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<h2 class="unclear">Securities-Backed Loans… Just the Tip of the Iceberg?</h2>
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<p>Aging bull markets are naturally predisposed to excesses –particularly in debt and leverage– and once again nontraditional loans are taking center stage.</p>
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<figure class="wp-block-image size-large"><img src="https://ns2020-investech.investech.com/wp-content/uploads/2021/06/iceberg-4ReskwNsh68-unsplash-1024x576.jpg" alt="" class="wp-image-8264"/><figcaption>Nine-tenths of an iceberg's volume is below the water</figcaption></figure>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Markets are relaxing merrily on a powerful time bomb</strong> - Stock and bond market leverage is everywhere.</p><cite><em>Business Insider – 7/30/17</em></cite></blockquote>
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<p>The article goes on to say, <em>"Some of (this leverage) is transparent, such as NYSE margin debt which was $539 billion as of the June report. But the hottest form of stock and bond market leverage is opaque, offered by financial firms that usually don’t disclose the totals: securities-based loans (SBLs) – or “shadow margin” because no one knows how much of it there is."</em></p>
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<h2>Innovative Lending Practices Make a Come-back</h2>
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<p>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. 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:</p>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Borrowing With Stock Soars as Market Rises</strong></p><cite><em>Wall Street Journal, 7/28/17</em></cite></blockquote>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Fidelity taps Goldman Sachs to expand lending services through RIAs</strong></p><cite><em>Investment News, 7/27/17</em></cite></blockquote>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Goldman Sachs is launching a digital platform for the rich to borrow as much as $25 million</strong></p><cite><em>Reuters, 7/27/17</em></cite></blockquote>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Wall Street Sharks Entice Customers With Securities-Backed Loans</strong></p><cite><em>Seeking Alpha, 8/13/17</em></cite></blockquote>
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<p>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.</p>
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<div class="wp-block-image pushleft"><figure class="alignleft size-large is-resized"><img src="https://ns2020-investech.investech.com/wp-content/uploads/2020/12/MorganStanley-1024x502.png" alt="Morgan Stanley ad for securities-backed loans" class="wp-image-4901" width="483" height="237"/><figcaption>Morgan Stanle<strong>y</strong> Advertisement</figcaption></figure></div>
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<p>According to a July 2017 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.”</p>
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<h3>What are securities-backed loans (SBLs), and why are they popular?</h3>
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<div class="wp-block-image"><figure class="alignright size-large is-resized"><img src="https://ns2020-investech.investech.com/wp-content/uploads/2020/12/WellsFargo.png" alt="Wells Fargo advertising securities-backed loans" class="wp-image-4902" width="359" height="304"/><figcaption>Wells Fargo Advertisement</figcaption></figure></div>
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<p>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.</p>
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<p>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.</p>
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<h3>The sales pitch is irresistible!</h3>
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<p>Looking at the promotional materials shown in this report 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.</p>
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<div class="wp-block-image pushright"><figure class="alignright size-large is-resized"><img src="https://ns2020-investech.investech.com/wp-content/uploads/2020/12/UBS-1024x751.png" alt="UBS advertising securities-backed loans" class="wp-image-4903" width="435" height="319"/><figcaption>UBS Advertisement</figcaption></figure></div>
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<ul class="is-style-default"><li>With an SBLOC, the cash is readily available (up to the credit limits) any time you need it.</li><li>Other than securities related transactions, there are no restrictions on how you use the loan.</li><li>An SBLOC lets you keep your investment account intact, allowing it to continue to grow.</li><li>By borrowing to meet your cash needs, you can avoid selling securities and triggering capital gains taxes.</li><li>Because SBLs are backed by portfolio assets, interest rates can be much lower than traditional loans.</li><li>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.</li><li>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.</li><li>Typically, no personal financial statements, tax returns, or other documents are required.</li></ul>
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<h3>What’s in it for the brokers?</h3>
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<div class="wp-block-image"><figure class="alignright size-medium"><img src="https://ns2020-investech.investech.com/wp-content/uploads/2020/12/GoldmanSachs-300x204.png" alt="Goldman Sachs securities lending advertisement" class="wp-image-4904"/><figcaption>Goldman Sachs Advertisement</figcaption></figure></div>
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<p>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.</p>
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<h2>So, where’s the risk with SBLs?</h2>
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<p>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.</p>
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<p>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:</p>
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<ul class="is-style-default"><li>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.</li><li>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.</li><li>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. This is a major drawback to asset-backed loans…</li></ul>
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<blockquote class="wp-block-quote is-style-headline-highlight"><p><strong>Why Goldman Sachs Seized a Client’s 217-Foot Yacht</strong></p><cite><em>Wall Street Journal - 8/10/17</em></cite></blockquote>
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<ul class="is-style-default"><li>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.</li><li>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.</li></ul>
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<p>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.</p>
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<p>First published in our September 15, 2017 issue. Also available to read in PDF format. <a href="https://ns2020-investech.investech.com/wp-content/pdf_files_wp/SBLs.pdf" target="_blank" rel="noreferrer noopener">Download the PDF</a>.</p>
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