Margin loans and short selling explained

MARGIN loans, short selling and stock lending have combined to cause severe difficulties for certain stocks - we explain how they work.

Margin loans and short selling explained

THE unholy trinity of margin loans, short selling and stock lending have combined to cause severe difficulties for certain stocks - and individuals - in recent weeks, and arguably have contributed to a more volatile and less informed market.

Each is a simple concept.

Margin borrowing is taking out a loan to buy more stock than you can afford; or borrowing against shares you own.

Short selling is the reverse of normal share market practice: it is selling a stock first, and buying it later. If the price falls after you sell you profit, as your selling price is more than your buying price.

Stock lending is where the owners of shares lend them out, for a fee, to borrowers who are free to use them in any way they like - although the shares remain owned by the lender, who can recall them from loan at any time.

How the three have coalesced in a firestorm (if you're one of the company directors involved) is that certain company directors have borrowed heavily on their shareholdings; hedge funds have aggressively short sold some stocks such that the directors' loan-to-value ratios have been breached and their lenders have sold them; and in many cases, hedge funds have borrowed stocks from institutional shareholders and super funds to short sell them in the first place.

Hedging their bets

Short selling is a popular strategy employed by hedge fund managers and absolute-return funds, many of whom run "long-short'' funds, which simply aim to capture returns from rising and falling share prices, within the same fund. In this way, the funds can, in theory, generate a positive return no matter how the share market is performing.

But before a hedge fund - or anyone else - can short a stock, they have to borrow it. This is where the prime brokerages and custodians come into the picture.

"Prime brokerage' is a term for a package of services investment banks offer hedge funds, without which they could not operate.

A prime broker lends stock to a hedge fund so it can short-sell, executes its trades and keeps its cash in a central account.

Each fund that uses the prime broker service signs a custodian agreement, agreeing that its entire portfolio goes into a pool. The prime broker can lend that stock to someone else in that same pool - such as 1000 funds.

If there's no stock left in the pool to sell, the prime broker can go to another prime broker and ask if it has any spare stock it can lend - for a fee.

A prime brokerage pool must be square at T+3 (that is, settlement must occur three days after trade).

In practice, every day is a T+3 even, so the pool must be square each day.

A custodian holds stocks on behalf of institutional managers and trustees of super funds. Most custodians offer a product called a securities lending program, in which the beneficial owner of the stocks authorises the custodian to lend them into the market.

It might sound counter intuitive that a super fund or long-only managed fund would lend stock to a hedge fund that sells it short -- thus depressing its price. So why do they do it? The answer is, for the fee income, in the form of an interest-rate return.

"Participating in a stock lending program adds some incremental value over time to a fund, in an additional return to the underlying investors,'' Russell Investment Group chief investment officer Pete Gunning says.

"The fund receives extra income, it never loses ownership of the stock, it is paid its dividends and franking credits in cash, and it can recall the stock, in which case the short-seller - or anyone else who has borrowed it for whatever purpose - has to give it back.''

Anthony Patterson, managing director of Perennial Investment Partners, has a different view.

"Many funds are lending stock to people who are shorting their own long positions,'' he says.

"If I were lending our stock in Macquarie Group, for example, it could be lent to a hedge fund currently shorting Macquarie.

"That sounds a bit counter intuitive. If you're a fund lending a stock you own, how is the stock price being forced down in your interest?''

Mr Patterson says Perennial does not lend stock from its own portfolios, although some of its institutional clients have entered stock-lending programs.

"We don't believe stock lending works in the best interests of our investors. I have not seen any numbers that satisfy me that those who lend their stock perform better long-term - particularly if you take into account the market impact of what can occur to their stocks when hedge funds get involved.''

The only way a fund could lose on stock lending in the situation of a price fall, Mr Gunning says, is if the underlying manager panics and begins to think there's something inherently wrong with the company, and sells out of the stock, realising a loss.

"Clearly, there's a lot of volatility in the market, and that includes pretty well-known stocks that have suddenly fallen sharply, and potentially some is due to hedge funds short-selling them.

"But long term, you'd like to think markets are efficient and share prices return to what is the fundamental value of the company. In that case, as a stock is shorted lower, there should come a point where the stock becomes oversold and cheap on fundamentals, in which case long-only funds buy back into the stock.

"So, a fund lending stock still has it on the books, and is participating in the long-term future of the stock.

"But in the interim period, given that there are hedge funds and traders trading among themselves, lending stock into the market for extra income can add value to the underlying fund. If the stock recovers in price they will be net better off under the stock-lending program.''

Mr Patterson agrees that if a stock is shorted too far, it can become good value and the long-only funds buy back in.

"But if you're lending stock to hedge funds to short it, you are exaggerating stock price volatility,'' he says.

"Volatility can be good, because it's an opportunity for people to add value.

"The theory is that ultimately the stock price will go back to its true value: that's if markets are efficient, but we might have one at the moment that is not.

"You can argue that the way that margin loans, short selling and stock lending have combined recently has given us forced sellers, and a market in which people don't understand what's going on.''

Karl Siegling, investment director at absolute-return fund manager Cadence Capital - which uses a prime brokerage service to short-sell securities - says short sellers are  "simply betting against those in the market who say that a stock price is going up''. But he sees "tricky situations'' developing as a result of convergence between margin loans, short selling and stock lending.

"`I think we are seeing structures and practices that have developed in the market stress tested for the first time, and there are some real problems in the maintenance of a fully informed and equal market,'' he says.

"In particular, we have a situation where margin-loan stock is being on-lent to be short sold, and I suspect that practice will come under review.''

The major problem, Mr Siegling says, is that the situation has developed where there are certain investors who may become forced sellers, but the market doesn't know this because directors don't have to disclose their margin loans, nor the share-price trigger points at which they might be forced to sell stock -  or be sold out by their margin lenders.

"I think there is going to have to be some legislative change,'' Mr Siegling says. "The real risk is if a party lends money to a director of a company, and it has the stock as security for that loan, if they then give that stock to someone else, or that stock goes into a pool where it can be short sold, that is potentially dangerous, because the person that lent the money has unique knowledge that could cause the borrower to come under severe financial difficulties.

"It's possible that they could give that stock to a player who could short sell it, knowing there's a margin loan against it.'' This is particularly the case for small to mid cap companies where directors may be prominent on the share register.

Mr Siegling says if he were to borrow money and put his stock there as deposit, he would insist on a contractual arrangement that that stock could not be on-lent to someone else to short.

"You could go as far as to say the real problem is these directors have borrowed money against their own stock,'' he says. ``Maybe margin lending to directors shouldn't be allowed - that would solve the problem.''