Recent trends in interest rates have far reaching effects on decision making for executives and business owners. Due to a multitude of economic issues and policy positions, overall interest rates have collapsed. It is anyone’s guess as to what future trends or policies will be, but a review of the components for managing indebtedness can generally help in moving toward making better decisions.
There are a myriad of factors affecting how and whether a business chooses to borrow. Of course, those decisions vary depending on the leader and the situation. From an executive level view, a company’s indebtedness should be viewed by costs, risks, future opportunities and past commitments. Often, there are also conditions that could lower a company’s borrowing costs or increase investor return at the same cost.
The Risk Parallax
Every lender views any counter-party as a greater risk than the counter-party views themselves. For example, most homeowners with a mortgage are highly confident they will make their next payment, while the lender on the other side of that transaction sees every borrower as one payment short of the next eviction. This is risk parallax. What’s seen of the same risk depends on the viewpoint.
When reaching the zero bound of interest rates, strange things are likely to occur. The risk parallax and the zero bound combine to form an environment where cash yields zero and overnight lending can be Prime plus one (currently 4. 25 percent). A business finding itself simultaneously a borrower and a lender is almost certainly leaving money on the table from this risk parallax and other factors. The negative cash flow from having cash and loans outstanding, as well, is not always controllable; such as past bond issues that are non-callable. But many times it is controllable. This is especially true for closely held businesses where a CEO may also be the CFO and, perhaps, the only shareholder.
In this case, the owner of the business should look for opportunities (given comfort with the risks) to lend personal cash to the company. He could magnify his personal returns many times by simply offering a market rate (4.25 percent versus .01 percent in cash). This will essentially lead to becoming the company’s “banker” where allowed and appropriate. There is no sense in a business owner paying others to take risks he is willing to take himself.
Loaning the “Loan”
So what if the owner is invested as he likes and does not want to sell anything to take on the company’s indebtedness? One alternative would be to personally guarantee the loan and trap a spread. Some owners may have already taken on this risk by co-signing a bank note. As an alternative, let’s say an owner-CEO has a personal stock and bond portfolio at any major firm (Schwab, Goldman, Merrill, etc). All of these firms also own a bank. Their cost of money is currently 30-day LIBOR (0.23 percent). Any securitized loan above that rate is a money maker for them since it is nearly risk-free (collateralized by more than 100 percent). Larger personal loans (one million dollars or more) can easily be done, currently under 1.5 percent. Imagine the possibilities of pledging the family’s Exxon shares and loaning the “loan” proceeds to the company at 4.25 percent. In the current environment, one could easily make three points of annual “float,” essentially 30,000 dollars per million.
In addition to the positives, one should also be aware of some of the limitations of such an arrangement. Loans at these brokerages are heavily regulated as they would be at any bank. However, as the brokerage’s collateral is the stock or bond positions they hold and not the business itself, swift declines in the market value of their collateral will make them edgy. This is particularly true of concentrated positions and illiquid stocks. This can be mitigated by pledging larger amounts of collateral. (Three times the loan size as collateral, for example.) With 3-1 coverage, the collateral could lose half its value before the brokerage got anxious. Some of these loans can also have fixed interest rates, but most are variable. Schwab does not offer fixed rate loans, but UBS and others do. The firms that offer fixed rates over multi-year terms (some up to five years) normally hedge this risk in their loan book. The rates are higher in fixed rate loans due to risks for the brokerage firm, and costs in mitigating that risk. Expect to pay about 0.5 percent extra for each year of a lock; five years fixed currently would be around four percent annually. If interest rates move against the lock, they may have a pre-payment penalty if paid off early. This is a one-way street, so don’t expect a payment if rates go the other way. Many of these firms will quote LIBOR plus 2.75 percent as the starting rate for a variable loan, but they are quick to negotiate.
It is highly likely that this strategy would present risks. It is also quite possible that these same risks are already being taken and the interest rate advantage is currently going to the bank. Co-signing a Prime line at a bank often looks just like what is described above from a risk perspective, but not at a 1.5 percent cost of funds.
There may not be a silver lining to many clouds hovering over Wall Street these days, but this strategy presents a way to avoid being the victim of the low-rate environment and make lemonade from lemons.
Gil Baumgarten is founder and president of Houston based Segment Wealth Management and a 28-year veteran of the securities and investment businesses.
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