Securities-Backed Lending for Beginners

Equally as attractive to certain borrowers, depending upon the specific loan arrangement, a securities-backed loan might require interest-only payments. The borrower can have these interest-only payments automatically deducted from a bank account, resulting in far less strain on cash flow while times are good than a traditional amortizing loan would have required.

This is particularly attractive compared to margin loans. At the time of this writing, a securities-backed loan for a customer who had $5,000,000 invested at one major American financial institution was equal to the bank’s base rate minus 2.5 while the margin loan was the base rate. The interest savings is not insignificant. To be specific, with a base rate of 5.75%, the securities back loan cost 3.25% per annum; an incredibly inexpensive rate that is nearly unbeatable compared to alternative sources of financing.

How Does a Securities-Backed Loan Differ From a Margin Loan?

When a customer of a broker-dealer opens a margin brokerage account, he or she gives the broker-dealer a lien on the securities in the account. The broker-dealer then lends money to the client, often by borrowing it from another institution and charging a mark-up, with the margin interest rate determined by the total amount of margin debt outstanding at any given time. Under current Federal Reserve regulations governing margin brokerage accounts, the broker-dealer can lend as much as 50% of the value of a holding. For example, if you deposited $3,000,000 into an account, you could either borrow $1,500,000 against it by writing checks from the brokerage account and withdrawing those funds or, alternatively, you could buy $3,000,000 more worth of securities on credit, taking the assets in your account to $6,000,000 with an offsetting $3,000,000 in debt against it in hopes of leveraging your returns. In contrast, a so-called cash account does not allow you to this but you also don’t need to worry about things like rehypothecation risk.

Aside from usually, but not always, offering less attractive lending rates, margin loans can be a bit more dangerous in that broker-dealers do not provide customers guaranteed cure periods when a customer is given a margin call. That is, a broker-dealer doesn’t have to give you time to deposit additional collateral in an account but, instead, might liquidate securities to protect itself even if it means triggering significant capital gains taxes for you even if you would have been willing to wire money into the account to avoid such an outcome. With a securities-backed loan, that might be less of a concern as, depending upon the covenants found in the promissory note, you might have a certain number of days or weeks to come up with surplus collateral you can put up to avoid liquidating your stocks, bonds, and other holdings or, alternatively, to pay down the balance of the outstanding loan.

Usually, margin loans are meant for short-term needs or as a way to amplify returns by buying more securities than your equity would otherwise permit. In contrast, securities-backed loans are meant to be a flexible funding source for affluent and high net worth investors; a financial tool in a financial toolbox that makes life easier. For example, imagine a wealthy real estate developer is sitting on a personal fixed-income portfolio of $10,000,000 in Treasury notes and gilt-edged tax-free municipal bonds. One day, he gets an opportunity to buy a small office building at a great cap rate. He wants to close the deal quickly to avoid having other potential buyers compete with him. He could use his bond portfolio to create an on-demand securities-backed loan, wiring the entire $3,000,000 to an escrow account and offering to close in a matter of days, after which he plans on obtaining a traditional commercial mortgage and repaying the securities-backed loan. Depending on the private bank, the developer might even call the banker and have the refinance done all in-house, saving time and effort.

Securities-Backed Loans Can Be Extremely Dangerous in the Wrong Hands

Despite all of their advantages, securities-backed loans can be extremely dangerous when not managed with prudence and care. This is because investors often forget – or worse, yet, refuse to believe – that events like 1929-1933, 1973-1974, and 2007-2009 can happen without warning; that, somehow, the disasters that befell the capital markets in the past are nothing but a distant memory caused by forces from which we are now immune. That kind of thinking can lead to bankruptcy and ruin. Even perfectly fine businesses with fantastic core economic engines that make wonderful long-term holdings can, have, and will in the future lose 50% or more of quoted market value from time to time. It is an inevitable part of free market capitalism due to the auction nature of the securities markets. In my personal opinion, I think the empirical evidence is clear that you largely cannot avoid it and you are a fool for even trying.

Put another way, when equity and fixed-income markets go into a free fall, which will happen again at some point in the future, the quoted market valuation of a myriad of assets can collapse to levels previously believed to be unthinkable. Unless the borrower has a lot of surplus liquidity outside of the securities that are backing the loan, or the securities backing the loan consist almost entirely of things such as short-term U.S. Treasury bills, this can result in collateral calls followed by forced liquidation at extremely unattractive prices. That is, the borrower has the option to buy and hold taken away from him. He can’t wait for a recovery, even if he is patient and emotionally capable of doing so. You never want to find yourself in this position.

Another danger with securities-backed loans is that the lender may decide that it no longer feels comfortable with a specific security serving as collateral. For example, imagine that your family holds a large block of stock in what was formerly a well-respected company, Eastman Kodak. As digital cameras cut into the profits of what was once the world’s premier photography giant, the bank, noticing the financial ratios such as the dividend coverage ratio, interest coverage ratio, and other metrics of financial soundness were suffering, may have decided that it would no longer accept Eastman Kodak as collateral. You would have had to either sell your Eastman Kodak shares and invest the money in something that was acceptable to the lender, or you would have needed to contribute additional capital to the secured account that held the collateral to avoid having your line of credit reduced or canceled. For truly high net worth individuals dealing with sophisticated private banks, an alternative that might have been acceptable would have been to purchase put options on either the stock in question or a broad market index to serve as a form of insurance against a security-specific or equity market decline.

On a final note, securities-backed loans also have one specific restriction that is important: The borrower cannot use the money to pay down margin debt or to invest in securities.