a small firm, where a rise in the value of one paid-off portfolio can create great strains on an under-capitalized lender, custom institutional loans bring the typical capital resources of a large regulated firm to the table thereby ensuring prompt fund disbursement, accurate legal and regulatory compliance, and immediate return of shares upon loan or credit-line payoff.
When collateral securities are not titled to the lender and a simple lien is placed and lifted upon exit from the line of credit, the process can be predictable and easy to work with. Return of shares upon payoff is in fact a misnomer with custom institutional lending; the shares are simply freed of the lender lien.
SIPC-insurance on all brokerage accounts also provides a measure of protection in the unlikely event that the lending institution itself should falter.
Another commonly cited plus with custom institutional lending is found in low interest rates. Monthly LIBOR-based rates tend to provide funding under 2% (as of July, 2010), and the best such programs offer very high advance rates (as high as 95%) in an institutionally managed setting. The net result of this is that the client can be sure of a very competitive loan with what may be a higher LTV than what they could obtain anywhere else.
A custom institutional line of credit stock loan also means convenience and familiarity. Online access to borrower's account ensures real-time monitoring and reporting for record-keeping purposes. Printouts of account statements are as easy as a "print" command. Custom institutional loan clients almost always have access to a licensed account representative at their institution for assistance with their loan or any other financial matter should it arise.
Custom institutional loans typically allow prepayment anytime without penalty, not just on anniversary dates as is often the case with ToT-style loans. They do not require heavy qualifying, FICO scores or extensive documentation beyond proof that there are no pre-existing liens on the collateral (e.g., tax, divorce) - hence the term "limited doc" (as opposed to "no-doc", which these loans are not). The securities - stocks, bonds, mutual funds -- are the chief eligibility criteria for the loan or credit line. In most cases, loans close within 48 hours of receipt of signed loan documents, or 5-7 days from initial loan inquiry, and cash funds are always available for withdrawal immediately by Visa/ATM card, wire, or on a walk-in basis.
Because of the heightened credit requirements surrounding real estate investments these days, these custom lending facilities can provide a handy line of credit for real estate professionals as "instant standby financing". An investor with a custom line of crediting can simply tap the line immediately and take full advantage of investment opportunities.
Although every borrower should consult with their licensed CPA or other financial planner for guidance on tax matters, the plain fact is that a line of credit leverages the inherent value in the securities portfolio, whereas a Transfer of Title loan does not.
Finding a Securities-based Loan Provider The following is provided solely as a convenience for our readers using keywords aimed at locating lists of securities-based lending firms. Please note that we do not endorse any lender, broker, or loan organization arising from these searches. You are encouraged to choose the loan firm that is most suited to your own preferences in concert with your licensed financial advisor.
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More on securities finance from Wikipedia here.
Tags: buying stock on margin, margin loan rates, margin loan interest, stock margin loan, securities lending, lending securities, stock loan
