Securities-backed loans have been a hot product as the value of investors’ portfolios soared during the latest bull market. Morgan Stanley, Bank of America and others have loaned out billions of dollars with securities as collateral. The loans made it into the Financial Industry Regulatory Authority’s annual priorities letter in January and, more recently, LPL Financial announced a partnership to offer the lines of credit through Goldman Sachs.
To dive into the loans a little further, WealthManagement.com interviewed Bryan Loew, the head of TD Wealth Lending Sales, overseeing securities-backed loans. Loew has more than 10 years of experience in private banking and broke down some of the nuances of the loans, who the borrowers are, what they are using the money for, and the risks to both clients and lenders.
(Responses have been edited for length and clarity.)
Wealthmanagement.com: Most of our readers are advisors who are probably familiar with collateralized, or securities-backed, loans. For anyone who might not be, can you give a brief explanation of what they are?
Bryan Loew: So, in their most basic form, they are loans or lines of credit that are secured by eligible securities at a brokerage or advisory firm. They have to be in a taxable account. Tax-deferred accounts—like 401(k)s, IRAs and Roth IRAs—are not eligible forms of collateral. And the loans, or lines of credit, can be used for any legal reason other than the purchase of additional securities. That’s a major restriction there, that you’re not allowed to purchase additional securities in the brokerage accounts with the proceeds from these facilities.
WM: Why would someone want a loan backed by their securities? How much are they borrowing and what are most borrowers using the money for?
BL: That’s a pretty broad question because, again, the clients can use them for any legal reason, other than pursuing traditional securities. Cash flow is a big one for a lot of high-net-worth individuals. Clients who have a small salary relative to their overall annual compensation may be in need of cash flow higher than their base salary. So these lines of credit are a personal, working capital facility for these individuals.
Real estate is another big one that we see for a lot of people. Real estate financing tends to be what you call cash-flow financing (for example, mortgages), meaning that you need due diligence on tax returns, either personal or commercial, depending on what type of real estate is being purchased and what the structure is. Having these types of lines of credit allows clients to actually purchase the real estate and, perhaps, even give really advantageous terms because they’re doing all-cash purchases, yet they’re using their securities-based line of credit as the financing. And then over time they will look to do permanent financing on the real estate after that transaction has gone through.
Other things that we see are business investments. Sometimes people have an opportunity to purchase businesses or assets, inexpensively. So this could be a way of raising cash to do that. Or, it could even be an injection of cash into an existing business. Sometimes there are businesses that have seasonality and rather than going through the traditional forms of financing, leveraging a personal balance sheet for a quick source of cash is advantageous.
And then there’s the other things, like large purchases for individuals or even life events; sometimes weddings, bar mitzvahs and other things of that nature. It could be a way of doing financing for certain families.
WM: So why not just go to the bank and get a loan? Or take out a private equity loan against a home?
BL: The primary difference between mortgages and [a home equity loan] versus collateralized loans, is that mortgages and home equities typically take around anywhere from a 30 to 60 days to process and they are cash-flow [dependent], meaning individuals have to submit their tax returns and other sources of documentation. And there’s been a lot of scrutiny around that, given the past abuses that have happened in the industry.
These [securities-backed] loans are often used as, I don’t want to say quick, but more temporary forms of financing. So when you think about the uses, such as real estate, it’s done temporarily, perhaps has a bridge loan if you’re in between purchasing and selling a home, or another piece of real estate as an investment. You’re doing that for the short term until you put permanent sources of financing in place.
If you’re using it for cash-flow purposes, it’s really just about cash flow and then it gets paid back in the latter part of the year.
It’s not a permanent source of financing. It tends to be one that’s probably shorter in duration, I would say, a couple years or less in duration. But the primary difference here is that it’s quick and it’s easy to do. And oftentimes the big benefit is the pricing tends to be a little bit better than what you might see elsewhere.
WM: What does this mean for someone’s capital gains and taxes in general?
BL: We always tell our clients that they really need to defer to their own CPA for specific tax advice, but the one strategy that we do see being employed with these lines of credit is to help defer capital gains taxes.
If a client were to come to an advisor and say “I need X amount of money,” and they’re sitting on large capital gains in their portfolio—let’s say they’ve been invested in the market over the past five years and they’ve seen significant gains—rather than sell out that portfolio and interrupt the investment strategy that the advisor put together, you could take a loan out against them and continue to defer capital gains until there might be a more opportune time.
WM: The popularity of securities-backed loans has grown in recent years, along with the market. Now that volatility has returned, so to speak, what does this mean for these loans?
BL: As it pertains to risk and collateral, it’s important for an advisor, as well as the client, to fully understand all of the risks. Otherwise, if there’s a major market pullback, they could be in the position where they have to come up with additional collateral or cash.
For example, having a client that puts a facility in place using 90 percent of the line of credit is more different than having a client that puts a facility in place and is using only 20 percent of the credit available to him. In those types of situations, if you have a client who’s only using 10 or 20 percent, even if the market does have, let’s call it a 50 percent pullback, the likelihood of that client having a capital callback is going to be very low. The client who has a 90 percent utilization obviously is going to have a lot less of a buffer built in and could be in a bad situation a little quicker. So knowing your client’s individual circumstances are extremely important.
The other thing is the composition of the portfolio. If a client owns asset classes that tend to be less volatile, a market pullback would impact them less than, say, someone who is in all small-cap stocks. Another thing I would say is important to monitor are major asset allocation changes in a portfolio.
I’ll give kind of an extreme example but it’s really one that’s used so that people understand the ramifications. If you have a client that’s invested 100 percent in Treasury securities and a large line of credit against it, and you move them into a portfolio that’s all equities and small caps, on the total opposite end of the risk spectrum, more than likely you’re going to cause a capital call.
WM: Can you put the importance or significance of this lending for TD Wealth into context?
BL: I think, in general, the awareness of securities-backed lending is growing among the general population. Obviously, we’ve had a favorable market environment for a long time now. People see their portfolio is an available source of financing, so it becomes an option for a lot of people, versus in 2008 when the portfolios weren’t an available option for them, in terms of financing.
For TD Wealth, we don’t look at it strictly as a product when we think about securities-based lending; we think about goal-based advice, which is what we try to do for our clients and we look at securities-based lending as a possible solution to achieve whatever our clients goals are. So, if it means security-based lending, that’s great. If the client can achieve their goal without [borrow]ing, that’s great too; or a mortgage or home equity [loan].
I’m sure there’s a camp who advise against this type of loan, regardless of circumstances, or are leery of them. What do you say to those people? Do they have any fair points?
Everybody’s entitled to their opinion, not to say they are wrong or right, one way or another. The way I think about it is that every client has its own unique set of circumstances. If you were going to build a house, you wouldn’t want to go in there with just a screwdriver, a saw and no hammer. So, securities-based lending is just a tool in an advisor’s toolkit to help them achieve goals for their clients. It could be right for a particular client; for a lot of clients, it might not be right.
WM: Are clients asking about securities-backed loans or is it really TD Wealth that is putting this option out there?
BL: I think it’s always something you need to educate the clients on. The industry is changing rapidly. For me, and I think TD Wealth, the important thing is to put a menu of options in front of the client, whether it’s investment options, banking options or lending options, going through the plusses and minuses of them and then make the decision together with the client. So there’s probably some level of increased awareness.
WM: How has technology impacted securities-backed loans?
BL: Just about 10 years ago, a lot of banks would still accept paper statements once a month as monitoring. Now, with technology, you can get real-time data feeds and view it once a day, intraday and even up to the second.
So that allows for the safety and soundness of these portfolios. If the market is moving against your client, you can try to get ahead of it as quickly as possible. Whereas before, you could’ve had upwards of a 30-day data lag because you were waiting on that snail mail to come.
