Yves here. Stock market panics are normally not a big deal….unless there is a lot of margin lending, as before the Great Crash, where punters could borrow 70% to 90% against their holdings, plus the widespread use of trusts allowed for leverage-on-levarage.
There’s no reason to think the current amount of additional shadow margin lending remotely approaches that of the late 1920s. But the fact that the brokerages have figured out how to skirt margin lending rules is a bad sign, both of speculative excess and a hopelessly negligent SEC.
As Wolf stresses, leveraged stock trading increases the odds of a self-reinforcing selling as well as damage to the lenders, which means worse consequences to the economy than the loss of paper wealth.
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street
Stock and bond market leverage is everywhere. Some of it is transparent, such as NYSE margin debt which was $539 billion as of the June report. But the hottest form of stock and bond market leverage is opaque, offered by financial firms that usually don’t disclose the totals: securities-based loans (SBLs) — or “shadow margin” because no one knows how much of it there is. But it’s a lot. And it’s booming.
These loans can be used for anything – pay for tuition, fix up that kitchen, or fund a vacation. The money is spent, the loan remains. When security prices fall, the problems begin.
Finra, the regulator for brokerages, doesn’t track this shadow margin, nor does the SEC. Both, however, have been warning about the risks. No one knows the overall amount of this shadow margin, but some details have been reported:
- Morgan Stanley had $36 billion of these loans on its balance sheet as of the end of 2016, up 26% from 2016, and more than twice the amount in 2013.
- Bank of America Merrill Lynch had $40 billion in SBLs on the balance sheet at the end of 2016, up 140% from 2010;
- UBS and Wells Fargo “also have made billions in such loans, people familiar with those banks” told the Wall Street Journal. Raymond James, Stifel Nicolaus… they’re all doing it.
- Fidelity used to fund its own SBLs for its clients, but three years ago partnered with US Bancorp.
- Even the little ones are trying to get their slice of the pie: In April, robo-advisory startup Wealthfront, with less than $6 billion, announced that it would offer SBLs to its clients.
And now Goldman Sachs, which has been offering SBLs to its 12,000 super-wealthy clients through its Private Banking unit — accounting “for more than half of the unit’s $29 billion in loans outstanding,” according to the Wall Street Journal — announced on Thursday that this wasn’t enough and that it is partnering with Fidelity Investments to spread these loans far and wide.
This effort to lever up investors’ portfolios occurs after an eight-year bull run, with stock indices hopping from one all-time high to the next even as the economy has been growing at a dreadfully slow pace and even as corporate earnings have mostly gone nowhere for years.
Since July 2012, the trailing 12-month “adjusted” earnings-per-share of the companies in the S&P 500 rose just 12% in total. Over the same period, the S&P 500 Index itself soared 80%.
These adjusted earnings are now back where they’d been on March 2014. Three years of earnings stagnation. However, over the same three-plus years, the S&P 500 index has soared 33%.
As earnings have stagnated while stock prices have jumped, the P/E ratio for the S&P 500 companies has soared from 14.8 at the beginning of 2012 to 24.8 now. And bonds have seen an enormous bull run too.
It is at these precariously high levels of the markets that brokerages go into hyper-drive to push “shadow margin” on their clients, using inflated securities as collateral. If markets decline, brokerages start making margin calls, and investors will be forced to sell securities into a falling market at the worst possible time, or else the brokerage will liquidate their portfolios. Investors could lose every dime in their accounts and might be personally responsible for the remainder of the debt.
After eight years of bull market, no one is thinking about risk anymore.
Goldman Sachs will offer these SBLs to about six million accounts managed by 3,850 brokers and wealth managers that use Fidelity’s technology, though they will not be available to Fidelity’s own retail brokerage or wealth-management clients. The Journal:
The centerpiece of the action is a new online platform, called GS Select, that will offer loans of between $75,000 and $25 million, with borrowers’ portfolios of stocks and bonds serving as collateral, the companies said Thursday. Goldman’s software can analyze the holdings and make a decision within a day about how much to lend and on what terms.
Andrew Kaiser, head of Goldman Sachs Private Banking, told The Journal that this partnership with Fidelity is just the first of several:
Small wealth advisers and independent broker-dealers are good fits because they aren’t already connected to a bank, he said.
What’s in it for Brokerages?
SBLs are a source of revenue that replaces some of the revenue brokerages lost as they’re moving away from charging commission on trades to charging fees on assets under management. When clients need money, they’d normally sell some securities and withdraw the proceeds from the account. This would lower the asset balance of the account, and therefore the fees for the broker. So brokerages encourage clients to leave their assets intact and add a big loan to the account. This keeps the asset-based fee intact, and the brokerage also earns interest income on the loans.
Everyone at the brokerage benefits from the deal. The Wall Street Journal:
Several Merrill Lynch brokers said they have asked longstanding clients to open securities-backed lines of credit to help them hit bonus hurdles, assuring that clients wouldn’t need to use it or pay any fees for opening it. Merrill brokers receive ongoing payments for getting clients to tap credit lines, and those loan balances contribute to year-end bonus calculations, people familiar with matter said.
Brokerage executives have said the longer a client has one of these loans tied to their account, the more likely they are to use it.
“We were dramatically pushed to put these on all of our client accounts,” said Steven Dudash, a former Merrill Lynch broker who has been managing his own investment-advisory firm since 2014. “Whenever you’re product-pushing, it’s not in the client’s best interest.”
What’s in it for Their Clients?
Clients get to pile on low-interest-rate debt and huge risks, including the chance of losing more than all the assets in the account if push comes to shove in the markets and their collateral value gets crushed. They will have to sell into a crash at the worst possible time, and even after they sold all their assets, they might still owe the broker, and the broker will go after them for the remaining debt. The Journal explains:
These arrangements are structured to benefit the brokerage, with the client shouldering virtually all the risk, critics say. And these loan products are often pushed without regard to whether clients even need them, they add.
There is another side effect to this margin debt, whether it is out in the open, like NYSE margin debt, or the shadow margin of those SBLs: When markets decline and forced selling kicks in, it causes a further decline in the market, which causes even more forced selling. Leverage has been the great accelerator on the way up over the past eight years. And it’s also the great accelerator on the way down.
“Covenant-lite” loans – risky instruments issued by junk-rated borrowers, with few protections for creditors – set an all-time record at the end of the second quarter. Read… Risk has been Abolished, According to Institutional Investors
8 comments
Comments are closed.
I guess it makes sense that they’d do this, because that’s where most of the savings now are.
(Currently getting a ‘ICO Now’ ad from Google. Guess that mania’s starting looking for suckers.)
Even more worrisome are the dark pools of private equity loans.
https://www.ft.com/content/9547c2d6-e530-11e5-bc31-138df2ae9ee6
We wrote about that yesterday.
Actually, no for now. First, PE is only about 6% of global equity, and I suspect only a somewhat higher % of US equities.
Moreover because the lines authorized are known (~$40 billion, which is not much relative to $3 trillion in total AUM), which so far is not all that high while we have no idea re the magnitude of shadow margin. As it stands now, banks would be OK. Even with growth, it would wipe out some PE funds and limited partners in a worse case scenario. So very very nasty but unless the banks get stupid (very possible!) and allow too much in the way of credit lines relative to the LP commitment, then the banks could suffer losses. But as we wrote, a lot of influential GPs don’t like it at all and are tying to curtail the practice.
By contrast, in a liquid market like stocks, you could kick off cascading sales like the 1987 crash. That nearly killed the MERC, and if it had gone down, the NYSE would have shut down and may never have opened again, per its then chairman, John Phelan. You would have had pretty serious margin losses and the mother of all flights to quality.
Shorter: if you get enough levered stock market trading, you can have Seriously Bad outcomes. While the PE leverage on leverage also has the danger of creating systemic risk, the more likely danger is to investors, not banks or the financial system. And some people are already alarmed. By contrast, no body seems all that worried about the leverage in stocks, and that could kick off trouble much more readily due to cascading selling.
Curious what opinions are of the relative merit, compared to SBL, of short selling shares one already owns and passing dividends thru to the buyer rather than paying interest. At current valuations, I would think it hard to sleep owing a defined amount secured by such fragile collateral.
Unfortunately, at least for retail accounts, Regulation T imposes a 150% margin requirement on short sales — 100% to buy them back, plus a 50% cushion in case their price goes up instead of down.
Despite the cash raised by the short sale, it doesn’t produce any withdrawable equity, since all the proceeds have to be held by the broker as margin.
How are institutional investors (and esp. pension funds) not up in arms about this, beyond because they’re led by exactly the same class of incompetent social climbers as the rest of the FIRE sector is?
Based on my research, current practice is to offer 50% LTV on equity holdings. I think it’s hard to say that this represents a meaningful systemic risk (acknowledging black swan etc etc), especially as no data is presented regarding average balances (these are typically revolving lines). Many of these also have explicit terms that prevent their use in purchasing securities, as this would risk reclassification as a margin line. So I’m not really sure calling it shadow margin is appropriate…More like shadow credit cards…Doesn’t really roll off the tongue I guess.