Comeback of the `cashless collar'
Dallas Business Journal - by Rusty Cawley Staff Writer
DOWNTOWN DALLAS -- Stymied by changes in tax rules, the Metroplex's wealthiest investors are turning to one of the financial world's oldest strategies -- the "cashless collar" -- for protection from losses on the stock market.
Many of those investors are among the area's New Rich: Entrepreneurs who have gained enormous wealth by selling public stock in their young powerhouse companies, which are often in the sectors of high technology and telecommunications.
"Dallas is very entrepreneurial territory," said Donald H. Relyea, first vice president for investments in the Dallas office of Everen Securities Inc. "There are a lot of new young millionaires here."
Unfortunately for these new millionaires, their entire net worth is often tied up in their company's stock. If the price of that stock takes a tumble, so does that millionaire's net worth.
"They're aware that it happened overnight," Relyea said, "and it could go away overnight."
But the Metroplex's Old Money also has a need for strategies like the cashless collar. An investor who owns a large portfolio of large-cap stocks -- such as IBM, Coca-Cola, Disney or Wal-Mart -- has good reason for concern with the Dow Jones Industrial Average nearing the 11,000 mark.
"Alan Greenspan was talking about `irrational exuberance' when the Dow was under 7,000," said R. Scott Nycum Jr., managing director at the Dallas office of private bank JPMorgan. "With shares in large-cap companies climbing so high, an investor with a portfolio of those stocks may want some downside protection."
`Collateral enhancement'
Wealthy investors once depended on an assortment of protection strategies.
Perhaps the most popular was known as "shorting against the box," in which the investor borrowed stock and sold it to lock in a gain. The strategy also deferred -- and sometimes eliminated -- the investor's tax obligations.
Then Congress passed the Taxpayer Relief Act of 1997.
"For all practical purposes," said Everen's Relyea, "that eliminated shorting against the box."
The legislation also killed other popular (and exotic) strategies, such as depositing stock into a trust in exchange for a share of a diversified portfolio, or making cash payments to lock in a stock price.
Without these options, the wealthy-but-nervous investor is left with two basic options.
One is to sell the stock, a move that creates a tax obligation and kills any chance at profiting from future gains in the share price.
The other is to put a collar on the stock.
"All of sudden," Relyea said, "the cashless collar has become much more attractive."
Like many tools in the financial world, the cashless collar is simultaneously simple and complex.
Essentially, the investor is trading away a portion of a stock's upside in return for protection against a downturn.
"We think of it as `collateral enhancement,' " said Prentiss Burt, vice president in JPMorgan's brokerage house.
Greed vs. fear
To create the collar, the investor's money-management team uses stock options. These are contracts to buy or to sell a stock based on that stock's future performance.
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