In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.
The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.
From the Wall Street Journal article: Margin Calls Bite Investors, Banks
Today’s article from the Wall Street Journal on investors taking out large loans backed by portfolios of stocks and bonds is one of the most concerning and troubling finance/economics related articles I have read all year.
Many of you will already be aware of this practice, but many of you will not. In a nutshell, brokers are permitting investors to take out loans of as much as 40% of the value from a portfolio of equities, and up to a terrifying 80% from a bond portfolio. The interest rates are often minuscule, as low as 2%, and since many of these clients are wealthy, the loans are often used to purchase boats and real estate.
At the height of last cycle’s credit insanity, we saw average Americans take out large home loans in order to do renovations, take vacations, etc. While we know how that turned out, there was at least some sense to it. These people obviously didn’t want liquidate their primary residence in order to do these things they couldn’t actually afford, so they borrowed against it.
In the case of these financial assets loans, the investors could easily liquidate parts of their portfolio in order to buy their boats or houses. This is what a normal, functioning sane financial system would look like. Rather, these clients are so starry eyed with financial markets, they can’t bring themselves to sell a single bond or share in order to purchase a luxury item, or second home. Of course, Wall Street is encouraging this behavior, since they can then earn the same amount of fees managing financial assets, while at the same time earning money from the loan taken out against them.
I don’t even want to contemplate the deflationary impact that this practice will have once the cycle turns in earnest. Devastating momentum liquidation is the only thing that comes to mind.
So when you hear about margin loans against stocks, it’s not just to buy more stocks. It’s also to buy “pretty much everything…”
From the Wall Street Journal:
Loans backed by investment portfolios have become a booming business for Wall Street brokerages. Now the bill is coming due—for both the banks and their clients.
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