Shadow Margin & Securities-Backed Loans: The Tip of the Iceberg?
10/04/2017 6:00 am EST
It’s been over 12 years since we warned about the highly questionable mortgage lending practices that mushroomed during the Housing Bubble. Now it appears that innovative lending is back in vogue, cautions Jim Stack, money manager and editor of InvesTech Research.
Aging bull markets are naturally predisposed to excesses—particularly in debt and leverage—and once again nontraditional loans are taking center stage.
Securities-backed loans (SBLs) are among Wall Street’s hottest new products in this bull market, and they’ve been growing faster than Jack’s beanstalk over the past few years.
SBLs are often referred to as “shadow margin” because they’re not tracked in the margin debt figures, nor are they tracked by either the SEC or the brokerage regulator FINRA.
Nobody knows how extensive such loans are, but based on anecdotal evidence they total at least $100 billion and we believe the figure could be much larger.
According to a July Wall Street Journal article, Bank of America’s wealth unit had $40 billion in outstanding securities-backed loans at the end of 2016, up 140% from 2010. Morgan Stanley had $30 billion in these loans, more than double the amount in 2013.
And, not to be left behind, Goldman Sachs is teaming up with Fidelity and other brokerages to broaden the availability of credit via its new digital lending program, “GS Select.”
What are securities-backed loans (SBLs), and why are they popular? In simple terms, SBLs are loans that are marketed to investors as an easy and inexpensive way to access extra cash by borrowing against the securities in one’s investment portfolio without having to liquidate those holdings.
Funds can be used for any purpose except buying more stock or repaying a margin loan. For instance, these loans might be used for buying real estate, investing in a business, funding education, or for personal use like taking a trip or paying for a wedding.
Fixed loans can run the gamut from $25,000 to $25 million or more, depending on the lender and the amount of collateral. A typical SBL agreement permits an investor to borrow from 50% to 95% of the value of the assets in his or her non-retirement investment account, based on the size of the portfolio and the types and mix of securities held.
These lending arrangements can be set up as a fixed loan, but more often they’re established as a revolving SBL line of credit (SBLOC). It’s not uncommon for a firm to require that account assets have a market value of at least $100,000 to qualify for an SBLOC.
The sales pitch is irresistible! Looking at the promotional material from broker websites touting SBLs, who wouldn’t want to avail themselves of this offering? According to the ads, you’ve worked hard to grow your investments over the years; now you can capitalize on those assets to finance your dreams without drawing down your portfolio.
These are some of the benefits of establishing a securities-backed line of credit (SBLOC) being touted to potential customers:
With an SBLOC, the cash is readily available (up to the credit limits) any time you need it. Other than securities related transactions, there are no restrictions on how you use the loan.
An SBLOC lets you keep your investment account intact, allowing it to continue to grow. And by borrowing to meet your cash needs, you can avoid selling securities and triggering capital gains taxes.
Because SBLs are backed by portfolio assets, interest rates can be much lower than traditional loans. Once an SBLOC is in place, it can be used repeatedly and you’re only required to make monthly interest payments — there is no maturity date.
There are usually no fees to establish the loan or credit line and funds are available quickly. Goldman Sachs’ digital platform promotes a 24-hour turnaround. Typically, no personal financial statements, tax returns, or other documents are required.
What’s in it for the brokers? SBLs and lines of credit have become lucrative new sources of income for brokerages, helping to replace revenue lost due to recent cuts in commission rates. In addition, brokers retain portfolio assets, along with their associated fees, as customers can access cash without making withdrawals.
In some cases, establishing these loans may factor into a broker’s compensation, and marketing these credit options creates sticky clients as it’s hard to transfer assets to another broker with a securities-backed loan outstanding. Even if a client doesn’t use the line of credit immediately, the longer it’s in place, the more likely it is that he or she will eventually tap it.
So, where’s the risk? With SBLs, as with all financial obligations, it’s vitally important to read the fine print or risks section before committing.
Careful attention to this step reveals that brokerages and banks get all the benefits of secured, full-recourse loans, while customers take all the risk. This may seem acceptable in a healthy bull market, but it can be catastrophic to the pledged portfolio in a downturn.
The following are some of the risks that investors may face if they borrow against an investment account. It’s these risks that prompted the SEC and FINRA to issue a special Investor Alert in 2015 regarding this type of lending:
If the value of the securities declines below a minimum level, you may be subject to a collateral “maintenance call” with little or no advanced warning, giving you minimal time to pay the loan or deposit more cash or securities in the account.
Note that if this occurs, there are no extensions, and a broker can change its collateral maintenance requirement at any time without notifying you.
If you are unable to meet a maintenance call, the broker can liquidate part, or all, of your portfolio holdings at their discretion. You do not pick the stocks to sell. In a bear market, that could mean selling core holdings at a market bottom or alternatively realizing significant tax gains on long-held securities.
In a major downturn, you could be forced to forfeit all your pledged assets — in this case, the stocks, funds, and bonds in your portfolio. In the worst-case scenario, you might lose more funds than are held in the collateral account, and as a full recourse loan, you would be liable for any deficiency.
For SBLOCs, the interest rate on your loan is generally a floating rate that can change daily. With interest rates rising, the cost of your SBLOC could increase significantly.
The proliferation of SBLs and SBLOCs obviously increases the risks in this late-stage bull market. While history shows that excessive debt accumulation does not trigger a stock market peak, it can accelerate and intensify losses when the leverage starts to unwind in a bear market.
Today’s levels of these securities-backed loans are small relative to overall consumer and business debt, but they can be dangerous. Like subprime mortgage loans 10 years ago, if trouble appears in terms of mass collateral maintenance calls, it could be just the tip of the iceberg.