Loans backed by stocks and bonds are growing and Wall Street couldn’t be happier. As a potential borrower, should you be? As with almost all things financial, portfolio backed loans have both pros and cons for the investor seeking a loan.
Mostly for the brokerages, banks and others doing the lending, it’s all pros. Fees are lucrative and borrowers (aka investors) take on most of the risk.
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Size Of The Market
In terms of the overall size of the loan market – it’s huge. According to The Wall Street Journal executives at Morgan Stanley (NYSE:MSF) said in July that loans to individuals were a big growth area and revenue driver. They said the loans helped expand the bank’s overall wealth lending by about $3.5 billion in Q2.
Goldman Sachs Group Inc. (NYSE:GSC) recently undertook a new partnership with Fidelity Investments to expand its securities-based lending business. Wells Fargo & Co. (NYSE:WFCD) changed practices around its lending products through brokers this year and stopped offering bonuses tied to loan volume. In part, this may be due to the attention regulators have focused on the practice.
How Securities-Based Loans Work
Designed much like margin loans, brokerages lend against the value of an investor’s portfolio. Unlike margin lending the money can be used for other things besides buying more securities. As an investor, you can get cash without selling assets, locking in losses, incurring taxable gains or missing out on future gains. Since loans are secured, rates are relatively low.
On the other hand, if the market tanks, lenders will demand repayment. If the margin call isn’t met, the securities will be sold and you will be responsible for any remaining balance.
Quick Source Of Funds
One variation on a securities-based loan is a securities-based line of credit. This is just like any other line of credit and there is no charge until the money is used. This gives high net worth individuals a source of funding for a quick purchase of, say a distressed piece of real estate.
Most banks and other lenders believe the longer an individual holds a securities-based line of credit the more likely they will be to use it. Some analysts call this a “ticking time bomb” just waiting to go off.
If you have a securities-based loan or a line of credit you are actually using and your lender decides the collateral (your stocks) are not as “solid” as originally thought, you may be forced to sell holdings and invest in something else just to satisfy the lenders uneasiness.
Alternatively, you may have to add additional securities or cash to your collateral to continue to secure the loan. Even if you were not using a line of credit, the lender could simply cancel it, giving you no emergency backup or funding source for that next opportunity.
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Trading Value For Lifestyle
Ultimately, if you borrow against what constitutes your retirement account and things go bad, you may financially injure yourself for the rest of your life. You can say you will sell that new car to pay off that loan before you sell the stock but, most people will sell the stock thinking they can make it up in the market.
Most people invest for long-term financial security. If you borrow against that security you increase the chance things will work out badly. It’s something worth thinking about if you are considering a securities-based loan or line of credit.