Hidden Market for Equity Pledges for Asset Backed Lending



Chroniclers

Hidden Market for Equity Pledges for Asset Backed Lending


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Summary

  • Banks will issue loans at a significant discount to the prevailing share price in order to mitigate the risk of loss in the event of borrower default and / or a decline in the share price.
  • A crucial aspect of this facility is that even though the pledged shares are blocked by the lending bank, they remain in the name of the borrower, which means that the investor continues to benefit from dividends and free shares.
  • Nonetheless, there is a good reason why such a market stays small: It comes with a lot of risk.

On days like these, investors look for liquidity from multiple sources just to keep going. One of the many sources is equity backed loans.

In this scenario, an investor obtains instant liquidity to meet his immediate needs and other personal needs, all supported by his investment in stocks. Typically, a loan is offered by banks with a credit limit determined by the market value of the shares.

Banks will issue loans at a significant discount to the prevailing share price in order to mitigate the risk of loss in the event of borrower default and / or a decline in the share price.

The pledged shares are then “frozen” and investors do not regain full control of the shares until after having cleared their bank loan.

A crucial aspect of this facility is that even though the pledged shares are blocked by the lending bank, they remain in the name of the borrower, which means that the investor continues to benefit from dividends and free shares.

Having said that, it seems to me that securities lending on the Nairobi Stock Exchange (NSE) is not as hot as I thought it was.

In September 2021, only 41,000 investors in total had pledged more than 6.5 billion shares according to the latest report from the Capital Markets Authority (CMA) for the third quarter of 2021.

This number of investors represents 2.36% of the total number of shareholders. In fact, the number has fallen from a high of 45,000 in March 2020, possibly due to lenders’ risk aversion to a bear market and weak investor sentiment.

But in the good times of 2006-8, banks encouraged clients to borrow against their equity portfolios to cover their budget deficits and cash flow needs, rather than selling their investments.

But maybe I could be wrong. With pledged stocks accounting for 6.6% of the total (98.78 billion) shares listed on the NSE #ticker: NSE, the valuation of the pledged shares could easily be north of 130 billion shillings. If this is even half correct, it means that the market is important and stocks are likely to be mostly liquid stocks of large profitable companies like Safaricom #ticker: SCOM Equity #ticker: EQTY and KCB #ticker: KCB.

Nonetheless, there is a good reason why such a market stays small: It comes with a lot of risk. After all, a serious bear market is enough to force some clients to liquidate their investments to repay their loans, causing a forced-sell chain reaction that drives stock prices down.

That’s why the value of your investment portfolio is what matters most. If you can’t repay, lenders can sell your investments to get back what they loaned.

It is therefore important that the portfolio is diversified. If you are too focused on a particular stock, you could quickly find yourself below the required maintenance threshold if that investment drops significantly.

However, with a diversified portfolio, one can change the securities offered as a pledge if the pledgee [lender] agrees.

Either way, on days like these, it pays to have more cash on hand. Borrowing against stocks without selling is the right financial aid for investors. Borrowing money against the value of stocks makes the money readily available. The cash on hand covers immediate and future needs as your inventory continues to build up.

Mwanyasi is the Managing Director of Canaan Capital


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