If you’re a financial adviser, there’s nothing like securities-based loans to get clients to love you. Or to hate your guts when things don’t go as planned.
I’m referring specifically to “non-purpose” credit secured by stocks, bonds, and other eligible assets. In general these loans can be used to finance anything except for the purchase of other securities.
James Onorato, president of Summit Capital in Pepper Pike, Ohio, describes the prudent way to use non-purpose debt:
“When someone needs a large sum of money very quickly it can be a useful tool. I had a client that purchased a home before he could sell and extract the equity from his old home. He called me, had $100,000 instantly, and repaid it from the sale proceeds of his old home.”
Convenience is one benefit. Low rates are another. The three-month London interbank rate, often used as the base rate for these loans, is trading around 0.25%. Tack on 60 basis points, and it’s possible to extend credit at all-in rates of less than 1%. (Yeah, some deals are getting done that low.)
Client’s perspective: What’s not to love? The money is cheap, and there’s no need to make monthly payments on principal as you would with, say, a traditional mortgage.
Lenders are just as enamored with this business. “Spread banking is really profitable,” says John Straus, a partner at FallLine Strategic Advisors, a management-consulting firm that focuses exclusively on the wealth management industry.
Returns are great and the risks are relatively low for lenders since they control the collateral, he says. “The problems are more for clients,” if the value of the investments securing the loans falls too low. Then they get margin calls and can’t stop forced liquidations in their accounts.
Given the attractive risk-reward balance, it’s no wonder big brokerages are building up their loan assets. Morgan Stanley is an example: At the end of 2014, clients’ securities-based loans added up to $21.9 billion, up 49% from 2013. (Morgan Stanley declined to comment for this column.)
Industrywide, the growth of securities-based lending is significant enough for the Financial Industry Regulatory Authority to take notice. It put these lending programs on its watch list for 2015 and expressed concerns about investor leverage.
Maybe Finra should put Congress on its watch list. After all, Dodd-Frank and the Volcker rule may be helping drive the growth of securities-based lending. Proprietary trading at banks is in a big slump, and the wirehouses are making up for those lost earnings with interest income from non-purpose loans.
Make way for unintended consequences.
The big shops are goosing compensation for financial advisers who market non-purpose loans. They’re paying them to encourage clients to take more risk. And the independent investment advisers are in the fight, too, promising, “I can get you better rates at one of our custodians.”
Therein lies the problem.
“Any fad on Wall Street goes to an extreme,” says Mr. Straus. “If it’s not in the best interest of the client, it will eventually be exposed.”
Are these dirt-cheap, incredibly convenient, non-purpose loans—which can be pulled when markets go bad—in the best interests of clients?
George Ball, chairman of the Houston-based wealth-management firm Sanders Morris Harris, answers this question from a historical perspective. “The brightest minds in the world have tried to borrow short-term to fund long-term needs. And none of them have succeeded over time.”
The ending of any such mismatch, he adds, “is sure to be a tragedy.”
Let’s say your client borrows $500,000 against a fee account with $1 million in total assets. Instead of using it as a short-term bridge loan, as in the aforementioned example from Mr. Onorato, he uses the money to pay off the mortgage on his house. But then, let’s say the securities lose $250,000, and now the equity value of the account is only 33 %.
Uh-oh. Margin call.
And it’s not just the client’s problem. In the arbitration case that follows, it’s easy enough to predict what your aggrieved client tells the Finra panel:
“I wanted to sell. But my adviser said stocks were going higher and, at these interest rates, I’d be stupid to pay off the loan. Now, I’m not sure whether I can afford to stay in my house.”
That’s client money on crack. That’s a tragedy.
Every bear market has villains. Last time, they were the lenders who originated subprime mortgages. And let’s not forget the bankers and traders who lovingly nurtured those Petri-dish securities nobody understood.
Next time…
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The New York Times describes my novels as “money porn,” “a red-hot franchise,” and “glittery thrillers about fiscal malfeasance.” Through fiction I explore the dark side of money and the motivations of those who have it, want more, and will steamroll anybody who gets in their way.