Do your homework on securities-backed loans

Just as the stock market stalls out at near-record highs, registered investment advisers are stepping into the field of securities-backed loans.
On one hand, an increase in the popularity of such loans makes sense. Because the stock market is high, the value of clients’ portfolios might be at a peak and therefore easily able to back large loans. On the other hand, with the market at a near-record level, the chances of a correction that would push down the prices of the stocks backing the loans also are high and that could force sales of the securities, possibly at a loss.

In January, the Financial Industry Regulatory Authority Inc. warned that it was looking into the marketing of such loans, indicating it had concerns that they were being sold inappropriately. Although Finra doesn’t regulate RIAs, it suggests investment advisers nonetheless should be cautious in recommending them to their wealthy and near-wealthy clients.

To be sure, securities-backed loans can be appealing to clients. They can be used for any purpose, from buying a boat to starting a business. There is no setup cost, they can be obtained in a relatively short period — more quickly than a second mortgage, for example — and they generally carry competitive interest rates.

Further, the client continues to have all of his or her portfolio in the market and to share in any market gains, so that the value of the equity portfolio could rise. That no doubt seems better than selling part of the portfolio to make the acquisition or the business investment, and possibly paying capital gains taxes on the securities sold.

For advisers, the payoff is the appreciation they get from clients for helping them complete a purchase or investment with minimal hassle and no disruption of their investment portfolio. Advisers also continue to receive fees based on the full portfolio value. If the assets were sold instead, reducing the value of the portfolio, any asset-based fees would decline.

Wirehouses, banks and custodians like securities-backed lending because it can increase the number of interest-paying loans outstanding, bolstering that income stream. This explains the new efforts to sell these loans through advisers.

The big danger is that the number and amount of such loans outstanding, including those marketed through advisers, will peak right before a severe market correction, just as the number of home equity loans peaked shortly before the real estate bubble burst in 2007.

Clients taking out securities-backed loans might see only the advantages and not the risks. As Tim Welsh, president of Nexus Strategy, told InvestmentNews last week: “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.”

MARKET CORRECTION

The risk is that if there is a market correction, the value of the securities backing the loan will fall and the lender will sell the securities, or ask the client to put more money down to back the loan. Since stock prices are more volatile than house prices, the risk of such an outcome is greater than for home equity loans.

Investment advisers approached about suggesting these loans to their clients, or asked about the loans by clients, should consider carefully for whom they are appropriate.

They should take into account the size and purpose of the loans, the percentage of the equity portfolios that would be needed to back the loans, the risk tolerance of the clients, and whether it makes sense to leverage the portfolio to avoid capital gains taxes that would be generated by selling the stocks to fund the purchase or investment.

Advisers should also consider whether the clients have underwater stocks that could be sold to finance the deals instead of taking on the leverage. And they must make sure the clients understand the risks.

In short, advisers must do their homework on securities-based loans, so they can guide them appropriately.

Their role is to help clients achieve their long-term financial goals and also to protect them from making mistakes as they seek to satisfy short-term wants and needs.