# Loan Stock Explained: Usage, Functionality, and Lender Risks

## What Is Loan Stock?

Loan stock is a financial tool in which shares of [common](https://www.investopedia.com/terms/c/commonstock.asp) or [preferred stock](https://www.investopedia.com/terms/p/preferredstock.asp) are used as collateral to secure a loan from another party. The loan acts like a traditional loan but involves equity security. It earns a fixed interest rate and can be secured or unsecured.

Using loan stock as [collateral](https://www.investopedia.com/terms/c/collateral.asp) brings risk with it. This is because the stock's market value could decline, leaving the lender with insufficient collateral if the borrower defaults. In case of borrower default, the issuing business's shares might fall into the hands of lenders, which could lead to new voting rights and ownership stakes for financial institutions.

Lenders may maintain physical control of the shares until the borrower pays off the loan and then sees the shares returned.

Read to learn the mechanics, benefits, and potential pitfalls of loan stocks.

### Key Takeaways

*   Loan stock is a type of equity security used as collateral to secure a loan, similar to how a mortgage uses a property as collateral.
*   The use of loan stock as collateral carries the risk that the stock's market value could decline, leaving the lender with insufficient collateral in the event of a borrower's default.
*   If a borrower defaults, the issuing business might see its shares fall into the hands of lenders, potentially granting new voting rights and ownership stakes to financial institutions.
*   Loan stock agreements can be long-term and may include unsecured or convertible options, which further influence the risk and benefits involved for both lenders and borrowers.
*   The Federal Reserve's inclusion of stocks as collateral through its Primary Dealer Credit Facility (PDCF) highlights the risks associated with collateralizing loans with equities during volatile economic periods.

## How Loan Stock Collateral Works

When loan stock is being used as collateral, the lender will find the highest value in shares of a business that are publicly traded and unrestricted; these shares are easier to sell if the borrower is unable to repay the loan.

Lenders may maintain physical control of the shares until the borrower pays off the loan. At that time, the shares would be returned to the borrower, as they are no longer needed as collateral. This type of financing is also known as portfolio loan stock financing.

## Potential Risks of Loan Stock for Lenders

Because share prices fluctuate with market demand, the stock's value as loan collateral isn't guaranteed long-term. If the stock's value drops, the collateral might not cover the outstanding loan amount.

If the borrower defaults at that time, the lender may experience losses in the amount that is not covered by the current value of the shares being held. Stock prices can fall to zero, or the company might go bankrupt, leaving the loan uncovered.

## How Loan Stock Affects Issuing Companies

The issuing business of a stock used to secure a loan may have concerns regarding the outcome of the agreement. If the borrower defaults on the loan, the financial institution that issued the loan becomes the owner of the collateralized shares. As a shareholder, a financial institution may gain voting rights and partial ownership of the issuing company.

## Businesses Specializing in Loan Stock

There are full-fledged businesses that function solely by providing options for loan-stock transactions, allowing a portfolio holder to obtain financing based on the value of their securities, as well as other factors such as the [implied volatility](https://www.investopedia.com/terms/i/iv.asp) of their holdings and creditworthiness.

A [loan-to-value (LTV)](https://www.investopedia.com/terms/l/loantovalue.asp) ratio, much like a home appraisal, is set based on the portfolio, with funds backed by the borrower's security holdings.

## Role of the Primary Dealer Credit Facility in Loan Stock

In September 2008, as an emergency measure, the Federal Reserve expanded the range of eligible collateral on loans through its [Primary Dealer Credit Facility (PDCF)](https://www.investopedia.com/terms/p/primary-dealer-credit-facility-pdcf.asp) to include some equities. This was one of many unprecedented actions by the central bank during the [2008 financial crisis](https://www.investopedia.com/terms/c/credit-crisis.asp), with the PDFC ending in 2010 as the economy stabilized.

In March 2020, the Fed reopened the PDCF to address the stock market crash and liquidity problems associated with the spread of the COVID-19 pandemic and resulting containment measures instituted by public health officials. The reopened PDCF included a broad range of equities as eligible collateral. It ended in March 2021.

The reopened PDCF made the Fed a holder of loan stock collateral against the overnight loans it made through the PDCF. This potentially exposed the Fed to substantial stock market risk during a very volatile period and raised concerns that the Fed, as a government institution, might end up in the position of becoming a direct shareholder in some publicly traded companies.

## What Are the Characteristics of Loan Stock?

Loan stocks are long-term agreements so are seen as a form of long-term debt financing. They are negotiated at a fixed rate with predetermined interest payment periods and the amount of collateral.

## What Are the Different Types of Loan Stocks?

Loan stocks can be unsecured or convertible. Unsecured loan stocks are more risky, and these lenders are equal to other unsecured creditors if there is a default. Convertible loan stocks allow for the conversion into common shares, providing lenders with a form of collateral. The conversion must happen under specified conditions and with a predetermined [conversion rate](https://www.investopedia.com/terms/c/conversion-rate.asp), as with an irredeemable convertible [unsecured](https://www.investopedia.com/terms/u/unsecured.asp) loan stock (ICULS).

## What Is Stock Lending?

Stock lending is the lending of shares to another party for a fee as well as with interest charges. Stock lending is primarily done in short-sell trades where the seller doesn't own the stock but needs it for the trade. It can also be used for hedging and arbitrage trades.

## The Bottom Line

Loan stock is common or preferred stock used as collateral to secure a loan.

The risk for the lender is if the price of the shares drops from when the deal was made, effectively reducing their collateral value and putting them in danger of not recovering the loan amount if it goes into default.

Loan stock can be secured or unsecured. Secured loan stock provides risk reduction for lenders in the form of an asset that can be seized if the borrower defaults. Unsecured loan stock is riskier and leaves lenders equal to other unsecured creditors in the event of default.

Stock price fluctuations (not just drops) can affect the value of the loan stock used as collateral, leading to possible insufficiency in covering the loan amount in case of borrower default.

There are potential consequences for the lender and the issuing business if the borrower defaults. These include the shares of the issuing business falling into the hands of the lender and the lender acquiring voting rights and partial ownership if it becomes a significant shareholder.

The Federal Reserve's Primary Dealer Credit Facility accepts stocks as collateral during financial crises. This showcases the risk in collateralizing loans with equities during volatile economic periods and, more broadly, the significance of loan stock in economic stability.

> **Article Sources**
>
> 1.  Board of Governors of the Federal Reserve System. "[Primary Dealer Credit Facility](https://www.federalreserve.gov/regreform/reform-pdcf.htm)."
>     
> 2.  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](https://www.federalreserve.gov/newsevents/pressreleases/monetary20200317b.htm)."
>     
> 3.  Federal Reserve Bank of New York. "[Primary Dealer Credit Facility](https://www.newyorkfed.org/markets/primary-dealer-credit-facility)."