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Re: Chrisau post# 105068

Saturday, 11/25/2006 2:01:40 AM

Saturday, November 25, 2006 2:01:40 AM

Post# of 285815
Shortchanged

Liz Moyer 12.11.06

Your broker may be making a pretty penny lending your stock to a hedge fund without your knowledge. Here's how to get a cut of the action.
Roger Metzler, a retired mergers and acquisitions attorney in Walnut Creek, Calif., likes his investment in NovaStar Financial (nyse: NFI - news - people ): The stock pays a $5.60 dividend, for a yield of 18.5%. He doesn't mind that NovaStar, a Kansas City, Mo. real estate investment trust, is the target of hard-charging short-sellers who for nearly two years have kept the shares among the most heavily shorted stocks on the New York Stock Exchange. In fact, he is counting on this short-selling to continue.

Metzler profits from it by lending his 32,000 NovaStar shares to traders through his brokerage account at Smith Barney. In exchange, Smith Barney pays him 13% a year. The arrangement adds up to income of $129,000 annually--that's $4 a share on top of his $5.60 dividend. "If I'm going to hold it, I might as well get as much money out of it as I can," he says.

Metzler is an exception, not the rule. Wall Street securities houses rake in $10 billion a year in revenue from lending the shares of long-term holders to active traders. The borrowers could be hedge funds, who either are trying to short a stock or scrambling to cover a stock loan that has been called in, or they could be investment houses that need an underlying instrument for a derivatives contract. Until recently very little of the revenue from stock lending has found its way into the pockets of retail investors, says Joshua Galper, managing principal of Vodia Group, a New York City consulting firm that analyzes securities lending.

To understand the economics of stock lending, consider what happens when the borrowed shares are readily available. Short-seller S borrows a share of, say, ExxonMobil (nyse: XOM - news - people ) from lender L and sells it for $72. In place of the missing share, S hands L a ticket entitling L, in effect, to all the dividends on that share.

S also pledges that L will get a slice of something else: S places 102% of the share's value, meaning $73.44, in Treasury bills paying 5.25%. The lender ends up collecting, in this case, perhaps a fifth of the interest this kicks off.

S is in a position to demand good terms because there are lots of ExxonMobil shares sitting in pension funds and, so long as the stock loan is well collateralized, there is no harm to the lender in surrendering the share in exchange for a total-return ticket.

Now, what if the stock in question is not a blue chip but rather a REIT with a poorly covered dividend and a focus on the subprime mortgage business, which many expect to come under pressure? Then there will be many short-sellers eager to borrow shares but not many shares available to borrow. L can demand good terms--keeping all 5.25 points of the interest or even, for a really hard stock to find, that plus another 8 points of premium.

In fact, if Metzler is getting a 13% annual fee on NovaStar, then Smith Barney is probably charging the short-seller a bit more than that.

Besides collateral, there is one other thing that some lenders have to concern themselves with, and that is taxes. Pension funds don't care, but an individual lending shares owes tax at up to 35% on cash in lieu of the dividend. A genuine dividend (from ExxonMobil, albeit not from a REIT) would be taxed at only 15%.

U.S. pension funds have $14 trillion of stock available to be lent out, usually through intermediaries like Goldman Sachs (nyse: GS - news - people ). But the rapid growth in loan demand from hedge funds has forced brokerages to turn increasingly to their retail customers. The three largest online brokerages collectively have $935 billion worth of stock to lend.

Now here's Wall Street's dirty secret: Brokerage firms are free to lend out any shares that customers put in margin accounts, the kind of account that allows the customer to borrow against his securities. Take a look at the fine print on your brokerage application. If you see a line of credit attached you've probably got a margin account.

Does your brokerage pass along to you any of the profits it gets from its stock loan department? Probably not. But straight-arrow brokerages at least make up to you the tax cost of not getting genuine dividends.

If you want to profit by lending shares of a sought-after stock like NovaStar, you may have to first move them (or threaten to) out of your margin account into a cash account where the broker can't touch them without your permission. Charles Schwab (nasdaq: SCHW - news - people ) has a program allowing retail customers with hard-to-borrow stocks to get some of the fee revenue.

The firm refuses to quote rates, but customers contacted by FORBES report Schwab paying 8% for NovaStar shares. Fidelity Brokerage says it is looking into setting up a similar program for its retail customers.

It is easy for investors to find out if they own shares that are likely to command premiums. The stock exchanges publish daily lists on the most heavily shorted stocks, thus the hardest to borrow. Netflix (nasdaq: NFLX - news - people ), Martha Stewart Living Omnimedia (nyse: MSO - news - people ), Krispy Kreme (nyse: KKD - news - people ), NovaStar, and even at times the NYSE Group (nyse: NYX - news - people ) itself have made the list. Overstock.com (nasdaq: OSTK - news - people ), an online retailer that sells brand-name products at clearance prices, is such a favorite of short-sellers that lenders are charging 54% a year for the shares, according to Vodia Group.

A price war in online brokerage has all but eliminated commissions for active traders who keep big balances. Competition may come next to fee sharing by the stock loan department. At the moment brokers are reluctant to share fees unless the customer has a large block, a cutoff of $100,000 worth of shares being typical. A work-around for smaller investors is to pool resources with family and friends. Mary Helburn, a Denver, Colo. investor, and many of her family are together lending 59,000 shares of NovaStar through their Smith Barney accounts. That yields income of $19,800 a month.

A word of warning before you buy a stock with the intention of lending it. Short-sellers don't go after ExxonMobil. They tend to go after companies with weak balance sheets or disappointing cash flows, and sometimes they are vindicated. Over the past year NovaStar's price is up slightly but Overstock.com's has halved.

http://www.forbes.com/home/free_forbes/2006/1211/152.html

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