Tag Archives: securities loans

Margin Calls Mount On Loans Against Stock Portfolios Used To Buy Homes, Boats, “Pretty Much Everything”

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In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.

The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.

From the Wall Street Journal article: Margin Calls Bite Investors, Banks

Today’s article from the Wall Street Journal on investors taking out large loans backed by portfolios of stocks and bonds is one of the most concerning and troubling finance/economics related articles I have read all year.

Many of you will already be aware of this practice, but many of you will not. In a nutshell, brokers are permitting investors to take out loans of as much as 40% of the value from a portfolio of equities, and up to a terrifying 80% from a bond portfolio. The interest rates are often minuscule, as low as 2%, and since many of these clients are wealthy, the loans are often used to purchase boats and real estate.

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At the height of last cycle’s credit insanity, we saw average Americans take out large home loans in order to do renovations, take vacations, etc. While we know how that turned out, there was at least some sense to it. These people obviously didn’t want liquidate their primary residence in order to do these things they couldn’t actually afford, so they borrowed against it.

In the case of these financial assets loans, the investors could easily liquidate parts of their portfolio in order to buy their boats or houses. This is what a normal, functioning sane financial system would look like. Rather, these clients are so starry eyed with financial markets, they can’t bring themselves to sell a single bond or share in order to purchase a luxury item, or second home. Of course, Wall Street is encouraging this behavior, since they can then earn the same amount of fees managing financial assets, while at the same time earning money from the loan taken out against them.

I don’t even want to contemplate the deflationary impact that this practice will have once the cycle turns in earnest. Devastating momentum liquidation is the only thing that comes to mind.

So when you hear about margin loans against stocks, it’s not just to buy more stocks. It’s also to buy “pretty much everything…”

From the Wall Street Journal:

Loans backed by investment portfolios have become a booming business for Wall Street brokerages. Now the bill is coming due—for both the banks and their clients.

Among the largest firms, Morgan Stanley had $25.3 billion in securities-based loans outstanding as of June 30, up 37% from a year earlier. Bank of America, which owns brokerage firm Merrill Lynch, had $38.6 billion in such loans outstanding as of the end of June, up 14.2% from the same period last year. And Wells Fargo & Co. said last month that its wealth unit saw average loans, including these loans and traditional margin loans, jump 16% to $59.3 billion from last year.

In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.

Securities-based loans surged in the years after the financial crisis as banks retreated from home-equity and other consumer loans. Amid a years long bull market for stocks, the loans offered something for everyone in the equation: Clients kept their portfolios intact, financial advisers continued getting fees based on those assets and banks collected interest revenue from the loans.

This is the reason Wall Street loves these things. You earn on both sides, while making the financial system much more vulnerable. Ring a bell?

The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.

Even before Wednesday’s rally, some banks said they were seeing few margin calls because most portfolios haven’t fallen below key thresholds in relation to loan values.

“When the markets decline, margin calls will rise,” said Shannon Stemm, an analyst at Edward Jones, adding that it is “difficult to quantify” at what point widespread margin calls would occur.

Bank of America’s clients through Merrill Lynch and U.S. Trust are experiencing margin calls, but the numbers vary day to day, according to spokesman for the bank. He added the bank allows Merrill Lynch and U.S. Trust clients to pledge investments in lieu of down payments for mortgages.

Clients may be able to borrow only 40% or less of the value of concentrated stock positions or as much as 80% of a bond portfolio. Interest rates for these loans are relatively low—from about 2% annually on large loans secured by multi million-dollar accounts to around 5% on loans less than $100,000.

80% against a bond portfolio. Yes you read that right. Think about how crazy this is with China now selling treasuries, and U.S. government bonds likely near the end of an almost four decades bull market.  
 

About 18 months ago, he took out a $93,000 loan through Neuberger Berman, collateralized by about $260,000 worth of stocks and bonds, and used the proceeds to buy his share in a three-unit investment property in the Bushwick section of Brooklyn, N.Y. He says that his portfolio, up about 3% since he took out the loan, would need to fall 25% before he would worry about a margin call.

Regulators earlier this year had stepped up their scrutiny of these loans due to their growing popularity at brokerages. The Financial Industry Regulatory Authority put securities-based loans on its so-called watch list for 2015 to get clarity on how securities-based loans are marketed and the risk the loans may pose to clients.

“We’re paying careful attention to this area,” said Susan Axelrod,head of regulatory affairs for Finra.

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I think the window for “paying close attention” closed several years ago.

All I have to say about this is, good lord.

by Mike Kreiger

RIAs Join Brokers In Promoting Securities-Backed Lending

These loans are growing quickly beyond wire houses, but some are concerned about the risks and conflicts of interest

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Traditionally a major focus at bank-owned brokerage firms, securities-backed loans — where a wealthy investor puts up their portfolio as collateral for a big-money purchase &mash; are increasingly being marketed through independent registered investment advisers.

In the past two years, use of the products has soared as custodians beef up their lending capabilities. Pershing Advisor Solutions, a subsidiary of The Bank of New York Mellon Corp., began offering the loans to RIAs last year and has already issued 254 of them worth $1 billion through more than 20% of its 570 RIA clients. Fidelity Investments, which serves about 3,000 RIAs, has seen balances for securities-backed loans increase 63% in its RIA segment over the past two years.

“Non purpose loans have gotten more attention over the last year-plus with the custodians,” said John Sullivan, a former lending specialist at Smith Barney who is now a relationship manager at Dynasty Financial Partners. “Every effort is being made by firms like Dynasty and the various custodians that are out there to be able to replicate or in some cases exceed the existing platform” at the wirehouses.

For years, the loans have been a popular product at the wirehouses, including Bank of America Merrill Lynch and Morgan Stanley Wealth Management. They are billed as a way for wealthy investors to make large purchases, such as a yacht or vacation home, without having to sell a portion of their portfolio or incur capital gains taxes in the short term. Bank of America Merrill Lynch had $11.7 billion in margin loans outstanding, according to its most recent SEC filings from March.

There is no upfront cost to set up a securities-based line of credit, and firms offer competitive rates, which are sometimes lower than a traditional bank loan and are particularly attractive now with low interest rates. The loans can be made in a relatively shorter period of time than traditional bank loans as well. They take as few as eight business days at Pershing.

But there are other reasons firms, including the wirehouses like securities-backed lending. The loans provide another income source from clients in fee-based accounts and can be more profitable for the firm than other investment products because they don’t have to share as much of the revenue with their advisers who sells the clients on the loan.

“Lending growth will enhance the stability of revenue and earnings for the firm as a whole and make our client relationships deeper and stickier,” Morgan Stanley & Co.‘s former chief financial officer, Ruth Porat, said in an earnings call in July.

RIAs specifically don’t receive any additional compensation from a bank or custodian for selling securities-backed loans, but there are other benefits. For example, the loans allow wealthy clients to make multimillion dollar purchases without cutting into the assets under management. Bob LaRue, a managing director at BNY Mellon, said new business from clients often results as well — and, of course, the dollars left in the portfolio have the potential for gains, which raise AUM.

Herein lies the rub, according to Tim Welsh, president and consultant of Nexus Strategy, a wealth management consulting firm. “They don’t sell, so the assets under management stay the same — so it inherently has a conflict of interest,” he said.

That can be a problem, Mr. Welsh said, particularly because client demand typically is highest for these kinds of loans at the wrong time.

“In every bull market I’ve seen, this is always a predictor of the top,” Mr. Welsh said. “When people start borrowing money against their assets, they’re really confident that they’re going up. And investors are always one step behind in terms of tops and bottoms.”

The risk is that if the value of a client’s portfolio drops, the firm can sell the securities or ask that the client put down more money to back that up. Using securities as collateral can be subject to greater volatility than other types, such as a home equity loan.

“When the markets rationalize, bills come due, and if you don’t have liquidity, all of a sudden you have to sell,” Mr. Welsh said. “It definitely raises the risk profile up immediately.”

Adviser Josh Brown of Ritholtz Wealth Management has dubbed the growth in these loans a “rich man’s subprime.”

“Once again, super-cheap financing based on an asset whose value can fluctuate wildly (a stock and bond portfolio, in this case) is being used for the purchase of assets that can be significantly less liquid, like real estate, fine art or business expansion,” Mr. Brown wrote in a story last year on the growth of the loans in the wirehouse space. “Don’t say I didn’t warn you.”

Regulators have taken notice as well. The Financial Industry Regulatory Authority Inc., which oversees broker-dealers, warned in January that it was looking into the marketing of securities-backed loans as part of this year’s regulatory agenda.

“Finra has observed that the number of firms offering [securities-backed loans] is increasing, and is concerned about how they are marketed,” the regulator said.

That said, Mr. Sullivan and others who defend securities-backed lending said it works well if that risk is taken into account.

“It’s really about staying invested for the long-term and meeting short-term cash flow needs with some borrowing that’s not going to exceed a certain percentage on the assets,” Mr. Sullivan said.

Mr. LaRue said advisers have to consider whether it makes sense to trade leverage for the tax benefits.

“The appropriateness of leverage depends on each individual client’s needs,” he said. “If you are borrowing [to avoid the capital gains] taxes and keep a favorable investment strategy in place, then perhaps leveraging those assets at a low interest rate makes sense.”

By Mason Braswell for Investment News