FINRA and SEC Alert re: Securities-Backed Lines of Credit

This article is reposted from a FINRA and SEC Investor Alert.  A summary can be found here.

Securities-Backed Lines of Credit – It May Pay to See Beyond the Pitch

An increasing number of securities firms are marketing and offering securities-backed lines of credit, or SBLOCs, to investors. SBLOCs can be a key revenue source for securities firms, especially in times of solid market returns and growing investment portfolios, when investors may feel more comfortable leveraging their assets. Firms market SBLOCs as a type of financing and liquidity strategy that can unlock the value of your investment portfolio. Between 2012 and 2014, one large brokerage firm that offers these programs reported a 70 percent increase in its securities-based lending business, while another firm reported an over 50 percent increase.

The Financial Industry Regulatory Authority (FINRA) and the SEC’s Office of Investor Education and Advocacy (OIEA) are issuing this investor alert to provide information about the basics of SBLOCs, how they may be marketed to you, and what risks you should consider before posting your investment portfolio as collateral. SBLOCs may seem like an attractive way to access extra capital when markets are producing positive returns, but market volatility can magnify your potential losses, placing your financial future at greater risk.

What Are SBLOCs?

SBLOCs are loans that are often marketed to investors as an easy and inexpensive way to access extra cash by borrowing against the assets in your investment portfolio without having to liquidate these securities. They do, however, carry several risks, among them potential unintended tax consequences and the possibility that you may, in fact, have to sell your holdings, which could have a significant impact on your long-term investment goals.

Set up as a revolving line of credit, an SBLOC allows you to borrow money using securities held in your investment accounts as collateral. You can continue to trade and buy and sell securities in your pledged accounts. An SBLOC requires you to make monthly interest-only payments, and the loan remains outstanding until you repay it. You can repay some (or all) of the outstanding principal at any time, then borrow again later. Some investors like the flexibility of an SBLOC as compared to a term loan, which has a stated maturity date and a fixed repayment schedule. In some ways, SBLOCs are reminiscent of home equity lines of credit, except of course that, among other things, they involve the use of your securities rather than your home as collateral.

How Do SBLOCs Work?

Many firms might offer you the opportunity to pursue an SBLOC, including your brokerage or advisory firm, a clearing firm (a firm that maintains custody of your securities and other assets, such as cash in your account), or a third-party lender like a bank. To set one up, you and the lender execute an SBLOC contract. The contract specifies the maximum amount you may borrow, and you agree to use your investment account assets as collateral. If the value of your securities declines to an amount where it is no longer sufficient to support your line of credit, you will receive a “maintenance call” notifying you that you must post additional collateral or repay the loan within a specified period (typically two or three days). If you are unable to add additional collateral to your account or repay the loan with readily available cash, the firm can liquidate your securities and keep the cash to satisfy the maintenance call.

SBLOCs are non-purpose loans, which means you may not use the proceeds to purchase or trade securities. However, an SBLOC still provides a fair amount of flexibility when you consider the restrictions on other types of loans, such as a mortgage or auto loan, or borrowing on margin. Those types of loans all require that loan proceeds be used for a specific purpose. Money from an SBLOC can be used to finance virtually anything you might want, from home renovations and real estate purchases to personal travel or a new business venture. They also can be used, for example, to fund education expenses or to pay an unexpected tax bill.

But remember: The fact that you might be eligible for an SBLOC doesn’t mean the loan is necessarily a good idea.  And be aware that SBLOCs are just one type of securities-based lending offered to investors. Other types include margin and stock-based loan programs.

What About Credit Limits?

A typical SBLOC agreement permits you to borrow from 50 to 95 percent of the value of the assets in your investment account, depending on the value of your overall holdings and the types of assets in the account. To qualify for an SBLOC, firms often require that both the market value of your portfolio assets and your initial withdrawal on an SBLOC meet certain minimum requirements. It’s not uncommon for a firm to require that your assets have a market value of $100,000 or more to qualify for an SBLOC.

In general, securities that are eligible to serve as collateral for an SBLOC include stocks, bonds, and mutual funds held in fully paid-for, cash accounts. The maximum credit limit for an SBLOC typically is based on the quantity and type of underlying collateral in your account and is determined by assigning an advance rate to your eligible securities. Advance rates vary by institution, depending on the firm’s underwriting criteria. Typical advance rates range from 50-65 percent for equities, 65-80 percent for corporate bonds, and 95 percent for U.S. Treasuries. For example, if your account contains a mix of equity securities and mutual fund shares with a total market value of $500,000, you could be eligible to borrow from $250,000 to $325,000 for an SBLOC.

SBLOCs generally allow you to borrow as little as $100,000 and up to $5 million, depending on the value of your investments. Once approved, you can access your SBLOC funds using checks provided by the firm, a federal funds wire, electronic funds transfer, or ACH payments. SBLOC funds may be available to you within a week from the date you sign your SBLOC contract.

Interest Rates and Repayment

The interest rates for SBLOCs are often lower than those you would qualify for with a personal loan or line of credit from your bank or by using a credit card to fund purchases. In fact, some SBLOC lenders might not run a credit check or conduct an analysis of your liabilities before setting and extending the credit line and may determine your maximum limit solely based on the value of your portfolio. SBLOC interest rates typically follow broker-call, prime or LIBOR rates plus some stated percentage or “spread”—and you will be responsible for interest payments on an ongoing basis. Although interest is calculated daily, and the interest rate on your loan can change every day, it is usually charged monthly and will appear on your monthly account statement. Some firms offer the option of a fixed rate SBLOC.

Weigh Potential Advantages and Risks

An SBLOC may allow you to avoid potential capital gains taxes because you don’t have to liquidate securities for access to funds. You might also be able to continue to receive the benefits of your holdings, like dividends, interest, and appreciation. Marketing materials for SBLOCs also promote the flexibility of spending that comes with an SBLOC as a key feature. And, some firms market SBLOCs as part of a retirement income strategy to fund short-term expenses.

However, as with virtually every financial product, SBLOCs have risks and downsides. Be aware that marketing materials touting the advantages of SBLOCs may suggest benefits that you may not achieve given the risks. For instance, if the value of the securities you pledge as collateral decreases, you may need to come up with extra money fast, or your positions could be liquidated. So even if an SBLOC may be an appropriate solution for you, it always pays to ask questions.

10 Questions to Ask Before Taking Out an SBLOC

Before you use your assets as collateral for an SBLOC, take time to understand the risks, and get answers to important questions about how this type of lending arrangement could impact your long-term investment goals.

  1. When I take out an SBLOC, what am I agreeing to?  Make sure you fully understand the details of any SBLOC offered to you, including the terms of your agreement with the lender and how the lending arrangement will impact your holdings, including potential tax consequences, maintenance call requirements, and other costs. You need to know what aspects of the arrangement are out of your control. For example, the interest that you pay on your loan may change every day. In addition, your firm may decide that a security that was previously eligible as collateral for an SBLOC is no longer eligible. If this happens, your credit limit will be adjusted to reflect the change, leaving you with less money to borrow than you planned for. You also may be required to post additional assets to shore up the account if the remaining eligible securities cannot cover the balance. In addition, some SBLOC agreements permit the lender to increase the percentage of equity you must keep in your pledged accounts, which would require you to deposit additional securities or cash into the account or pay down the loan.
  2. Who is the lender?  Before you sign up for an SBLOC, understand who you are doing business with (your brokerage or advisory firm, one of its affiliates, a clearing firm, or a third-party lending institution). Many brokerage firms offering SBLOCs do so through a bank affiliate, so your broker may not be the point of contact for your loan and may not know much about how the program works. Make sure you know who to contact with questions about the SBLOC and ongoing account services. If your securities firm is offering the SBLOC for a third-party lending institution, ask your firm how they will continue monitoring your account and how, and when, you will be notified if a collateral shortfall or other issue may impact your assets.
  3. Should I use my investments as collateral?  While SBLOCs’ low rates and quick access to cash may be appealing, remember that your investment portfolio may not be the best option for loan collateral. The prices of securities in your portfolio are constantly shifting, which means that the collateral backing your line of credit may be volatile. If the market is up and the value of your assets increases, then great. But nothing guarantees that the market, or the value of your assets, won’t go down.
  4. What if the value of my portfolio decreases?  The firm might sell your securities if you receive a maintenance call and are unable to meet it. SBLOCs seem like a great option for extra capital when markets are producing positive returns and interest rates are low, but a market downswing or change in interest rates could make it much less enticing, and this can happen at any time. The value of your holdings is always changing, so you can’t assume that the price today will be the price tomorrow. And keep in mind that SBLOCs are classified as demand loans, which means lenders may call the loan at any time.
  5. Does my investment mix matter?  Consider the extent to which your portfolio is diversified. If your portfolio is concentrated in a particular stock or sector, a single market event could cause your portfolio value to drop precipitously and trigger a maintenance call. Then you might be forced to liquidate your assets at the bottom of the market. Other assets may be more appropriate to serve as collateral for a loan, and without terms that allow the lender to liquidate your investments at a moment’s notice. With that in mind, if you do decide to pursue an SBLOC, consider taking out less than the maximum amount of credit offered to you.
  6. What if my securities are liquidated to meet collateral requirements?  There might be tax consequences. For example, if your lending firm notifies you that securities will be liquidated to maintain collateral at a sufficient level to support your SBLOC, you could be faced with paying capital gains taxes on the proceeds from these sales, depending on your cost basis in the stock and other factors affecting your tax status. Lenders often are permitted to make these decisions without giving you any notice. One way to protect yourself and your assets are to limit the amount you borrow. If you are offered an SBLOC based on a high percentage of the value of your assets, consider taking a lesser amount than what you are offered, so that you are not putting such a substantial portion of your portfolio on the line.
  7. What impact will an SBLOC have on my pledged investments?  If you pledge securities that typically receive dividend payments, you should determine whether those payments will be credited to your loan balance and what, if any, circumstances will cause ownership of your holdings to change. In addition, certain account features may change with securities pledged for an SBLOC, such as check-writing privileges and recurring distributions. Some firms cancel check-writing privileges for your account when you take out an SBLOC because you will be issued a new set of checks directly tied to the SBLOC.
  8. What about interest rates?  If interest rates rise, it could cause a spike in the broker-call, prime, or LIBOR rates that apply to your SBLOC. If this happens, the cost of your SBLOC may increase significantly. Also, for accounts that have money market funds or bank sweeps, depending on your firm’s SBLOC policy, the debit in your account from the interest charge may be paid from redemptions, effectively reducing your cash or money fund balances. Interest payments may be rolled into the balance, which, over time, can erode the value of your account (particularly if the SBLOC is sizeable), or increase your indebtedness. In addition, depending on the interest rate environment, if you have a money market fund or cash in your account, you may be paying more in interest for your SBLOC than you are earning.
  9. How is my broker compensated with SBLOCs?  Your broker or adviser may receive additional compensation or a portion of the fees generated by SBLOCs sold to customers. Some firms pay salespersons quarterly depending on how much money you have borrowed on the line of credit. Your broker or adviser also will benefit from your SBLOC because you don’t have to liquidate assets in your account to pay for things with cash, which would diminish the assets held in the account and the potential fees and commissions that could be earned by your broker or adviser from holding or engaging in future transactions with those assets. For example, with a fee-based account, by encouraging investors to take out an SBLOC to fund some purchase or financial need rather than liquidate securities, the firm continues to earn fees on the full account value, and may also earn revenue from the new loans.
  10. Can I move to a new firm if I have an SBLOC?  It is not as easy to pick up and move your assets to a new firm if they are pledged as collateral for an SBLOC. This makes an SBLOC a “sticky” product because it makes it more difficult to leave your current brokerage or advisory firm. To move, you will likely have to pay off the loan.

Today, financing opportunities come in all shapes and sizes. Remember to exercise caution and consider the risks before pledging your securities as collateral. You worked hard to build your investment portfolio.

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