Investors can use a diversified portfolio as collateral for loans. Certain investors, usually those with considerable wealth and experience, have almost access to credit through a practice known as securities lending.
Whether through a private bank or other financial institution, loans and credit lines backed by securities can be especially useful for those who occasionally make large purchases, such as buying real estate or buying private operating companies.
This is different from lending to securities, whereby a broker lends securities to traders for the short sale of those shares or other assets. Securities-backed loans, also known as securities-based lending, instead of using securities as collateral to secure investor loans.
What is a Securities Loan?
A securities-backed loan is a debt secured by a portfolio of investors for qualifying securities such as stocks and bonds. The borrower deposits securities into an account where the lender has a lien, and the lender will often provide funds for a loan of 50 to 95 percent of the market value of the securities.
The exact amount depends on the specific underlying assets in the portfolio and the level of diversification. For example, a lender may approve more funds relative to a portfolio of U.S. Treasury bills than a portfolio that has one concentrated stock.
The lending process in action
When a borrower wants access to credit funds, he or she writes a check against the credit line or submits payment instructions to the bank account.
As the value of the underlying collateral changes, the credit capacity of the account fluctuates, which may result in the deposit of additional collateral in the form of cash or the deposit of other stocks and bonds not previously included in the collateral.
The borrower may also repay some or all of the outstanding loans. Unless executed within a certain period of time known as a “hardening period”, which may range from two days to 30 days, the lender will liquidate the securities acting as collateral through the sale.
Qualified borrowers may include individuals, joint investors and revocable life trusts in which the trustee, creditor, and beneficiary are identical. Depending on the financial institution, loans can range from USD 100,000 to USD 5,000,000 or maybe more for high net worth individuals. These loans have terms that are tailored to the short- and medium-term borrowers; five years is common.
Use for investors
Securities backed loans have several advantages. They can offer the borrower significantly lower interest rates and reduce risk over alternatives such as margin loans, although they still carry a higher risk than other forms of lending.
In addition, they offer greater repayment flexibility and provide a defrosting period to meet additional security requirements. This is different from the requirement for an immediate loan payment.
The interest rate on a securities-backed loan is often based on a premium over the Good Finance Investment Corporation (GFIC).
This range varies, but, typically, the higher the value of the investor portfolio, the lower the interest rate. In certain cases, the lender may lower the interest rate on the loan under the supervision of the securities if it is allowed to pledge a “precautionary” lien on the real estate or property of the investor. This may also allow the investor to deduct interest on her tax return. Some securities backed by securities also offer a special interest payment.
Risky securities lending business
Despite their benefits, securities backed by securities come with some risks. Even a stable company with historical stock price stability can succumb to the difficult economic environment and see its stock price fall.
When the capital market and fixed income perform poorly, which typically happens in cycles, the market value of many assets may hit levels that were previously unimaginable.
Unless the lender has a lot of excess liquidity outside the securities that support the loan, or the securities that support the loan make almost entirely assets such as short-term US Treasury bills, this can cause the bank to call on the investor loan.
This could cause forcible liquidation of lenders at unattractive prices. The borrower now had the ability to buy and take it from him, and he had no choice to wait for the market to recover.
Another danger of a securities backed loan is that the lender no longer feels comfortable with some security that serves as collateral. For example, imagine that you own a large block of stock in what used to be a well-respected company, such as Good Finance.
As digital cameras eroded the company’s profits, the bank may have decided that it would no longer accept Good Finance as collateral.
You would either need to sell your Good Finance stock and invest in something that is acceptable to the lender’s needs, or you would need to contribute additional capital to a secured account held by your collateral to avoid a credit line reduced or canceled. In order to mitigate other types of risks, securities backed by securities also have a significant limitation:
The borrower cannot use the money to pay off margin or invest in other securities.
The balance sheet does not provide tax, investment or financial services and advice. The information is presented regardless of the investment goals, risk tolerance or financial circumstances of any particular investor and may not be suitable for all investors.
Past performance is not indicative of future results. Investing involves risk including the possible loss of equity.