A Dangerous Game: Using Your Portfolio as Collateral
Six years into a bull market, people might be feeling pretty good about the stability of their portfolios. By many accounts, the U.S. economy is doing well, and it's reassuring to see stocks notch record highs almost every month.
As investors feel more confident, more investment professionals are suggesting that clients don't need to sell stocks or bonds just because they need some quick cash. Instead, they are suggesting clients borrow against their portfolios and take out a securities-based line of credit (SBLOC), loans that use stock, bond and mutual funds already owned in the brokerage firm's accounts as collateral.
To borrowers, securities-based lending, also known as non-purpose lending, might seem like a perfect solution. It's fast, easy and often comes at rates lower than traditional bank loans. But as some borrowers learned during the housing crisis, borrowing against potentially volatile assets can give rise to significant risks.
How Does It Work?
Securities-based loans allow an investment firm to extend an investor a line of credit without selling the assets backing the loan, much as the once popular home equity line of credit (HELOC) allowed banks to extend credit to homeowners without touching the underlying home.
The number of investment firms offering securities-based loans has soared in recent years, capturing the attention of regulators, including the Financial Industry Regulatory Authority, concerned about how they are marketed and used.
Often, investment firms and/or their bank affiliates can extend a securities-backed line of credit within a matter of days, if not hours. Since a financial institution already knows the value of the assets, it's relatively easy to assess how much they're worth.
Investment firms advertise the ability to borrow anywhere from half a portfolio's value up to nearly the entire value of an investor's holdings, depending on the assets used as collateral. And because the stocks, bonds, and mutual funds backing the loans are usually liquid and may be easily sold, SBLOCs are often offered at better rates than standard personal loans.
While some borrowers surely use these loans to do responsible things, like pay down higher interest rate student loans, some borrowers are also using them to fund an extravagant lifestyle, according to an annual priority review letter from the Financial Industry Regulatory Authority, with the cash going to make a down payment on a new home or to buy expensive works of art and yachts.
There's only one thing borrowers can't do with the money: buy more stocks, bonds or mutual funds.
With stock indices hitting record highs recently, taking out an SBLOC may seem like an easy way to get access to cash without having to sell securities. But if the market slips, an investor borrowing against his or her investment accounts can quickly find him or herself in a bind.
If there's a decline in the value of the securities collateralizing a loan, lenders can demand that borrowers put up more collateral on short notice. If a borrower doesn't pony up the extra collateral within the designated time frame, the lender then has the right to sell as many of his or her securities as necessary, potentially without the investor's input on which ones to sell and which to hold. This can also result in unexpected and adverse tax consequences for the borrower.
In some instances, a lender could skip straight to selling the assets without first offering a borrower the chance to deposit cash or additional collateral into the account. In either case, the borrower might be left with unexpected tax obligations and other fees.
But borrowers have to be on their guard even if the stock market isn't crashing. Many brokers reserve the right to call back a securities-based loan at any time, for any reason.
Things can really get tricky if a lender comes calling and an investor has already spent his or her borrowed money on something that isn't easy to sell right away, such as a house, or can't be returned, like college tuition payments.
Another set of risks can emerge if the investment firm transfers the assets to an outside lender, rather than acting as the lender itself. FINRA has seen some cases where those outside lenders weren't registered with FINRA or any other regulatory authority, making it difficult to ascertain their financial stability or to verify what they are doing with the assets once they are transferred to them.
The U.S. Securities and Exchange Commission has charged some fraudulent loan programs that were unable to return assets, or to pay profits, to investors who borrowed from them.
Hedging The Risk
If you decide to go ahead with a securities-based loan, there are ways to minimize these risks.
First, ask your investment firm, and verify in the loan documents, whether they or an affiliate bank will be the lender, or if the loan would be outsourced to a third-party. That can open a conversation on some of the fine-print terms of the loan, including what the firm does with the securities when they are being used as collateral, what rights you have in the event the lender calls for more collateral and how the repayment process works.
Also ask your investment firm what additional fees are associated with the loan, including early termination fees, late repayment fees, and anything that might be charged for liquidating securities in the event of a default.
Furthermore, you can plan to borrow the smallest percentage possible, even if the lender is offering to give you more.
If an investor borrows just 20 percent of the value of their portfolio while the investment firm is offering them up to 50 percent, that borrower might be less likely to run into a situation where they have to meet a short-term call for more collateral. Locking down the down payment on a new vacation home might be great, but if the lender comes knocking, that ocean view will lose its charm rather quickly.