Case 088Lending and leverageCore

A client needs a Rs 2 crore bridge for 9 months and holds Rs 4 crore of equity at 50% loan-to-value and Rs 2 crore of debt funds at 80%. Is a loan against securities enough, and what fall in equity triggers a margin call?

The situation

Neha Saraogi has agreed to buy a flat and must pay Rs 2 crore now; the sale of her old flat will bring in more than that in about nine months. She holds Rs 4 crore of diversified equity funds and shares, which the bank lends against at 50% of value, and Rs 2 crore of debt funds, which it lends against at 80%. The bank's illustrative rate is 10% a year, and it can change its loan-to-value ratios at any time.

Her debt funds are expected to earn about 7% a year. Selling them instead would realise gains taxed at her slab rate, which she must confirm.

Your task

Can she borrow the Rs 2 crore against her portfolio, what market fall would cause a margin call, and is borrowing better than selling?

Quick check

If Neha pledges only her equity, how far can equity fall before a margin call?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Yes, if she pledges both: capacity is Rs 3.6 crore against a Rs 2 crore loan, and equity would have to fall about 80% before a margin call. Pledging only the equity gives exactly Rs 2 crore of capacity and no headroom. Nine months of interest at an illustrative 10% is Rs 15 lakh, but her debt funds keep earning about 7%, so the net carry is about Rs 4.5 lakh, likely less than the tax on selling.

Step 1How much will the bank lend against this portfolio?

Each asset lends its value times its loan-to-valueThe share of a pledged asset value that a lender will advance, lower for assets whose prices swing more. ratio. A pawnbroker will lend more against a gold coin than against a painting, because he knows what the coin will fetch next month. Equity lends Rs 4 crore times 50%, Rs 2 crore; debt funds lend Rs 2 crore times 80%, Rs 1.6 crore; together Rs 3.6 crore against a Rs 2 crore need. The volatile asset gets the lower ratio, which is why the equity decides how safe the loan is.

What the lender will advance: collateral times its loan-to-valueEquity, Rs 4 cr at 50%Rs 2.0 crDebt funds, Rs 2 cr at 80%Rs 1.6 crTotal capacityRs 3.6 crLoan Rs 2 crorePledge only the equitycapacity Rs 2.0 cr = loan: any fall is a callPledge bothRs 1.6 cr of headroom above the loan
Neha's Rs 4 crore of equity lends Rs 2 crore and her Rs 2 crore of debt funds lend Rs 1.6 crore, so pledging both gives Rs 3.6 crore of capacity against a Rs 2 crore loan, while pledging equity alone leaves no headroom.
Step 2What fall triggers a margin call?

Find where capacity falls to the loan. With debt funds steady, every 1% fall in equity cuts capacity by 1% of Rs 2 crore. Headroom is Rs 1.6 crore and equity contributes Rs 2 crore of capacity, so equity would have to fall 80% before capacity reaches the Rs 2 crore loan. Now stress the lender's side too: a 40% fall combined with the bank cutting equity's ratio to 40% leaves Rs 2.56 crore of capacity, still above the loan. That second test matters, because the ratio is the bank's to change.

The relationship
0.5×4(1−f)+0.8×2=2  ⇒  f=3.6−22=80%0.5 \times 4(1 - f) + 0.8 \times 2 = 2 \;\Rightarrow\; f = \frac{3.6 - 2}{2} = 80\%
0.5 x 4equity's lending value, Rs crore
0.8 x 2debt funds' lending value, Rs crore
2the loan
ffall in equity prices at which a call arrives
What it says in wordsThe margin call comes when the pledged assets' lending value, after the fall, equals the loan.
A margin call arrives when capacity falls below the loan1234Rs crore0%20%40%60%80%100%Fall in equity pricesLoan Rs 2 croreCall at an 80% fallPledge both: Rs 3.6 crEquity only: call on any fall40% fall, LTV cut to 40%: Rs 2.56 cr
Pledging both assets, capacity meets the Rs 2 crore loan only after an 80% equity fall, and survives a 40% fall with the equity ratio cut to 40%; pledging equity alone puts capacity below the loan after any fall at all.
Step 3Is borrowing better than selling the debt funds?

Compare the net carry with the tax. Interest for nine months at 10% is Rs 15 lakh, but the debt funds she keeps earn about 7%, so the true cost of borrowing is the 3-point gap, about Rs 4.5 lakh. Selling Rs 2 crore of debt funds would realise their accumulated gain at her slab rate; if that tax is above Rs 4.5 lakh, borrowing is cheaper, and she also avoids selling and rebuying. The judgement: borrow, pledge both assets for headroom, and repay from the flat sale, with a written plan for what she sells if that sale slips.

Where candidates lose it

Candidates add up the capacity, see Rs 3.6 crore against Rs 2 crore, and never ask what is actually pledged. Pledge only the equity and the same client gets a margin call on the first bad day.

The second miss is comparing the loan rate with nothing. The 10% rate looks expensive until you net it against the 7% the kept debt funds earn and the tax a sale would trigger.

What the interviewer asks next

  • The flat sale slips by six months. What happens to the loan, and what would you do?
  • Half her equity is a single mid-cap stock that the bank lends against at only 30%. Redo the capacity.
  • Why would a bank lend at a lower rate against debt funds than against equity?

Company names and figures are illustrative.