By MICHAEL WURSTHORN and ANNAMARIA ANDRIOTIS at The Wall Street Journal
Loans backed by investment portfolios have become a booming business for Wall Street brokerages. Now the bill is coming due—for both the banks and their clients.
Some lenders, including Bank of America Corp., are issuing margin calls to clients after the global market drubbing of the past week, forcing investors to choose between either putting up more money or selling some of the securities underlying the loans.
Banks, meanwhile, are likely to take a hit to a key profit source if investors pull back from these loans as many expect.
Among the largest firms, Morgan Stanley had $25.3 billion in securities-based loans outstanding as of June 30, up 37% from a year earlier. Bank of America, which owns brokerage firm Merrill Lynch, had $38.6 billion in such loans outstanding as of the end of June, up 14.2% from the same period last year. And Wells Fargo & Co. said last month that its wealth unit saw average loans, including these loans and traditional margin loans, jump 16% to $59.3 billion from last year.
“Your largest wealth creator for the top end has been inflation in financial assets. You’re now seeing wealth destruction,” said Charles Peabody, a bank analyst at Portales Partners LLC. Even including Wednesday’s stock-market rally, the S&P 500 index is down 5.8% in the year to date.
Mr. Peabody said he believes profitability in banks’ wealth-management arms will fall in the coming quarters, in part due to an expected decline in their securities-lending businesses.
In a securities-based loan, the customer pledges all or part of a portfolio of stocks, bonds, mutual funds and/or other securities as collateral. But unlike traditional margin loans, in which the client uses the credit to buy more securities, the borrowing is for other purchases such as real estate, a boat or education.
Securities-based loans surged in the years after the financial crisis as banks retreated from home-equity and other consumer loans. Amid a yearslong bull market for stocks, the loans offered something for everyone in the equation: Clients kept their portfolios intact, financial advisers continued getting fees based on those assets and banks collected interest revenue from the loans.
The result was “dangerously high margin balances,” said Jeff Sica, president at Morristown, N.J.-based Circle Squared Alternative Investments, which oversees $1.5 billion of mostly alternative investments. He said the products became “the vehicle of choice for investors looking to get cash for anything.” Mr. Sica and others say the products were aggressively marketed to investors by banks and brokerages.
While the loans make up a small share of overall bank lending, the industry’s biggest brokerage firms have all reported higher securities-based loan balances or higher client-loan asset totals, each quarter for more than two years. Client-loan asset totals include securities-based loans and margin accounts.
Even before Wednesday’s rally, some banks said they were seeing few margin calls because most portfolios haven’t fallen below key thresholds in relation to loan values.
“When the markets decline, margin calls will rise,” said Shannon Stemm, an analyst at Edward Jones, adding that it is “difficult to quantify” at what point widespread margin calls would occur.
Bank of America’s clients through Merrill Lynch and U.S. Trust are experiencing margin calls, but the numbers vary day to day, according to spokesman for the bank. He added the bank allows Merrill Lynch and U.S. Trust clients to pledge investments in lieu of down payments for mortgages.
A Morgan Stanley spokeswoman said “it is not an issue for most borrowers,” but declined to say how frequently margin calls are being made.
Wells Fargo declined to provide details on recent client margin calls.
Brokerages prefer to offer these types of loans to clients that have diversified portfolios of stocks and bonds, according to lending executives at brokerage firms and analysts. Clients may be able to borrow only 40% or less of the value of concentrated stock positions or as much as 80% of a bond portfolio. Interest rates for these loans are relatively low—from about 2% annually on large loans secured by multimillion-dollar accounts to around 5% on loans less than $100,000.
Aaron Schindler, a 51-year-old financial adviser in New York, holds one of these loans. While he isn’t worried about a margin call just yet, he says he plans to keep a close eye on the market.
About 18 months ago, he took out a $93,000 loan through Neuberger Berman, collateralized by about $260,000 worth of stocks and bonds, and used the proceeds to buy his share in a three-unit investment property in the Bushwick section of Brooklyn, N.Y. He says that his portfolio, up about 3% since he took out the loan, would need to fall 25% before he would worry about a margin call.
“When you stick to [borrowing] lower numbers, it would take a significant drop for this to occur,” Mr. Schindler said.
Regulators earlier this year had stepped up their scrutiny of these loans due to their growing popularity at brokerages. The Financial Industry Regulatory Authority put securities-based loans on its so-called watch list for 2015 to get clarity on how securities-based loans are marketed and the risk the loans may pose to clients.
“We’re paying careful attention to this area,” said Susan Axelrod, head of regulatory affairs for Finra.