Definition of Loan Stock Agreement

Loan stock agreements are used in short selling stock.

A loan stock agreement, or a "securities lending agreement," is a legally binding contract. It is used primarily in the short selling of a stock. Short selling is the borrowing of a stock from another party for the purpose of selling the stock immediately in anticipation of making a quick profit.

Short Selling Described

Selling stocks short is a counterintuitive, advanced trading tactic that is generally recommended only for professional investors. It is considered counterintuitive because short sellers are on the hunt for the best stocks to sell; whereas most players in the stock market are on the hunt for the best stocks to buy.

Short sellers are stock sellers who do not own the stock they sell. Rather, they borrow and then sell other people's stock in the belief that the stock price will fall in the very near future. When (and if) the stock price drops, they buy the stock back at the lower price, pocket the profit and return the shares to the original owner.

Short Selling Example

Rules for short selling are clearly defined by stock brokerage houses.

For example, having read about the dismal earnings report from a particular company, an investor instructs his broker to "short" that company by 1,000 shares; these are shares that the investor does not own himself. His broker will then sell 1,000 shares of the company out of the brokerage house's own inventory of that company's shares, or the broker will "borrow" the shares from another customer or another broker.

Loan Stock Agreement Defined

Stock lending agreements require collateral.

Stock borrowers are required to put up some collateral before the borrower is able to "borrow" the stock. The loan stock agreement (securities lending agreement) is the contract between the borrower and the lender that states in detailed specificity the terms of the loan: the length of the loan and the nature of the collateral offered. The collateral (cash, another security or a letter of credit) must be of the same or greater value as the stock borrowed. The agreement further specifies the compensation (typically a fee) the lender will receive and how the contract will be enforced should the borrower renege on the contract.

Loan Stock Agreements and Rights of Ownership

The stock borrower has legal rights of ownership.

When a stock is loaned to a borrower, the title to the stock also transfers to the borrower. The borrower has the advantages of holding the security in the same manner as if she owned it. As such, the borrower will receive all coupon and/or dividend payments and any other rights, such as voting rights, during the period specified in the agreement. However, these dividends or coupons must be passed back to the lender in the form of what is called a "manufactured payment"--this is a tax concept whereby the lender of a stock receives the equivalent dividend payment from the borrower of the stock.

Benefits and Risks

Beware of the risks in short selling.

Securities lending has the potential to be a win-win proposition for both borrower and lender. The borrower will earn a profit from shorting a stock if the stock price falls. The advantage to the lender is the fee earned for loaning the stock. The risk to the borrower, however, is that the price of the stock could rise. In this scenario the borrower will lose money due to the necessity of having to repurchase the stock at a higher price than when the stock was initially borrowed. When large numbers of short sellers try to cover their positions in a stock, it can drive up the price even faster. This is called a "short squeeze", a phenomenon that nearly assures the borrower will lose money.

References

• Loan Stock
• Securities Lending
• How Short Selling Works