Investors must gauge risks of securities-backed lending

Such loans are growing quickly, but some are concerned about the potential downside and conflicts of interest

By Mason Braswell

Jun 19, 2015 @ 12:00 pm EST

If your financial adviser asks you to use your portfolio as collateral for a loan for a new vacation home or another large purchase, you may want to think twice.

In the past several years, securities-backed loans, where investors are asked to use their securities as collateral, have become a hot-ticket item at many of the major brokerage firms, such as Morgan Stanley Wealth Management and Bank of America Merrill Lynch.

More recently, the loans have been gaining steam at smaller independent advice firms as well, but some experts worry that their popularity may be ignoring some major risks — including what could happen in a market downturn when the value of the portfolio drops.

“In every bull market I've seen, this is always a predictor of the top,” said Tim Welsh, president and consultant of Nexus Strategy, a wealth management consulting firm. “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,” he said.

Securities-backed loans 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.

There is no upfront cost to set up a securities-based line of credit, and firms offer competitive rates. The rates for those loans 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 can take as few as eight business days at some banks.

But advisers may have other reasons for recommending the loans. Securities-backed loans provide another income source from clients who otherwise pay a flat fee for advice 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 sell 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 on an earnings call in July.

Independent, fee-only advisers 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 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 Mr. Welsh.

“They don't sell, so the assets under management stay the same — so it inherently has a conflict of interest,” he said.

And if your portfolio drops in value, the firm can sell the securities or ask that you put down more money to back that up. That's a risk that isn't as high when using less-volatile collateral, 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 a 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.

Tom Anderson, who has written a book called The Value of Debt in Retirement, advises investors to think of securities-backed loans like coffee or wine.

“With the right amount, they can offer great benefits,” he said. “The key is moderation.”

Mr. Anderson advises that investors never borrow more than 25% of their portfolio's total value. A $300,000 account, for example, should never borrow more than $75,000, he suggested.

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