One of the first things we hear from our new clients is that they are approaching the issue of securities-based credit with trepidation. Some feel that a portfolio of stocks or bonds is much too unstable to be trusted as collateral for a loan (even though the lending institution might have no trouble with it). Others may have heard about the ill-fated “non-recourse stock loans” of the last decade, that led to the crashing and burning of many private lending firms. Still others might assume, understandably, that a stock portfolio loan or any securities-based credit line is in the same class and category as a conventional 50% margin loan, used mostly to purchase more stocks and to leverage one’s buying power in the market.
All of these concerns have at least some validity. A portfolio of securities often IS, by definition, more of an unstable form of collateral than say, a primary residence or a sports car, where values and depreciation change typically more slowly and predictably over time. A bit of bad news for a company can potentially cause a temporary or long-term drop in that company’s stock, for example, within a relatively short period. So isn’t it true that stocks and other equities are a bad bet as collateral for financing?
In the hands of amateurs, or inexperienced lenders, or lenders with poor risk analysis abilities/tools, yes. A loan or line of credit with a loan-to-value placed unrealistically or incompetently can put the transaction at risk of a requirement to either pay down the line or restructure the collateral into something more stable. This would indeed create trouble for the client borrower, particularly if their collateral was limited to just one, falling stock rather than a portfolio of stocks and other securities where the risk is spread around and averaged (as with the A. B. Nicholas LeverageLine).
But it’s the expertise of the lending institution and its risk analysis personnel that is key. A single stock portfolio for a small, thinly traded stock that was provided with a 90% LTV loan would likely quickly succumb to small movement in the stock’s price, particularly if the stock price was under $8/share. A 25% drop in the value of an $8 stock to $6 would require that 90% stock loan client – if they had taken out their whole allocation at 90% LTV – to shore up value, or restructure out of at least some of that stock into more stable securities such as top-rated municipal bonds to stabilize the collateral. When a lender places an unrealistically high loan-to-value on a stock portfolio, particularly a single-stock portfolio, the risk of having to adjust that collateral is relatively high.
At A. B. Nicholas our entire program is designed to minimize that risk to the greatest extent possible. Although no one can eliminate ALL risk associated with any securities transaction, our LeverageLine program is a customer-centric program designed to leave the client with what they want – and the lending institution with a satisfied future customer.
By this we mean that our lending institution partner — a top-rated, “household name” firm we are not permitted to publish here as we are not employees of that institution — has all the facilities and expertise to analyze every stock in every portfolio and to ensure that the quote we at A. B. Nicholas receive for our clients’ term sheets are accurate, reasonable, and low-risk. The risk committees and experts who develop our loan quotes do so with the latest stochastic and analytic tools, which utilize state-of-the-art algorithms, software, and history to develop an intelligent quote designed to lessen the potential for the need for client intervention to the absolute maximum. Every security, after carefully being assigned an LTV value, is averaged together to provide the overall collateral value and the LTV for the entire loan transaction. Our track record of very few requests to restructure portfolios mid-loan shows that these efforts have been very effective. The result: a better quality stock portfolio loan, created and maintained by experts who understand their subject field well.
Another point of anxiety for some potential LeverageLine borrowers, we’ve found, is lingering concern as a result of stories in the early 2000s about “non recourse stock loans” and how some clients were never able to receive the return of their portfolios when their nonrecourse private stock loan lenders collapsed.
Once again, there is good reason to be concerned in the case of non recourse stock loans. But first the definition: A non recourse stock loan, like any nonrecourse loan, means that in the event that a client cannot repay their loan they will owe nothing by forfeiting the collateral, regardless of what that collateral is worth (even if it does not cover the amount owed). The lender has “no recourse” — hence the name “non-recourse loan” — to collect any shortfall from the client’s assets.
These tips of stock portfolio loans were marketed as a way to obtain liquidity without a sale, but in fact, the private lenders who conducted these types of loans took possession of the client’s stock, sold most or all of it, then gave a portion back to the client as a “loan” an d kept the rest as profit. On top of the profit, the lender would get interest payments. And if the client exercised the “non recourse” provision and walked away, allowing their portfolio to in effect fulfill their repayment obligation, the lender could breathe a sigh of relief that he wouldn’t have to return the portfolio to the client.
The scheme worked fine as long as the stocks remained stable or dropped in price. But the minute the stocks began to rise, there were problems afoot. Since the lender had not put aside any money for buying back stock if a client paid off their loan and wanted their shares back, he would need to go into the market to buy those shares outright. If the price-per-share had gone up, then the cost to buy all those shares back could be much more.
This is what happened to many nonrecourse lenders when oil prices rose precipitously and long with them, the prices of oil stocks. Those clients who had used their oil stocks for nonrecourse loans wanted those portfolios back now — especially since those stocks were worth so much more. So they paid back their loan principals and waited for the return of their stock portfolios. However, the amount they paid back would have been way less than what the lender will have needed to buy back the now-more-expensive shares, which he had to do if he was to return the shares because he had sold them all to provide the loan to the client. If that lender did not have sufficient cash reserves — and most did not — they could not return the shares to the client. That was when the bottom fell out and regulators stepped in to shut these operations down. Many clients and brokers were caught in the down-draft.
The lesson of course: Never undertake any securities-based line in which you transfer ownership of your collateral to a third-party lender, particularly not a private, unlicensed, or non-institutional lender.
So setting loan-to-value safely and avoiding any form of transfer of ownership are two steps any stock portfolio loan client should require before entering into a loan agreement.
The third concern sometimes arises from individuals whose entire experience with securities-based lending is via their margin accounts at their brokerage. Their experience is based on investing in a stock or stocks, then seeking to leverage that by purchasing more of the same stock with a 50% loan. These are what are called “purpose credit” loans designed for purchasing more of the same stock.
They are single-stock — not portfolio — loans, and therefore are more vulnerable to changes in the company, stock, industry or market than the LeverageLine product, which allows a far higher loan-to-value but is “non-purpose credit” meaning the primary restriction is that you cannot use the loan proceeds to purchase more marginal shares of stock, making the LeverageLine non-purpose credit loan the diametric opposite of a margin-type loan in that regard.
Because LeverageLine stocks or bonds, etc. are all averaged together to determine collateral value, no single stock carries all the responsibility for the value of the collateral.
We like to say that fear of sudden margin calls is less likely with a LeverageLine given these differences. A securities-based line and a margin loan are designed to be so. In the case of our A. B. Nicholas LeverageLine program, we only offer credit lines where the lending institution partner has done their utmost to quote the credit line with an end-in-view to minimizing the risk to the client of any need to restructure the collateral or pay down their line principal.
Should anyone hesitate to engage a credit line agreement for their stock portfolio? We say on balance, no. Our history, our security measures, our professional expertise and care — all are designed to give each A. B. Nicholas client the confidence they need to use their LeverageLine proceeds in any legal manner they wish. As a replacement or supplement for other forms of financing, LeverageLine has performed admirably.