Securities based lending

In short

I once watched a rancher borrow against his herd instead of selling a single head, and it taught me something about people who hold more than they spend. If you are sitting on a large stock portfolio and need cash, a securities based loan lets you borrow against it without selling. The lender takes your shares as collateral, which is just something pledged to back the debt. The loan costs interest, and the lender can demand more collateral or sell your shares if prices fall. Asset values can drop fast, so the margin between borrowed money and pledged value is the whole story. Read the loan agreement slowly, and ask what happens on the worst day, not the average one.

The whole of it

What it is

A friend of mine, a builder who never sold a share of the company he started, once told me he felt rich on paper and poor on Tuesday. He had value locked up and bills that came due anyway. That is the problem a securities based loan tries to solve. The borrower pledges stocks, bonds, or funds held in a brokerage account, and the lender extends a line of credit against them. The borrower keeps owning the shares. The lender holds a claim on them until the debt is repaid.

People with very large portfolios often use these loans for real estate, a business venture, a tax bill, or plain living costs. The attraction is simple. Selling shares can trigger a tax bill on the gain. Borrowing does not count as a sale, so no gain is recognized at that moment. That is a real feature, and it is also where the care begins.

The loans come in a few shapes. Some are revolving lines, meaning the borrower can draw, repay, and draw again up to a limit. Some are fixed term loans. Many carry a variable rate, which is a rate that moves with a benchmark plus a set spread. Some are called non purpose loans because the agreement bars the borrower from using the money to buy more securities. Others are called purpose loans, which are used to buy securities and fall under different margin rules.

How it works

If you are holding a large account, here is how the machinery turns. The lender looks at each holding and assigns a lending value. This is the share of the holding's market price the lender will count as collateral. A broad, widely traded fund might get a high lending value. A single concentrated stock, or a thinly traded one, usually gets a lower one. The lender sets these figures, and they can change.

Then comes the loan to value ratio. That is the loan balance divided by the collateral's value. The lender sets a limit, and the borrower is wise to stay well under it. When prices fall, the ratio climbs even though the borrower did nothing. If it crosses the lender's limit, the lender issues a collateral call. The borrower then has to add cash or securities, or repay part of the loan, and the agreement sets how fast.

Here is the hard part. Many agreements let the lender sell pledged shares without waiting for the borrower to agree. The agreement sets whether the lender must give notice first, so the borrower should read that clause closely. A sale at a bad moment can lock in a loss and trigger a tax bill on top of it. The pledged account is also not free to move. The lender controls it while the loan is open.

Interest accrues on what is borrowed. Because the rate often floats, the cost can rise over time. The interest may or may not be deductible, and that depends on what the money is used for. A tax professional can answer that for a given case.

The numbers, and where to find yours

Every figure that matters sits in the loan agreement and the lender's fee schedule. Look for the lending value of each holding, the maximum loan to value ratio, the margin call or collateral call terms, the benchmark and spread behind the interest rate, and any fees to open, hold, or close the line. Ask for them in writing. A lender who is proud of its terms will hand them over gladly.

For the legal side, the Federal Reserve Board writes the margin rules in Regulation T and Regulation U, which govern credit used to buy or carry securities. Regulation U applies to certain bank loans secured by stock. FINRA, the Financial Industry Regulatory Authority, publishes investor material on margin and securities lending. The Securities and Exchange Commission's Investor.gov site also explains margin and collateral in plain terms. For tax questions, the Internal Revenue Service publishes guidance on interest deductions, including Publication 550 on investment income and expenses. Any dollar limit or percent that changes by year should be read from the official page, such as the the current figure, which the official source publishes each year set under Regulation T.

A worked example

Let me tell you about a woman I will call Margaret. She built a software company and now holds a brokerage account worth $20,000,000 in a broad mix of funds. She wants $4,000,000 for a down payment on a vineyard, and she would rather not sell and pay tax on the gains.

Her lender assigns a lending value of 70 percent to her mix. That means $20,000,000 times 0.70 is $14,000,000 of borrowing capacity. She borrows $4,000,000. Her loan to value ratio on the full $20,000,000 is $4,000,000 divided by $20,000,000, which is 0.20, or 20 percent. That feels safe, and it is.

Now say the market falls hard and her account drops to $8,000,000. The lending value is now 70 percent of $8,000,000, which is $5,600,000. Her loan of $4,000,000 still fits, but the cushion is thin. If her lender's collateral call point sits where the loan reaches 60 percent of account value, that is $4,000,000 divided by $8,000,000, or 50 percent. She is close. A further drop to $6,500,000 puts the ratio at $4,000,000 divided by $6,500,000, about 61.5 percent. The lender calls for more collateral. If Margaret cannot supply it, the lender may sell shares to bring the loan back in line.

Her bill for interest adds up too. Suppose her rate is 7 percent a year on $4,000,000. That is $4,000,000 times 0.07, or $280,000 a year, about $23,333 a month. She pays that whether her portfolio rises or falls.

The lesson is plain. Margaret chose a modest loan against a large account, and she still faces a real risk in a deep drop. A bigger loan would have left her far less room.

Where it goes wrong

I have noticed that trouble rarely arrives when things feel calm. It arrives fast. A sharp market drop can push the ratio past the limit in days. Many people think the lender will give them time to find cash. The agreement may say otherwise, and the lender may sell first and explain later.

Concentration is another trap. A borrower who pledges a single stock faces a lower lending value and a bigger swing. If that one company stumbles, the collateral shrinks while the loan stays put.

Rates can sting. A variable rate that looked gentle at signing can climb. The cost of carrying a large loan grows quietly, month after month.

There is also the matter of control. While shares are pledged, the borrower may be unable to sell them freely or move the account. A plan to sell for a good reason can stall if the lender has to release the collateral first.

Last, tax treatment can surprise people. A forced sale can create a gain. Interest may not be deductible. Estate planning gets tangled when a loan sits against assets that heirs will inherit. Each of these deserves a conversation with a qualified tax adviser and an attorney before signing, not after.

Questions to answer before you leave this page

What would happen to your loan if your account lost a third of its value in a single month, and could you meet a collateral call that same week without selling something you wanted to keep? Do you know the lender's exact lending value for each holding, and have you seen it in writing? Is your rate fixed or variable, and what would the monthly interest be if the rate rose by two percentage points? Does the agreement let the lender sell your shares without notice, and are you comfortable with that? Are you leaning too hard on one concentrated stock? Have you asked a tax professional how a forced sale or the interest on this loan would be treated for you? And have you asked yourself the plainest question of all, which is whether you would still sleep soundly on the day the market turns?