What Is a Manufactured Payment?
In finance, the term "manufactured payment" refers to a payment that must be made in relation to certain securities lending arrangements. Manufactured payments are a common feature of short selling, in which a borrower receives title to shares and must pay interest and/or dividend payments to the lender of those securities.
- Manufactured payments are the payments that must be made by securities borrowers to their lenders.
- They are commonly seen in short-sale transactions, in which interest and dividends must be paid to the transacting broker.
- Such payments make it difficult to estimate the risks of short-selling because if shorted companies begin paying dividends after the short sale has been made, the holding costs of that short position will rise accordingly.
How Manufactured Payments Work
Manufactured payments are a particular type of interest or dividend payment that arises when securities are borrowed. These differ from loan arrangements involving cash, where borrowers must pay back the balance owed via a series of interest and principal payments. With securities loans, borrowers receive a security that they must pay back at a future date, along with a series of "manufactured payments" rendered by the borrower during the life of the loan.
Manufactured payments are most commonly associated with the short sale of stocks. In this type of transaction, the short-seller borrows a certain number of shares from a brokerage firm and then immediately sells those shares in exchange for cash. The short-seller is then obligated to return the same number of shares to the brokerage firm at some future date, while also paying interest to that brokerage firm until the shares have been returned.
As part of this arrangement, short-sellers must additionally remit funds to the brokerage firm that are equivalent to any dividends paid by the shorted stock during the life of the loan. Therefore, for a dividend-paying stock, the short seller would be required to pay both interest payments and additional payments sufficient to match the company's dividends. Taken together, these combined payments are known as the "manufactured payments" of the loan.
An Example of a Manufactured Payment
To illustrate how manufactured payments work, consider the following scenario: Suppose you are bearish on the prospects of XYZ Corporation. Although this company trades at $100 per share, you believe it is overvalued and the fair value is closer to $25. You decide to borrow 100 shares of XYZ from your brokerage firm, then immediately sell them, realizing proceeds of $10,000. In exchange, you are required to pay monthly interest at an annual rate of 5%. Assuming XYZ does not currently pay dividends, your monthly cost is limited to this interest payment.
Let us now consider an alternate scenario where XYZ reports earnings that defy your expectations, ultimately causing its share price to climb. The company's sudden profitability enables it to begin paying dividends to investors. In this case, the manufactured payments you make to your transacting brokerage firm must consequently include the value of any dividends paid by XYZ, in addition to your existing interest costs.
Manufactured payments should be treated as investment interest expenses that must be reported on Schedule A of a tax return.