Many investors have heard of margin accounts and the horror stories of others who invested on margin and suffered substantial losses.
But few investors understand that securities-backed lines of credit (SBL) accounts, which have been aggressively promoted by brokerage firms in the last decade, are just as dangerous as margin accounts.
This is largely due to the fact that the equity and bond markets have been on an upward trend since 2009 and few investors (unless you are a Puerto Rico investor) have experienced market slides resulting in margin calls due to the insufficient amount of collateral in the SBL accounts.
Securities-Backed Lines of Credit Overview
It is only over the last several months of market volatility that investors have begun to feel the wrath of margin calls and understand the high risks associated with investing in SBL accounts.
For investors considering your stockbroker’s offer of a line of credit (a loan at a variable or fixed rate of interest) to finance a residence, a boat, or to pay taxes or for your child’s college education, you may want to read a little more about the nature, mechanics, and risks of SBL accounts before you sign the collateral account agreement and pledge away your life savings to the brokerage firm in exchange for the same loan you could have obtained from another bank without all the risk associated with SBL accounts.
First, it may be helpful to understand just why SBL accounts have become so popular over the last decade.
It should be no surprise that the primary reason for your stockbroker’s offering of an SBL is that both the brokerage firm and he/she make money.
Over many years, the source of revenues for brokerage firms has shifted from transaction-based commissions to fee-based investments, limited partnerships, real estate investment trusts (REITs), structured products, managed accounts, and income earned from lending money to clients in SBL and margin accounts.
Many more investors seem to be aware of the danger of borrowing in margin accounts for the purposes of buying and selling securities, so the brokerage firms expanded their banking activities with their banking affiliates to expand the market and their profitability in the lending arena through SBL accounts.
The typical sales pitch is that SBL accounts are an easy and inexpensive way to access cash by borrowing against the assets in your investment portfolio without having to liquidate any securities you own so that you can continue to profit from your stockbroker’s supposedly successful and infallible investment strategy.
Today the SBL lending business is perhaps one of the more profitable divisions at any brokerage firm and banking affiliate offering that product because the brokerage firm retains assets under management and the fees related thereto and the banking affiliate earns interest income from another market it did not otherwise have direct access to.
For the benefit of the novice investor, let me explain the basics of just how an SBL account works.
An SBL account allows you to borrow money using securities held in your investment accounts as collateral for the loan.
The Danger of Investing in SBL Accounts
Once the account is established and you received the loan proceeds, you can continue to buy and sell securities in that account, so long as the value of the securities in the account exceeds the minimum collateral requirements of the banking affiliate, which can change just like the margin requirements at a brokerage firm.
Assuming you meet those collateral requirements, you only make monthly interest-only payments and the loan remains outstanding until it is repaid. You can pay down the loan balance at any time, and borrow again and pay it down, and borrow again, so long as the SBL account has sufficient collateral and you make the monthly interest-only payments in your SBL account.
In fact, the monthly interest-only payments can be paid by borrowing additional money from the bank to satisfy them until you reach a credit limit or the collateral in your account becomes insufficient at your brokerage firm and its banking affiliate’s discretion.
We have heard some stockbrokers describe SBLs as equivalent to home equity lines, but they are not really the same.
Yes, they are similar in the sense that the amount of equity in your SBL account, like your equity in your house, is collateral for a loan, but you will not lose your house without notice or a lengthy foreclosure process.
On the other hand, you can lose all of your securities in your SBL account if the market goes south and the brokerage firm along with its banking affiliate sell, without prior notice, all of the securities serving as collateral in the SBL account.
You might ask how can that happen; that is, sell the securities in your SBL account, without notice? Well, when you open up an SBL account, the brokerage firm and its banking affiliate and you will execute a contract, a loan agreement that specifies the maximum amount the bank will agree to lend you in exchange for your agreement to pledge your investment account assets as collateral for the loan.
You also agree in that contract that if the value of your securities declines to an amount that is no longer sufficient to secure your line of credit, you must agree to post additional collateral or repay the loan upon demand.
Lines of credit are typically demand loans, meaning the banking affiliate can demand repayment in full at any time.
Generally, you will receive a “maintenance call” from the brokerage firm and/or its banking affiliate notifying you that you must post additional collateral or repay the loan in 3 to 5 days or, if you are unable to do so, the brokerage firm will liquidate your securities and keep the cash necessary to satisfy the “maintenance call” or, in some cases, use the proceeds to pay off the entire loan.
But I want to emphasize, the brokerage firm and its banking affiliate, under the terms of almost all SBL account agreements, are not required to give you any notice of any “maintenance call” or any account liquidation beforehand if they believe they are at risk of holding collateral that is insufficient to pay off the loan in full.
This is just what has happened to some of our clients in periods of rapid and steep stock or bond market declines, most recently during the March 2020 COVID-19 crash.
The nature, mechanics, and risks of an SBL account may appear to be the same as a margin account, but there are important differences in nature and mechanics and the risks can be far greater than a margin account.
First, an SBL account is an all-cash account, meaning you do not have margin privileges in that account; the account becomes dedicated collateral for the banking affiliate’s line of credit.
It is a so-called “non-purpose” account, meaning you agree not to use the loan proceeds for the purpose of buying securities; you can use the loan proceeds for any other purpose.
But the SBL account is more dangerous than a margin account. This is because it is governed by a different Federal Reserve regulation, which gives the banking affiliate the opportunity to lend more (as high as 95%) and is less restrictive in terms of the type of collateral in the SBL account (some banks permit securities with liquidity issues to serve as collateral).
The more the banking affiliate lends and the less liquidity of the collateral, the more devastating it.
There are more risks associated with SBL accounts than those discussed above. Before you open an SBL account and accept any loan, ask yourself and your financial advisor questions and read the lending agreement to understand the terms and associated risks of this investment product.
If your financial advisor misrepresented the nature, mechanics, and/or risks of opening the SBL account, you may have the right to file an arbitration claim.
Further, Regulation “Best Interest,” which became effective June 30, 2020, requires that your broker-dealer and financial advisor make sure it is in your “best interest” to open any account, including SBL accounts, and there are many related factors to be considered in making that determination.
Contact Us For a Free Initial Consultation With an Experienced FINRA Arbitratrion Attorney
The Law Offices of Robert Wayne Pearce, P.A. have highly experienced lawyers who have successfully handled many SBL account cases and other securities law matters and investment disputes in FINRA arbitration proceedings, and they will work tirelessly to secure the best possible result for you and your case.
Attorney Robert Pearce and his staff represent investors across the United States on a Contingency Fee basis which means you pay nothing unless we put money in your pocket after receiving a settlement or FINRA arbitration award.
For dedicated representation by an attorney with over 40 years of experience and success in SBL account and all kinds of securities law and investment disputes, contact the firm by phone at 561-338-0037, toll-free at 800-732-2889, or via e-mail.