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Using Your Securities as Collateral

In the world of loans, lenders expect that the borrower provide some type of ‘collateral’ in case the borrower is not able to pay back the loan in the future. Collateral is something valuable, with absolute value that the lender can posses from the borrower if the loan can not be paid. There are many types of collateral, ranging from houses, real property, cars, collectibles, or financial securities.

Financial securities are instruments that people use to invest money, such as bonds, stocks, mutual funds, and t-bills. These financial securities are worth a certain value, and may gain or lose value over time. Many financial institutions recognize these instruments and understand their value. Certain banks will even allow a person to use their financial securities as collateral for a loan. Many banks will also loan these securities out to investment banks or brokers in exchange for collateral such as cash or mortgages. There is big money to be made in securities finance lending. It is estimated that over $2 trillion in these loans exist globally.

One type of securities financing is known as a ‘stock loan’. A stock loan is used by an investor who owns free trading stocks and would like to convert their stock equity into cash without selling the shares. These types of loans use stocks or bonds as collateral. The borrower places their stock up as collateral to receive a certain loan compared to value of the shares current worth. There are a few types of stock loans that exist. The shareholder may place the stocks as collateral for a non-recourse stock loan or they can get a margin loan.

The first option, the non-recourse stock loan will give the borrower the ability to borrow money against the value of the shares that would be placed up as collateral. These loans are similar to home equity loans for stocks. The borrower is able to borrow against the current value of the securities offered as collateral. Since the shares of the stock are such solid collateral, the borrower is usually granted a below prime interest rate for the term of the loan. At the end of the loan’s term, the borrower may choose to either pay back the loan and receive the stock back with any appreciation, or forfeit the shares instead. A borrower may decide that if the stock has lost significant value to just hand back the stock with no further recourse. These loans are very useful to a stock owner who needs cash for any purpose but does not want to sell their shares.

Another option is a margin loan. This type of loan allows the borrower to buy more shares of stock with money borrowed against the value of the stock placed up for collateral. Most lenders will offer a high LTV on these margin loans as they are used to buy other securities that will be held under control of the brokerage. If the value of all the securities begins to drop below the LTV, the borrower will be required to sell all of their shares before the lender’s money is lost or put an immediate cash infusion to make up the margin requirement of the loan. When this happens it is called a margin call.

Depending on what the borrowers want to accomplish and their risk level will determine the right scenario for them. However, both options should be examined carefully in today’s market.

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