An expected uptick in M&A stands to position margin lending as an increasingly important revenue stream for the handful of banks that are able to put their funding advantage to work.
After their post-crisis retreat, loans collateralised by listed equities have gained in popularity by providing efficient and flexible financing solutions for corporates seeking to build stakes in potential acquisition targets. Private equity and sovereign wealth clients can often achieve tighter terms on loans by using listed stakes rather than relying on their own creditworthiness.
But while some banks are putting financing solutions at the centre of growing equity derivatives ambitions, with Bank of America Merrill Lynch highlighted by numerous competitors for its aggressive outlier pricing, for others the activity looks set to become a relic of history as they struggle to make it pay under a more stringent leverage and capital regime.
“It’s astonishing that US banks haven’t already stopped,” said the head of equity derivatives at one European house. “The spreads these are trading at show a disregard for the return they’re getting on assets in any jurisdiction – it’s just bizarre. It’s 2 percentage points off our return hurdles and that is huge.”
But for those with access to ample depositor funding, including the likes of BofA Merrill Lynch, Citigroup, JP Morgan and Morgan Stanley after it acquired the Smith Barney wealth management division, margin lending is proving to be a lucrative business despite the rapid tightening of spreads over the past 18 months.
“Large banks that are flush with cash can do margin loans at essentially no cost. They have to mark the trades, but the cost of carry is zero and the yield on a loan can easily be over 200bp. On paper it’s a great business,” said the head of equity derivatives structuring at one US house.
Transfer pricing
Capitalising on its funding advantage, BofA Merrill, which ranked as the second-largest US bank by deposits with US$1.1trn at the end of 2013, has positioned its financing business at the centre of an ambitious build-out of its equity derivatives operations.
The bank began a focused push in margin lending just over two years ago after loan-plus-collar structures, which had become the mainstay of equity financing activity in the wake of the crisis, became unattractive as rates and volatility declined. For collar financing, banks need to hedge the call option in the market by buying vega.
“Large banks that are flush with cash can do margin loans at essentially no cost … On paper it’s a great business”
“On a collar you get hit as the theta bleeds, which ends up costing you money. A margin loan costs you nothing except a little bit of hedging. You can make the argument that it’s 200bp of carry for quasi-zero risk,” said the structuring head. “It only ends in tears when a margin loan actually triggers and you lose your short.”
According to some competitors, BofA Merrill appears to be pushing its advantage to the limit in an effort to gain market share. BofA Merrill declined to comment for this article.
A prime broking head at another US house noted that the rest of the Street remained relatively bunched on pricing, even including houses that are making a concerted push, but one bank remains a wide outlier.
“We’re talking about a situation where one bank is coming in 15bp cheaper in a deal that might only be paying 35bp–40bp. There’s no single market player out there that is such an outlier and the rest of the market can’t react to it, as you’d be running a loss-making business,” he said.
Some competitors bemoan the strategy and its role in accelerating spread-narrowing and pushing terms to pre-crisis levels, but others believe that it could be a savvy move in building the business to benefit from an expected uptick in M&A activity as others step away.
“If you have cheap financing from a sustainable depositor base, allocating 3%–5% of the balance sheet to a completely different asset makes a lot of sense,” said the structuring head. “If you took a margin loan at 400bp in November 2007, you’d have lost a lot of money, but if you got in around 2012 or 2013, you’d be a genius.”
But while transfer pricing was necessary to support the ailing investment bank following the 2008 merger, many are surprised that a pricing differential still exists.
“It makes sense to build a business with transfer pricing if you genuinely believe it will secure market share, but if you’re still doing it more than five years on, it’s probably not a sustainable business,” said the PB head.
According to a European head of corporate equity derivatives at another US house, loan-to-value ratios have jumped back to pre-crisis levels following their dramatic fall to around 50% – a phenomenon that opened what had traditionally been a Europe-centric business to clients in the US, where LTVs are capped at 50% of equity collateral.
“There’s still quite a lot of willingness to take risk and LTV levels have gone to pretty punchy levels, and we now see 50% as more of a floor. We’re pretty close to the cap on how low pricing can get in an environment where we have to comply with leverage and capital rules,” said the derivatives head.
Paying off
So far, BofA Merrill’s push seems to be paying off with a presence on trophy deals. The bank took a key role last year in Liberty Media’s US$1.7bn margin loan financing that enabled the company to acquire a 27% stake in Charter Communications (see “Margin loan helps fund Charter purchase”, IFR 1976)
As the stake was being acquired from a number of financial sponsors, the deal was structured as a US$1bn four-year loan with an additional US$1bn accordion feature – affording flexibility for Liberty to upsize the deal as required. The loan was collateralised by purchased Charter shares and existing shares in Nasdaq-listed Sirius XM Holdings. Risk is typically shared among a syndicate of banks through the transfer of credit default swaps.
According to equity derivatives specialists, a number of similar transactions are currently in process and are expected to close in the coming weeks.
