What is loan stock?
Loan shares refer to ordinary shares or favorite stock that are used as collateral to secure a loan from another party. The loan pays a fixed interest rate, much like a standard loan, and can be secured or unsecured. A secured loan share may also be called a convertible loan share if the loan share can be directly converted into common stock under specified conditions and with a predetermined term. conversion rateas with an unrecoverable convertible not guaranteed loan stock (ICULS).
Key points to remember
- A loan security is an equity security used as collateral to secure a loan.
- This practice potentially creates the risk for the lender that the value of the collateral will fall if the stock price falls.
- The company that issued the shares can also be affected in the event of default, which can make the lender a major shareholder overnight.
- The Federal Reserve’s primary dealer credit facility accepts equities as collateral for overnight lending to major financial institutions, raising the same risks and concerns for the Fed.
Understanding Lending Stock
When loan shares are used as collateral, the lender will find the highest value in shares of a company that are publicly traded and unrestricted; these shares are easier to sell if the borrower is unable to repay the loan. Lenders can retain physical control of the shares until the borrower repays the loan. At that point, the shares would be returned to the borrower, as they are no longer needed as collateral. This type of financing is also known as portfolio loan equity financing.
Risks for lenders
Because the price of a stock can fluctuate with market demand, the value of the stock used to secure a loan is not guaranteed for the long term. In situations where a stock loses value, the collateral associated with a loan may become insufficient to cover the outstanding amount. If the borrower defaults at that time, the lender may incur losses of an amount that is not covered by the current value of the shares held. Since stock prices may even fall to zero or the company may go bankrupt, loans secured in this way can theoretically result in a completely unsecured loan.
Raise business concerns about lending actions
The company issuing a stock used to secure a loan may have concerns about the outcome of the deal. If the borrower defaults on the loan, the financial institution that issued the loan becomes the owner of the guaranteed shares. By becoming a shareholder, the financial institution can obtain voting rights in the affairs of the company and become part owner of the company whose shares it owns.
Lending stock companies
There are fully-fledged companies that operate solely by offering options for stock lending transactions, allowing a portfolio holder to obtain financing based on the value of their securities, as well as other factors such that the implied volatility of their assets and solvency. A loan to value (LTV) is established on a portfolio basis, similar to how the value of a home is assessed when obtaining a mortgage, and the funds are backed by securities held in the borrower’s portfolio .
Primary Dealer Credit Facility
As an emergency measure, the Federal Reserve expanded the range of eligible collateral on loans through its Primary Dealer Credit Facility (PDCF) to include some actions in September 2008. This was one of many unprecedented central bank actions in the face of the 2008 financial crisisand the PDFC was later phased out in 2010 when the economy stabilized.
In March 2020, the Fed reopened the PDCF to address the stock market crash and liquidity issues associated with the spread of the COVID-19 virus and the resulting containment measures instituted by public health officials. The reopened PDCF includes a wide range of stocks as eligible collateral.
This makes the Fed a holder of lending equity collateral against the overnight loans it makes through the PDCF. This potentially exposes the Fed to substantial stock market risk, during a highly volatile period, and could raise concerns that the Fed, as a government institution, may end up becoming a direct shareholder in certain publicly traded companies.
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