The rise of rich man’s subprime

Photo courtesy: John Moore — Getty Images

Lindsay (we’ll call her Lindsay to protect her identity) took a job in the securities-based lending department at Morgan Stanley right after college graduation. She had dozens of colleagues in her group when she first started and now she’s got hundreds, nearly all of them entry-level workers looking to get their foot in the industry.

They are there to support the brokers—ahem, financial advisors—as they turn as many of their clients’ investment portfolios into loan collateral as possible. Processing paperwork and assisting the firm’s wealth-managers-turned-loan-officers is their business—and business is booming.

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.

A contact of mine at Wells Fargo Advisors (formerly Wachovia / AG Edwards) told me they refer to these loans as their “13th month”—a reference to the 12 production months each broker has in the course of a year to generate revenues. Another friend of mine at Morgan Stanley told me that, were it up to his regional manager, they would be automatically sending out the paperwork for these loans with every single new account form. It’s worth noting that Morgan is actually behind many of its competitors in this space. According to Reuters, “For every dollar of client deposits, Morgan Stanley makes just 55 cents of loans, far less than the 70 to 80 cents that rival banks make in their brokerage businesses. Its profit margins are weaker than other major brokerages.”

If you know anything about Wall Street culture, then you already know that the competitive nature of the game will always drive a trend like this way past the bounds of logic and reason. You also know that compensation incentives will always get the job done. In fact, to spur even more portfolio lending, this December, Morgan instituted a new bonus system for 2014 in which “advisers can earn up to $202,500 for loan growth, up from $127,500 in 2013.” In a presentation last September, the firm’s CFO Ruth Porat mentioned a goal to triple the firm’s portfolio loan accounts from 2012 levels by 2015. By all accounts, they’re well on their way.

The mechanics of securities-based lending are extraordinarily simple, especially compared to almost everything else that transpires in the financial services industry. Wealth management clients of the wirehouse firms keep millions of dollars in their taxable brokerage accounts, predominantly invested in stocks, bonds, and mutual funds. Advisors at the firm are encouraged to convince their clients to borrow against these holdings. Clients are offered an ultra-low interest rate, typically between 2% and 5%. And they can borrow between 50% and 95% of their portfolio’s equity (cash) value, with the bond-equity mix of the account being the primary determinant of the loan’s size.

The only rule is that clients cannot use the loaned funds to purchase additional securities, like a margin loan. Instead, these borrowings are meant to allow clients to smooth out cash flow at a small business, fund the purchase of artwork and real estate, or refinance higher-rate loans like mortgages. The beauty of securities-based lending is that these are not underwritten loans nor do they require extensive due diligence because the assets are already sitting there at the firm and public securities are thought to be extremely liquid. Also, these loans can be arranged with minimal paperwork. Lindsay at Morgan Stanley informs me that they can typically be turned around, from request to dispersal of funds, within 36 hours. In the span of a week, borrowers can buy a boat backed by a portfolio of bonds without a single transaction taking place.

An accidental product of Dodd-Frank?

While portfolio-based lending is not a new business, it has become newly explosive as a product on Wall Street. It’s even gotten to the point where many employees of banks now include the term “Private Client Banking” on their business cards, where once the title of Vice President of Investments would have been.

With so much of The Street’s bread and butter businesses—banking, hedge funding, and prop trading—in jeopardy on the heels of financial reform efforts like Dodd-Frank, a renewed push into wealth management lending became an obvious move. As a result, while leverage and risk in the financial system has decreased, it has also shifted from the balance sheets of the banks to the account holders themselves. A July 2014 article published by Investment News documented a 32% rise in Morgan Stanley’s client liabilities, to a record $45 billion, from the same period a year before.

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.

The popularity of these loans and the ease in which they can be manufactured has created a huge profitability boost for the Morgans and Merrills. It’s also had some other, less obvious benefits for the firms that have focused on it. For example, clients with outstanding loans tied to their portfolios tend to stay put. This has made wealth management assets much stickier and less prone to departing for an independent RIA firm or a rival wirehouse. Sticky assets mean a lot of visibility to analysts, who often assign a higher multiple to businesses with higher visibility. This is why asset management profits are more highly prized than trading profits when companies like Goldman and JPMorgan are analyzed by the sell-side.

Securities-based lending has also filled the gaping hole in the revenue mix where commission-based stock trading once was. Merrill Lynch has recently told analysts that approximately 50% of its brokers have 50% of their client assets in non-transactional, fee-based accounts. Now that wirehouses have shifted their brokers’ business models away from trading commissions and selling concessions, something had to take its place. Insurance did the trick for awhile, as did credit cards and mortgages. But still, the funds sitting in mutual funds and Treasurys being managed in wrap accounts for less than 2% looked ripe for some sort of profitability enhancement. By leaving those portfolios intact but layering an additional stream of revenues onto the same assets, the wirehouse advisors found the proverbial “second bite of the apple.”

Glossy brochures implore clients to “unlock the value of your portfolio through a strategic approach that addresses both sides of your balance sheet” and “maximize the liquidity solutions available to you.” This is code for Hey, here’s a way you can have your cake and eat it too! Retail investors are being shown a way to continue to ride the markets higher while increasing their spending power. A big part of the pitch is that clients incur no taxable consequences from the sale of any securities and they also won’t miss out on any additional upside.

Defenders of the securities-based lending boom point out that wealthy people have always borrowed against their assets and that ultra-low rates make such offerings a logical option, especially compared to second-lien mortgages or credit card debt. And this is true. The bigger question revolves around whether a true financial advisor (read: a fiduciary) would really be recommending that their clients put retirement assets up as collateral for increased consumption in the first place. Can you really be giving quality advice while tacitly facilitating the purchase of luxury goods or other forms of consumption using additional debt?

Skeptics from the independent side of the wealth management industry would ask, rhetorically, whether or not most of these loans would be made with such frequency if the advisors themselves were not sharing in the fees. The answer is that, no, of course they wouldn’t.

Fiduciary advisors off Wall Street shudder when a prospective client mentions that his or her portfolio assets are 50% levered to a vacation home loan. An RIA friend of mine from the New Orleans area was asked by a client to match one of these wirehouse loans in order to take over the client’s investment accounts. She reluctantly made some calls to her custodian and a third-party lender to see what could be done. “I was actually relieved when it turned out that I couldn’t take on the client’s accounts and match the loan. I could do without bringing that kind of additional stress and aggravation into my practice.”

How this could get ugly

Now, you may be saying to yourself, “So what, a bunch of rich guys are getting in over their heads again, what else is new?” You may be wondering why this should be of any concern to the rest of us, who are going about our investing and way of life in a responsible manner. Fair question.

I would point out the striking similarities between the current spate of leveraging assets with the type of behavior that led to the most recent financial crisis. Consider:

  • Once again, the biggest banks on Wall Street are acting as the fulcrum for this leverage, connecting debt funding with investors of dubious levels of sophistication (anyone who believes that wealthy people are automatically savvy hasn’t spent much time around them).
  • Once again, a seemingly unencumbered source of instant cash (read: free money) has been streamlined, productized, turned into a conveyor belt-esque enterprise, and marketed to a mass audience. Morgan Stanley’s version is actually called Express CreditLine.
  • Once again, super-cheap financing based on an asset whose value can fluctuate wildly (a stock and bond portfolio in this case) is being used for the purchase of assets that can be significantly less liquid, like real estate, fine art, or business expansion.
  • Once again, investors are being goaded into a seemingly consequence-free transaction in which they’re being counseled to seek instant gratification.

If you think the seven-year bull market in stocks along with the endless bid in bonds has little to do with this trend, you’ve not been paying attention. The parallels between the new securities-based lending bubble and the subprime lending bubble are obvious. Substitute the notion that housing prices will always go up with financial assets and it’s clear that the same rationale is driving this scheme.

You could argue that the major difference between this credit boom and the last one is that subprime borrowers could not afford the housing loans to begin with, whereas high net worth investors already have the means to pay these loans back in the form of their investment accounts. Sure, today they do.

But are future stock and bond gains assured? Is the historic lack of volatility of today’s markets a permanent feature of the investment landscape or a temporary anomaly? If the Fed-induced stability we’ve enjoyed for three-quarters of a decade now should give way to another environment altogether, then what happens?

And if all of these leveraged “investors” are forced to sell at once, what will happen to the markets for everyone else? The mass-adoption of so-called “portfolio insurance,” a popular options-related strategy, taught us a nasty lesson in 1987. Then, like now, investors believed that they could be in the market without the risk that actually comes from being, well, in the market. It didn’t work out very well for the rest of us when these options trades created a cascade that left stocks 23% less valuable in the course of a single day.

I know, it’s hard to imagine right now, but at a certain point, the markets are going to move in the other direction. Are the bond funds and stock ETFs that everyone’s borrowing against equipped to handle a scenario in which wirehouse bankers begin demanding liquidation for millions in portfolio loan accounts at once? What about billions? Hedge fund prime brokers are fairly adept at working with margin clerks in times of excess volatility, but are Merrill Lynch financial advisors similarly capable?

Unfortunately, we may be forced to find out the hard way, as the securities-based lending rush continues. This is to say nothing of the dashed hopes for retirement when the piper comes calling for his pay at the worst possible time, during a bear market or a major correction.

Don’t say I didn’t warn you.

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