Loan stock refers to shares of common or preferred stock used as collateral to secure a loan. This type of loan earns a fixed interest rate, similar to a standard loan, and can be secured or unsecured.
A secured loan stock may also be termed a convertible loan stock if it can be directly converted to common shares under specified conditions at a predetermined conversion rate. For instance, in the case of an irredeemable convertible unsecured loan stock (ICULS), the conversion becomes possible following certain conditions.
Key Takeaways
- A loan stock is an equity security used as collateral to secure a loan.
- Market volatility risk: This practice poses the risk that the value of the collateral might fall if the stock price drops.
- Impact on issuing companies: Defaults can significantly impact the company that issued the stock, potentially making the lender a significant stockholder overnight.
- The Federal Reserve’s Primary Dealer Credit Facility accepts stocks as collateral for overnight loans, introducing similar risks and concerns for the Federal Reserve.
Understanding Loan Stock
When loan stock is utilized as collateral, lenders usually prefer publicly traded and unrestricted shares because they are easier to sell if the borrower defaults. In some cases, lenders maintain physical control of the shares until the loan is fully repaid. Once the borrower repays the loan, the shares are returned as they are no longer required as collateral.
This type of financing is also known as portfolio loan stock financing.
Risks to Lenders
The value of shares used as collateral can fluctuate with market conditions, making the loan’s security less reliable over time. If the stock loses value, the collateral might become insufficient to cover the loan. Defaults occurring under these conditions may force lenders to face losses, especially if the stock value has dropped significantly.
Stock prices can plummet to zero if the company goes bankrupt, leaving loans entirely uncovered.
Issuing Business Concerns Over Loan Stock
Issuing companies have their concerns regarding the consequences of securing loans with their stock. If the borrower defaults, the financial institution becomes the shareholder, granting it potential voting rights and partial ownership in the issuing business.
Loan Stock Businesses
Several specialized businesses facilitate loan stock transactions. They provide financing options, leveraging the value of the portfolio holder’s securities and assessing factors like implied volatility and creditworthiness. They establish a loan-to-value (LTV) ratio based on the portfolio, akin to appraisal in home mortgages.
Primary Dealer Credit Facility
During times of economic stress, the Federal Reserve took unprecedented measures. Notably, in September 2008, it expanded the eligible collateral for loans from its Primary Dealer Credit Facility (PDCF) to include certain equities. In response to the 2008 Financial Crisis and reinstated briefly in 2020 due to the COVID-19 crisis, this facility now encompasses a broader range of eligible equities as collateral.
This makes the Federal Reserve a holder of loan stock collateral, posing significant stock market risks, potentially making the Fed a shareholder in publicly traded companies.
Characteristics of Loan Stock
Loan stocks are seen as long-term debt financing, featuring fixed rates, specified interest payment schedules, and defined collateral terms.
Different Types of Loan Stocks
- Unsecured Loan Stocks: These are riskier, placing lenders among other unsecured creditors in case of default.
- Convertible Loan Stocks: These allow conversion into common shares, offering a form of collateral.
What Is Stock Lending?
Stock lending involves lending shares to another party for a fee and interest. Commonly utilized for short-sell trades, where the trader temporarily borrows stock to sell, it is also applied in hedging and arbitrage.
The Bottom Line
Loan stocks mitigate lending risks by providing shares as collateral. However, this introduces the risk that the value of collateral might decrease if share prices fall, potentially jeopardizing the lender’s ability to recover the loan amount in case of default.
Related Terms: unsecured loan fintech, convertible note, securitization, loan-to-value ratio, primary dealer credit facility.
References
- Board of Governors of the Federal Reserve System. “Primary Dealer Credit Facility”.
- Board of Governors of the Federal Reserve System. “Federal Reserve Board Announces Establishment of a Primary Dealer Credit Facility (PDCF) to Support the Credit Needs of Households and Businesses”.
