You are probably familiar with mortgage interest rates. You may be familiar with the interest (rate) paid on your CD os Money Market account at your bank. These are straightforward numbers, often tied to the Prime Rate. But your stock portfolio loan rates are based on other factors, which may not be familiar to you. In this article we attempt to decode the world of interest rates and give you another perspective on securities based lines of credit.
Let’s examine the issue of interest rates on LeverageLine transactions from the perspective of the lending authority. First and foremost to your lender is the issue of risk, principally, the risk that they will not be repaid their loan in the event you should stop repayment and/or default. Taking care of this issue, for a stock portfolio lender, is the beginning point for any serious loan quote.
The quality of collateral in the case of a securities based line of credit is the factor that determines whether or not the risk is worth it to the lender. The more liquid the collateral — the more buy-sell activity there is on the open market — the more attractive the portfolio is to the lender in terms of collateral, because robust buy-sell activity tells you that if there were a default, the collateral could easily be sold to satisfy the outstanding debt. A stock or portfolio of stocks with light, limited, and short-term history does not give the lender confidence that they could be made whole in the case of default, applications with such poorly traded securities would not qualify in most cases.
The second indicator of whether a stock portfolio is worth the risk is the price. Stocks with strong demand tend to be priced higher, a good indication of liquidity. Stocks under $5/share – generally referred to as “penny stocks” – are rarely attractive to a lender for that very reason. Conversely, stocks with a long and solid history or trading above $5 per share are considered good risks.
The risk assessment team at your lender will review your portfolio first with an eye on these factors. Once determined, loan-to-value is derived. With the valuation of the portfolio and the liquidity variables in hand, this figure can be safely set when in the hand of a risk assessment expert.
With loan-to-value set, the line authorization can be determined. If we were to assume for purposes of illustration a portfolio worth $1 million in eligible securities, at a 75% LTV, that would be a line of credit authorization of $750,000. This figure represents the maximum amount that the client-borrower can withdraw from this line of credit. At that figure, “base interest breakpoint” chart is used to determine the base interest that will apply.
The “base interest” is a figure determined by the lending institution from a variety of sources including the prime rate, comparative rates for other financial products and competitors’ offerings, and the base annual London Interbank Rate. Factors such as economic risk projections, interest-rate projections, Fed policy pronouncements, etc — can all affect this rate, which can be different with different lenders. But in all cases, portfolio interest rates are linked to the total loan authorization,
Examples of “break points” for interest calculation are $100,000-$249,999; $250,000-$499,999; $500,000-$749,000; $750,000-$999,999 and $1M. Each one will have its own base rate. The $100,000-$249,999 break point might be a base rate of 3%; but the $750,000 break point might be only 2%. As a rule, the larger the loan authorization, the lower the base rate.
At this stage the lending risk analyst has a loan authorization, an amount authorized, and a base rate. To this is added the final element, 30-day LIBOR, to arrive at the final rate and offer that in the case of A. B. Nicholas and LeverageLine, is the rate included in our term sheet offer to the client.
Why is 30-day LIBOR affixed? The answer is simple: A lending institution, no matter how skilled, cannot take into consideration all of the factors that might affect the world economy. But those who put together the prime rate and its international sister, the LIBOR rate, can. Adding 30-Day LIBOR matches the way interest is calculated each month by the lender, and how it is paid, so 30 days is a common sense choice (LIBOR is also published in weekly and annual increments).
With the economy slow and struggling, the Federal Reserve Bank set the rate for Prime very low; LIBOR matched this trend, with 30-day LIBOR as low as .021 in a struggling world economy. Today, with the economy booming and the ups and downs of potential trade agreements with China in the daily news, LIBOR and PRIME have surged. 30-day LIBOR in early December of 2018, for example, was 1.31.
So returning to our portfolio interest rate example above of a $750,000 line with a base rate of 2%, to this is added the current 30-Day Libor at 1.31% for a total effective rate this month of 3.31%. This means that next month, the client will owe (assuming he took all $750,000 out, which he does not have to):
.0331 times 750,000 = $24,825 divided by 12 months in the year = $2,068 due interest only, in next month. Should 30-day LIBOR shift downwards or upwards, the amount due for the following month would be adjusted accordingly.
Portfolio interest rates do not follow the typical interest rate determinants. Understanding how they are determined can help you become an informed borrower.