What Is Loan Stock?
Let me explain what loan stock is: it refers to shares of common or preferred stock that you use as collateral to secure a loan from another party. This loan comes with a fixed interest rate, just like a standard loan, and it can be either secured or unsecured.
If it's a secured loan stock, it might also be called a convertible loan stock, meaning you can convert it directly into common shares under specific conditions and at a predetermined rate—think of something like an irredeemable convertible unsecured loan stock (ICULS).
Key Takeaways
- A loan stock 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 drops.
- The company that issued the stock can also be impacted in the event of a default, which can make the lender a significant stockholder overnight.
- The Federal Reserve’s Primary Dealer Credit Facility accepts stocks as collateral for overnight loans to major financial institutions, raising the same risks and concerns for the Fed.
Understanding Loan Stock
When you're using loan stock as collateral, the lender will value publicly traded and unrestricted shares the most because they're easier to sell if you can't repay the loan.
Lenders might hold physical control of those shares until you pay off the loan, at which point they return them to you since they're no longer needed as collateral. You might hear this called portfolio loan stock financing.
Risks to Lenders
Share prices fluctuate with market demand, so the value of stock securing your loan isn't guaranteed long-term. If the stock loses value, the collateral might not cover the outstanding loan amount.
In a default scenario, the lender could face losses on whatever isn't covered by the current share value. Stock prices can drop to zero or the company could go bankrupt, leaving the loan completely uncovered in theory.
Issuing Business Concerns Over Loan Stock
The business that issued the stock might worry about what happens if you default on the loan. In that case, the lender becomes the owner of those collateralized shares.
As a new shareholder, the lender gains voting rights in company affairs and becomes a partial owner of the business.
Loan Stock Businesses
There are entire businesses dedicated to loan-stock transactions, where you can get financing based on your securities portfolio, considering factors like implied volatility and your creditworthiness.
They set a loan-to-value (LTV) ratio based on your portfolio, similar to assessing a home's value for a mortgage, with funds backed by your security holdings.
Primary Dealer Credit Facility
Back in September 2008, during the financial crisis, the Federal Reserve expanded eligible collateral for its Primary Dealer Credit Facility (PDCF) to include some equities as an emergency measure. This was part of many unprecedented actions, and the PDCF wound down in 2010 as things stabilized.
In March 2020, amid the COVID-19 stock market crash and liquidity issues, the Fed reopened the PDCF, accepting a broad range of equities as collateral. This positions the Fed as a holder of loan stock collateral for overnight loans, exposing it to stock market risks in volatile times and raising concerns about the government becoming a direct shareholder in public companies.
What Are the Characteristics of Loan Stock?
Loan stocks are long-term agreements, functioning as a form of long-term debt financing. They're negotiated at a fixed rate with predetermined interest payment periods and collateral amounts.
What Are the Different Types of Loan Stocks?
You can have unsecured or convertible loan stocks. Unsecured ones are riskier, putting lenders on equal footing with other unsecured creditors in a default. Convertible loan stocks let you convert them into common shares, offering lenders a form of collateral.
What Is Stock Lending?
Stock lending means lending shares to another party for a fee plus interest charges. It's mainly used in short-sell trades where the seller doesn't own the stock but needs it, or for hedging and arbitrage.
The Bottom Line
Loan stock reduces lending risk by giving lenders access to share collateral if you can't repay your debt. The main risk for the lender is a drop in share prices from the deal time, reducing collateral value and potentially preventing full loan recovery in default.
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