Understanding the Risks of Securities Backed Line of Credit (SBLOC)
Securities-backed lines of credit (SBLOCs) are a method of taking out a loan by using your portfolio as collateral. These lines of credit are “non-purposed,” meaning that they can be used for virtually anything except the purchase of further securities. This is in contract with margin loans and stock-based loans which have more restrictions.
But SBLOC salespeople do not always communicate the risks involved, as occurred when Morgan Stanely had to pay $1 million to settle a claim that it did not disclose the risks involved when advertising SBLOCs to its clients.
SBLOCs are often offered with variable interest rates. This rate changes daily although it is usually charged monthly. Taking out an SBLOC with a varying interest rate can lead to unforeseen costs, particularly for larger loans.
What are SBLOC Maintenance Calls? If the overall value of your pledged securities declines below the amount necessary to collateralize the SBLOC, the lending firm will give you a “maintenance call.” This call informs you that you must either post further collateral or settle the loan, usually within a few days. If you are unable to do either of these, the firm will liquidate the pledged securities and keep the cash. Even if you can further collateralize the SBLOC or settle the loan, the unplanned nature of this expenditure could lead to other hardships, having a domino effect on your overall wealth.
If a firm liquidates your pledged securities and keeps the cash, you might be further liable to capital gains tax on those securities, depending on their cost basis.
Did Your Financial Advisor Misled You?
Interest rates on SBLOCs generally follow Broker’s Call, prime, or LIBOR rates, in addition to a spread (percentage). It is sometimes possible to obtain an SBLOC without getting a credit check. It is often also possible to continue receiving gains from your pledged securities such as dividends and interest. And capital gains tax can be avoided because it is not necessary to liquidate the assets to collateralize the loan.
These and other advantages make SBLOCs an attractive option for many investors. But as with any financial product, there are risks involved, and investors need to be fully aware of them before committing to any securities-backed line of credit.
If your financial advisory or brokerage firm is offering you the SBLOC, it does not mean that they are the ones providing the line of credit. Not knowing who the actual lender is could mean you have less recourse to assistance if anything goes wrong with the line of credit. Not being in direct contact with the actual lender also means you might miss important notifications regarding the loan.
Your broker or advisory firm might earn a commission from selling an SBLOC to you. They might also receive recurring commissions so long as your securities are pledged into the SBLOC. It’s important to demand full disclosure from the entity advertising the SBLOC regarding any potential conflicts of interest. Sometimes, firms get paid a percentage of the amount of securities that you commit as collateral.
Such conflicts of interest would likely not occur when you deal with a Registered Investment Advisor (RIA) because they are obligated under law to follow the Fiduciary Standard, obviating any possible conflicts of interest. But it is still important to ask them in writing if there might be a conflict of interest, and receive their answer in writing.
Further aggravating this problem is that SBLOCs don’t diminish your assets when they are pledged so your broker would continue to earn other commissions on any transactions through your account, making them more likely to recommend SBLOCs over other products that do reduce the total value of your assets. The same is true for fee-based advisors who charge fees based on the total assets under management (AUM). Because SBLOCs don’t reduce your AUM in any way, there might be some bias toward recommending SBLOCs to you.
If you are unhappy with your current brokerage or financial advisory firm, you might not be able to change to another if you have an SBLOC in place with your existing firm, because your securities are pledged as collateral. You will need to pay the loan off completely to be able to change firms.
If your portfolio is not sufficiently diversified, forcing you to pledge only one or a handful of securities as collateral, a single major shift in the market could reduce the overall value of your portfolio, forcing liquidation of those securities at bottom-of-the-market rates. Depending on your risk tolerance, it might be more prudent to seek out a loan type that doesn’t allow the lender to liquidate your assets so quickly.
If you were misled or misinformed regarding a securities backed line of credit, you might have recourse. Speak to one of our attorneys now for free.