What is a fabricated payment?
In finance, the term “fabricated payment” refers to a payment that must be made under certain securities lending agreements. Manufactured payments are a common feature of short selling, in which a borrower receives the stock security and must pay interest and/or dividends to the lender of those securities.
Key points to remember
- Manufactured payments are payments that must be made by borrowers of securities to their lenders.
- They are commonly seen in short sale transactions, where interest and dividends must be paid to the broker making the transaction.
- Such payments make it difficult to estimate the risks of a short sale, because if the companies sold short start paying dividends after the short sale is completed, the costs of holding that short position will increase accordingly.
How Manufactured Payments Work
Manufactured payments are a special type of interest or dividend payment that occurs when securities are borrowed. These differ from loan agreements involving cash, where borrowers must repay the balance owing through a series of interest and principal payments. With title loans, borrowers receive collateral that they must repay at a later date, along with a series of “fabricated payments” made by the borrower over the life of the loan.
Manufactured payouts are most commonly associated with stock shorting. In this type of transaction, the short seller borrows a 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 a later 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 to the brokerage firm funds equal to the dividends paid by the short stock during the term 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 “fabricated payments” of the loan.
An example of a fabricated payment
To illustrate how manufactured payouts work, consider the following scenario: Suppose you are bearish on the outlook for XYZ Corporation. Although this company is trading at $100 per share, you think it is overvalued and the fair value is closer to $25. You decide to borrow 100 shares of XYZ from your brokerage firm and then sell them immediately, realizing proceeds of $10,000. In exchange, you are required to pay monthly interest at the annual rate of 5%. Assuming XYZ is not currently paying dividends, your monthly cost is limited to this interest payment.
Now consider an alternative scenario where XYZ reports profits that defy your expectations, ultimately causing its stock price to rise. The company’s sudden profitability allows it to begin paying dividends to investors. In this case, the manufactured payments you make to your transactional brokerage firm must therefore include the value of any dividends paid by XYZ, in addition to your existing interest charges.
Fabricated payments should be treated as investment interest expense that should be reported on Schedule A of a tax return.