Say what? An interest rate of 52.5%?

The Time Charles Schwab Asked for a Loan

Published on:
September 8, 2018
Last Update:
September 3, 2019

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

When certain stocks are in high demand, Charles Schwabborrows shares from customers and lends them to other clients. On Monday of this week the brokerage firm wrote to me a request: they would like to borrow the shares I bought in Orchid Paper Company.

What really got my attention was the rate of interest Mr. Schwab offered: an annual interest rate of 52.5% - A shockingly and unreasonably high interest rate. I had to call their customer service number to find out more.

Working out of Phoenix, Arizona, a friendly customer representative who identified himself as Joe, explained that the hefty interest rate was simply due to demand. There was a high volume of institutional clients who wanted to short the stock.

The loan terms were straightforward: Mr. Schwab, a.k.a. the borrower, may repay the loan at any time; I, a.k.a. the lender, may sell the stock at any time; and the interest rate of 52.5% translated to an expected $437 per month [1].

The shorts rationale

The short sellers are betting that the company will soon file for bankruptcy [2]. Management had recently announced that a major customer who represented 23% of the 2017 annual sales, had terminated the relationship. And that Orchid Paper's lenders are now demanding the company to be sold to a competitor (and to return the $210 million in outstanding liabilities.)

There was also the variable debt issue. In 2016 Orchid's cost of debt was 2%; it went up to 7% in 2017 and as of the second quarter of this year, the company was paying a whopping 9% interest rate.

The long rationale

There are potential buyers in my opinion. In the second quarter earnings call with analysts, Jeff Schoen, boss of Orchid, referred to comparable transactions of paper mills acquisitions over the past three years. They showed buyers who paid roughly $4,500 per ton of paper.

Since I mentioned Jeff Schoen, it is worthwhile to note his interest in the company had increasingly grown since he became its boss. His cost basis is in the double digits and while I cannot argue that an increased ownership stake is a sign of a promising future, it surely is better than if Schoen had been selling his common shares.

In short, Schoen and I are long the company while the market is short. And there is enough interest out there that short sellers are willing to pay an interest rate of 52.5% to prove Schoen and I wrong.

One great invention: the stock market  

"The market exists because of differences of opinion among investors, " wrote Seth Klarman in Margin of Safety. "If securities could be valued precisely, there would be many fewer differences of opinion, prices would fluctuate less frequently and trading activity would diminish.”

Rarely do you find in real life a difference of opinion in value as in the stock market. Imagine walking to your local coffee shop, expecting to pay two dollars for a large cup of coffee. Further imagine that next you a bystander says that coffee is way-over-priced and that he intends to wait until the price of coffee cools off (no pun intended.)

And as you leave the coffee shop, a white bearded gentleman approaches you and offers to pay you an interest rate of 52.5% to borrow the cup of coffee you just bought.  

But this the peculiar way in which the stock market acts. The market allows stocks to fluctuate in price because of reasons that reason does not understand. The stock market is an arena where opinions of belief rule over economic reality.  

Epilogue

Orchid investors, yours truly being one of them, saw the price of their shares drop to nill in early 2019. Let us this be a lesson that indeed, sometimes, the shorts see what the longs ignore.

FOOTNOTES
[1] 4,000 shares @ $2.50 times 0.525 divided by 12 months.
[2] Indeed Orchid Paper filed for bankruptcy in April 1, 2019.