Securities based lending products have gained popularity in the US under the auspices of Reg T and Reg U, two of the core regulations governing securities transactions. These regulations are artifacts of post-crash reform… no, not our century’s crash, but the Crash of 1929. Reg T primarily governs the extension of credit to a margin customer by a broker dealer, while Reg U addresses the potential “loophole” of an investor utilizing commercial bank credit to finance trading activities.
Both regulations were issued as a result of the Glass Steagal Act of 1933 (arguably still the most logical and effective market and financial reform in history), and have remained fundamentally unchanged since they were issued in 1936. The spirit of the twin regulations has always been to limit the extension of leverage for purposes of margin trading activities to the magical “50%” of a customer’s account credit.
Beginning with the gutting of Glass Steagal in the 1990’s, and further accelerated by our crash of the early 2000’s, the lines between commercial banks and brokers have blurred. Brokers-that-are-now-banks, and banks-that-are-now-brokers, find themselves in the odd position of having both a banking and a brokerage relationship with the same customer. At the same time, most commercial banks are bloated with cash deposits that they can no longer use for capital markets purposes, and are looking for new inexpensive and regulation “blessed” outlets for lending that cash.
One result is an increasing trend towards marketing securities based borrowing products, which under Reg U is called “non-purpose lending” (since the “purpose” of lending under the Reg is margin leverage). Using these products, a bank/broker makes a cash loan to an investor. The target customer seems to be the long-term buy and hold investor with substantial static portfolios of high-grade collateral. The rates offered are competitive and scaled to the quality of the securities pledged.
A quick scan of marketing websites shows that traditional banks that are now brokers – such as Wells Fargo and UBS – and traditional investment banks that are now deposit-taking institutions (at least in theory) – such as Morgan Stanley – are actively pushing these products to their brokerage clients. Traditional retail brokers with a heavy focus on wealth management – such as Raymond James, Fidelity and Schwab – are also in the game.
The practice has thus far attracted little serious attention from either regulators or tax authorities, but this might change. The applicable technical rule – Reg U – is quite easy to comply with. As long as the credit extended is not used for purposes of purchasing marginable securities and the proper forms and disclosure is made then everything is good. There are three significant issues however that may attract increasing attention as the practice grows.
- As a recent article in Investment News (The Hazards of Securities Based Lending as a Source of Retirement Income, February 2015) noted, this strategy can be used to avoid taxation on the extended funds, essentially exchanging debt for income. As more investors extract cash from their assets rather than liquidating them as taxable income, tax authorities may intervene.
- Securities based products are predicated on a perpetually “up” market, in which the leveraged portfolio retains its value and does not dip into what is effectively a margin call range. The intent of Reg T and Reg U is to avoid undue exposure to the lending institution in a down market, and to avoid massive freefall selling in markets from investors whose securities are subject to sudden need for cash to meet debt obligations. This has been brought forward on numerous occasions from numerous sources for several years, such as Market Watch (Pawning Your Portfolio, March 2013) and the Wall Street Journal (Margin Calls Bite Investors, Banks, August 2015).
- The extended credit can be used indirectly to finance margin trading, evading the intent of the Regs. Cash is the most fungible of assets, and compliance ultimately falls to the good faith reporting of the investor. The investor can easily secure a portfolio loan from one broker/bank and use those funds to finance trading activity with another broker. To date, there is no absolute requirement for a broker to confirm the source of cash – or the source of outside leverage of the customer – below certain thresholds. Net worth, credit status, source of funds and indebtedness are almost entirely self-reported by the investor to the broker at this point. This has never been a problem before in the context of Regs T and U – but eyebrows will raise if there is a downturn in the market that triggers panic portfolio liquidations.
Non purpose lending, or securities based borrowing, can be structurally useful for injecting cash liquidity into the hands of consumers. It is cost efficient for consumers, but as it becomes more widespread and the amount of actual effective leverage against securities portfolios increases, we would expect regulators to focus more attention on it. As often happens, technical compliance that does not meet with the intent of regulation often results in messy and costly intervention when something goes wrong.
Ultimately, this practice is very much in line with current regulatory scrutiny: the co-mingling of risks between the traditional commercial bank and the traditional broker. Industry bodies might do well to get ahead of the question by proposing standards and rules before this happens.