Brokerage firms' Loans Are an Increasing Risk to Investors

Brokerage Firms' Loans Are Increasing Risk to Investors
There is a growing trend of Wall Street brokerage firms encouraging investors to borrow money and use their securities portfolios as collateral for the loans. Morgan Stanley, Merrill Lynch, UBS, Wells Fargo Advisors, and JPMorgan reportedly are encouraging their high-net-worth clients to take so-called “non-purpose” loans that are collateralized by the clients’ securities portfolios. The loans increased risk and are suitable only for investors who understand the risk, are willing to accept the risk, and have the financial means to withstand the risk if it comes to fruition. This the type of seed that can germinate into massive investment losses.

Different from margin loans, the proceeds from non-purpose loans cannot be used to purchase additional securities. Of course, even that rule is not always followed, as evidenced by UBS reportedly having permitted Puerto Rico investors to use hundreds of millions of dollars of non-purpose loan proceeds to buy risky UBS leveraged bond funds.

A recent article in The Wall Street Journal article reported that portfolio lending increased by 28% at UBS between 2011 and 2013. Another recent article published by Investment News stated that there was a 32% rise in Morgan Stanley's client liabilities, to a record $45 billion, from the same period a year before. And according to Reuters, Morgan Stanley now makes loans on 55 cents of every dollar of client deposits, which is not even as high as some of its Wall Street rivals, which lend 70 to 80 cents for every dollar of client money.

It comes as no surprise that one motivation for recommending these loans may be that brokerage firms and stockbrokers are compensated for doing so. That is, some brokerage firms and brokers may recommend the loans based on their desire to be paid, rather than because the loans make sense for the client. And unlike other forms of loans, these loans can be put in place quickly with only limited paperwork. Morgan Stanley’s system is even called Express Credit Line. The loans also are not reviewed by underwriters and there often is little due diligence done because collateral for the loans is sitting in accounts at the brokerage firms.

To be clear, borrowing money against your securities portfolio is risky. If the securities drop in value, the brokerage firm generally is permitted to sell your securities without notice to pay down or pay off the loan. And if the securities decline so far in value that they are not even worth enough to pay off the loan, then the client loses their entire securities portfolio and has to come up with additional money to pay off the remainder of the outstanding loan.

We believe that Wall Street’s focus on pushing non-purpose loans is a harbinger of massive future investment losses for investors. As they say, history repeats itself, and we see this easy access to funds as being similar to facts that gave rise to the 2008 financial crisis that caused investors to lose billions of dollars and doomed many financial institutions.

Throughout the early 2000s, enticed by the massive revenue to be generated, mortgage brokers and banks made it very easy for millions of people to borrow money. That led to sloppy and reckless underwriting, including the issuance of NINJA loans (No Income, No Job and no Assets). When the real estate collateralizing the loans declined in value, millions of borrowers defaulted on their loans, causing a massive domino effect that saw trillions of dollars of money lost in various financial instruments tied to those loans.
We believe that encouraging brokers to recommend non-purpose loans similarly can lead to unethical behavior by unscrupulous brokers. We expect that brokers will take advantage of this easy access to cash. In our opinion, with no underwriting performed on the loans, the likelihood that the loans will be given to clients who cannot afford the risk is a near certainty.

Some may not be concerned about the potential for massive loan calls because of the years-long bull market. But when this Bull Run ends and the bears come out of hibernation, which is inevitable, the highly leveraged portfolios will see massive forced sell-offs. Brokerage firms will liquidate billions of dollars of securities in client accounts as they rush to protect themselves and pay down the loans that they had given to investors. And that sell off likely will drive securities prices even lower. Be forewarned. While we cannot predict the future, our securities fraud and investment loss lawyers believe that the writing already is on the wall that this use of non-purpose loans will lead to massive investment losses.

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