What Is Securities-Based Lending?
The term securities-based lending (SBL) refers to the practice of making loans using securities as collateral. Securities-based lending provides ready access to capital that can be used for almost any purpose such as buying real estate, purchasing property like jewelry or a sports car, or investing in a business. The only restrictions to this kind of lending are other securities-based transactions like buying shares or repaying a margin loan.
- Securities-based lending provides capital to help people buy real estate, to purchase personal property, or to invest in a business.
- These kinds of loans are generally offered to high-net-worth individuals by large financial institutions and private banks.
- The lender becomes a lienholder after the borrower deposits their securities into a special account.
- Borrowers benefit from easy access to capital, lower interest rates, and greater repayment flexibility and also avoid having to sell their securities.
Understanding Securities-Based Lending
Generally offered through large financial institutions and private banks, securities-based lending is mostly available to people who have a significant degree of wealth and capital. People tend to seek out securities-based loans if they want to make a large business acquisition or if they want to execute large transactions like real estate purchases. Such loans may also be used to cover tax payments, vacations, or luxury goods.
Here's how the process works. Lenders determine the value of the loan based on the borrower's investment portfolio. In some cases, the issuer of the loan may determine eligibility based on the underlying asset. It may end up approving a loan based on a portfolio consisting of U.S. Treasury notes rather than stocks. Once approved, the borrower's securities—the collateral—are deposited into an account. The lender becomes a lienholder on that account. If the borrower defaults, the lender can seize the securities and sell them to recoup their losses.
In most cases, borrowers can get cash within just a few days. It's also relatively cheap—the rate borrowers are charged is generally variable based on the 30-day London InterBank Offered Rate (LIBOR). Interest rates are typically two to five percentage points above LIBOR, depending on the sum.
Interest rates on securities-based loans are generally based on the 30-day LIBOR.
Also known as securities-based borrowing or nonpurpose lending, securities-based lending has been an area of strong growth for investment banks since the global financial crisis. In fact, securities-based lending accounts and balances have surged since 2011, facilitated by the steady rise in equities and record-low interest rates. Such credit is popular because it tends to be easier to obtain and requires far less documentation than a traditional loan.
Securities-Based Lending vs. Securities Lending
Securities-based lending is separate and distinct from securities lending. Securities lending is the act of loaning securities to an investment company or bank. Examples include stocks or other derivatives. While securities-based lending involves using securities as collateral for a loan, this kind of lending requires collateral in the form of cash or a letter of credit in exchange for the security in question. Securities lending normally doesn't involve individual investors. Instead, it takes place between investment brokers and/or dealers who complete an agreement that outlines the nature of the loan—the terms, duration, fees, and collateral.
Advantages and Disadvantages of Securities-Based Lending
Securities-based lending has a number of benefits for the borrower. It precludes the need to sell securities, thereby avoiding a taxable event for the investor and ensuring the continuation of the investor's investment strategy.
As noted above, SBL offers access to cash within a couple of days at lower interest rates with a great deal of repayment flexibility These rates are often much lower than home equity lines of credit (HELOCs) or second mortgages. These advantages are offset by the inherent volatility of stocks that makes them a less than ideal choice for loan collateral, and the risk of forced liquidation if the market falls and collateral value plunges. Nevertheless, SBL works best when used for short periods of time in situations that demand a significant amount of cash quickly such as an emergency or a bridge loan.
SBL also provides a number of benefits to the lender. It offers an additional and lucrative income stream without much additional risk. The liquidity of securities used as collateral and the existing relationships—with typically high-net-worth individuals (HWNIs) who use the SBL facility—also mitigate much of the credit risk associated with traditional lending.
Disadvantages and Risks
Securities-based lending can be a win-win for borrowers and lenders under the right circumstances. But its growing usage has led to concern because of its potential for systematic risk. For instance, a 2016 Morgan Stanley report stated security-backed loan sales amounted to $36 billion—a 26% increase compared to the year before. As interest rates continue to increase, financial experts are becoming increasingly concerned that there could be fire sales and forced liquidations when the market turns.
Securities lending is neither tracked by the Securities and Exchange Commission (SEC) nor the Financial Industry Regulatory Authority (FINRA), though both continually warn investors of the risks involved in this market. In April 2017, Morgan Stanley settled a case in which Massachusetts' top securities regulator accused the bank of encouraging brokers to push SBL in cases where it wasn't needed, and with that ignoring the risks involved.
Example of Securities-Based Lending
Let's say an individual wants to do a large renovation on their home to the tune of $500,000. They first reach out to their bank for a standard loan for the full amount and the annual percentage rate (APR) quoted is 5%. However, since she has a stock portfolio of blue-chip companies worth $1,000,000, she can pledge those securities against the loan and receive a better interest rate with an APR of 3.25%.
The lender sees the pledged securities as another layer of protection and thus offers a much lower interest rate for that protection. The borrower likes this scenario because the stock portfolio allows them to borrow at a lower rate while keeping the stocks invested. The investor also receives the loan quicker than they would have with a standard loan.