The use and abuse of securities based lending

According to a recent article in Fortune magazine, the latest push by the big investment firms is to get as many of their clients as possible to borrow against the value of their portfolios.  Clients can borrow from 50% to 95% of their portfolio’s value.

Securities-based lending, also known as non-purpose lending, is Wall Street’s hottest business. From UBS to Bank of America Merrill Lynch to JPMorgan, high net worth investors are being enticed to take out loans against their brokerage accounts at a blistering pace. A May 2014 article in The Wall Street Journal told the story of Jason Katz, a UBS broker who has arranged portfolio loans for 21 of his clients in the prior year, a four-fold jump from the year before. The Journal reported that portfolio lending jumped by 28% at UBS between 2011 and 2013.

The loan has an interest rate, which may be either higher or lower than a bank loan.  But what many borrowers may not realize is that their portfolio can be sold out without their approval.

Supposed someone “has” to have $100,000 for a new boat.  With a stock portfolio worth $200,000, that individual can get a quick loan without a single transaction taking place.   But if the value of the portfolio drops, the firm has the right to sell the portfolio instantly, without notice.

Should market volatility result in a capital call, securities held directly by wealth management customers can be liquidated instantly with very little risk to the brokerages who’ve extended the credit. In essence, we’re seeing re-leveraging amongst the 10% of America that owns 80% of the stock market, while the other 90% of the country has been forced to deleverage in recent years.

As a fiduciary, it is our job to advise our clients on risks.  While taking an occasional short-term loan may be the right thing to do in special circumstances, borrowing against a portfolio, especially near the limits is very, very dangerous.  Wall Street is pushing these loans to fatten it’s bottom line.  Don’t get hooked.

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Chinese guarantees and the illusion of safety

A “guarantee” is only as good as the guarantor. If you buy a car with a ten year parts and labor guarantee, you make the assumption that the company will be around for that long and able to make good on its promise.

That’s becoming a potential problem in China. The Wall Street Journal shows how a lot of Chinese loans are ‘guaranteed” by guarantors who may not be able to make good in case of trouble.

Since 2007, the central government has instructed banks to lend more to small firms run by entrepreneurs, the most efficient part of the economy but one that banks have traditionally eschewed. Banks prefer to lend to large and state-owned firms that have sufficient collateral – typically land – to cover their loans.
The banks’ solution has been to insist that in the absence of collateral, someone else guarantee the loan – absolving banks of the need to look too closely at borrowers’ ability to pay, while giving loans the veneer of being safe. In some cases, the guarantee will come from another small firm – maybe a neighboring factory, and a company run by a close friend.

This would not be a problem for the industrialized world if China had not become the world’s largest economy. Major firms throughout the world are making big bets on the Chinese economy. The Chinese are known for their “creative” accounting.   The next big “Black Swan” event could come at us out of the Orient.

Teach your kids about money

Kids learn about money from their parents.

They observe what parents do and what they say about money and pick it up by osmosis.  It’s the same way they learn to talk, and end up talking in the same dialect as their parents.

An article in the Wall Street Journal by Beth Kobliner tells us that

Three out of four American teens lack the skills to decipher a pay stub. That’s just one of the sobering findings from the first international test of teenagers’ financial literacy. American 15-year-olds posted barely average scores, with the U.S. ranking in the middle of the 18 countries whose students participated.

That tells us a lot about the financial skills of the average parent.

What’s to be done?

As a parent of young children, plan to getting better educated about saving, credit cards, debt, investing and all the things that make you financially literate.  If you don’t want to read books on the subject, get help from people whose job it is to educate you, like RIAs who are Certified Financial Planners.

At the very least, you can visit the website: Money as you grow, “20 things kids need to know to live financially smart lives.”