Investors Beware: Securities-Backed Lines of Credit

Securities-based lending has been described as “Wall Street’s hottest business.” Essentially, securities-based lending can be thought of as a brokerage firm extending a line of credit to a customer. Instead of using real property (such as a house) as collateral, however, stocks, bonds, and other securities in the customer’s brokerage accounts are used as collateral. In recent years, thanks to aggressive marketing and high-pressure sales tactics, investors have been borrowing money against the securities in brokerage accounts at a record pace. There are two types of securities-based loans: (1) margin loans, in which credit is extended for the purpose of buying securities, and (2) non-purpose loans, in which credit is extended for the purpose of purchasing anything other than securities.

Almost all of the major brokerage firms have begun recommending that their clients take out non-purpose loans, i.e., securities-backed lines of credit (SBLOCs). These loans are often marketed by brokerage firms to investors as an easy way to cash out securities in their accounts by borrowing against the assets in their portfolio without actually having to liquidate securities.

For instance, Morgan Stanley suggests using SBLOCs to “buy a home, finance a tax obligation, [or] expand your business.” Wells Fargo recommends SBLOCs be used to for “business opportunities” and JP Morgan recommends them “to cover near term expenditures or major purchases.” Merrill Lynch advises that SBLOCs may be used to pay for weddings, medical expenses, educational expenses, and so on. On its website, UBS advises that SBLOCs may be opened to make “luxury purchases such as yachts or private jets.”

Why are customers being pushed to open SBLOCs at a record-pace? It’s all about the money. SBLOCS give brokerage firms such as LPL Financial and Goldman Sachs, Merrill Lynch, Wells Fargo, Morgan Stanley, JP Morgan, and UBS the opportunity to cross-sell banking products, add new streams of revenue, and charge interest payments against the borrowed amount. The brokerage firms heavily incentivized their financial advisors to have their clients open SBLOCs, and oftentimes the advisors are rewarded with a percentage of the loan amount outstanding. It is reported that between 2012 and 2014, one large brokerage firm reported a 70% increase in its securities-based lending business, while other large firms reported an increase of over 50%. The numbers are only getting bigger as time goes on. Clearly, SBLOCs are a huge money-maker for Wall Street.

Securities-Backed Lines of Credit (SBLOCs) are extremely risky for the everyday investor

SBLOCs are extremely risky. Once again, the line of credit requires the investor to use their securities as collateral. The price of securities are constantly shifting, which means that the collateral backing the line of credit may also be volatile. If the value of the securities in the investor’s account declines as a result of market volatility, the investor may no longer have sufficient assets to support the line of credit, resulting in a “maintenance call,” where the brokerage firm notifies the investor that they must post additional collateral or repay the loan within a specified period. If the investor is unable to do so, the brokerage firm can liquidate the securities in the account and keep the cash to satisfy the maintenance call.

FINRA (Financial Industry Regulatory Authority), an organization authorized by Congress to protect the investing public, recently issued an Investor Alert in an attempt to warn investors of the dangers of securities-based lending. FINRA warns to:

Be aware that marketing materials touting the advantages of SBLOCs may suggest benefits that you may not achieve given the risks. For instance, if the value of the securities you pledge as collateral decreases, you may need to come up with extra money fast, or your positions could be liquidated.

Further, if interest rates rise, the cost of the SBLOC may significantly increase. Overtime, interest payments can substantially erode the value of the investor’s account or increase the indebtedness to the brokerage firm. Once an SBLOC is established, it is extremely difficult for the investor to move their money to another brokerage firm.

FINRA has fined brokerage firms for their failure to supervise customers’ use of leverage in their brokerage accounts, i.e., customers’ use of SBLOCs.

The investment fraud attorneys at ChapmanAlbin represent investors who have suffered losses due to inappropriate investments. If you have lost money due to taking out a securities-backed line of credit or other form of securities-based lending, call us for a free, no obligation consultation.