Seven years ago, investors were smitten with margin loans. They borrowed against their securities at a feverish pace and plowed the cash back into the stock market. In March 2000, the run-up in brokerage lending hit a zenith: Margin debt at New York Stock Exchange member companies was $278.53 billion, an all time peak. Some observers channeled Chicken Little: A chorus of people--from the chairman of the NYSE to television analysts to government regulators--warned of serious consequences ahead. Today, margin debt is up again, with outstanding debt at NYSE firms totaling $243.54 billion as of April 2006. Yet most of the experts haven't uttered a single peep. Could it be because many think margin loans are a good idea?
Unlike the last surge in margin debt, most of the people borrowing on margin are not using the money to snag more securities. They are investing outside Wall Street or obtaining personal items instead. For example, UBS AG reports that about 75 percent of the $10 billion in margin loans it has issued is currently being used for things other than stocks and bonds. Consumers are using the borrowed money to buy real estate, invest in businesses or--especially in the case of affluent borrowers--pick up luxury items like cars, jets, boats and artwork.
Long viewed as an unappealing way to raise cash, margin loans are now popular among wealth managers. (Warren Buffett, who has always beaten the drum against this type of borrowing, was known to opine, "Margin borrowing: If you're smart, you don't have to. If you're not, you'll get into trouble.") Many advisors now see margin debt as an attractive alternative to borrowing from banks, especially since the Federal Reserve has steadily been notching up interest rates. If you have a significant investment account, brokerage loan rates can be equal to and lower than bank rates. And unlike most bank loans, they don't come with fees, don't require as much paperwork, and are available almost immediately. Advisors say margin credit is particularly handy when wealthy clients need short-term money or bridge loans for real estate transactions and other investments.
Still, many financial planners reflexively deride borrowing against brokerage accounts. Consider one prominent manager's reaction to the practice. When she was recently asked about margin loans, she automatically assumed it was for buying securities and blurted back: "I'm not big on that. It's inappropriate for our clients." But a few minutes later, after she was asked her opinion of using margin loans for other purchases, she said, "Oh, we do that all the time. We'll borrow on margin because interest rates are often better. It's a smart way to borrow money."
For high-income investors with sizable brokerage accounts, borrowing against securities is one of the easiest and simplest ways to tap cash. A study released last year by the consulting firm Spectrem Group found that 11 percent of wealthy Americans--that is, those with $5 million or more in assets--had margin loans.
"It's almost a humiliating process for people of affluence to do bank financing," explains Marc Singer, a CFP in Coral Gables, Fla. whose fee-only firm has $750 million in assets under management. "You have to prove that you have a certain amount of money. You have to prove that you make a certain amount of money. It can feel like your privacy is being violated."
Singer notes that he recently had clients who wanted to lend their son $200,000 for a down payment on his first home. They decided to pull the money from a margin account rather than sell securities or use their home equity. "Everybody got what they wanted," Singer says. "The parents raised the cash, they made the loan to their son, and they didn't have to liquidate any assets or reduce their retirement portfolio. And every month they send their son the margin bill, and he pays it."
For their part, brokerage houses are riding the boom in margin debt; their bottom lines have expanded as more investors have taken out these loans. That's because firms like Charles Schwab have increased interest rates on margin loans in lockstep with the Fed, while barely altering the rate they pay on deposit and other interest-bearing accounts. Of course, as brokers see margin loans drive up revenues, they have, in turn, become more determined and more creative to nab investors' debt.
Margin loans have also been repackaged as suitable alternatives to home equity loans and second mortgages. For instance, Merrill Lynch, which is considered a pioneer in this area, offers packages such as "Mortgage 100" and "Parent Power." These programs allow clients to pledge securities in return for cash that they can use for home down payments for themselves or for their children.
At the same time, financial advisors at some brokerage firms like Smith Barney and UBS, earn rewards if they sell a margin loan that's used to buy something other than securities. And many of the brokerage firms give borrowers better rates if they use margin debt for non-stock purchases.
"We've seen that the Smith Barneys of the world are aggressively trying to get these loans out there," says CFP and CFA John Bird, who is president and co-founder of Albion Financial Group in Salt Lake City, Utah. "The nice thing is that all this competition gives you negotiating power. We're always looking for the lowest friction costs for our clients and the best after-tax interest rates."
The changing view of margin lending by wealth managers is part of a general shift in the overall profession. Top financial advisors say you can't focus primarily on asset management anymore; you have to also keep your eyes on the liability side of a client's portfolio. Today, being nimble about debt allocation is as important as being nimble about investments in financial markets, they point out. And that may mean consistently moving in and out of margin loans, LIBOR loans, home equity lines and other debt products to get better rates.
"It might also mean telling clients to hold onto debt," Bird says. "At their core, most of our clients want to blow out debt. Sometimes they will want to cash out financial assets at the wrong time. We have to explain the mathematics to them and get them to see why having debt is not automatically a bad thing."
Margin loans are not the only way to use securities to get cash. Going to a bank with securities as collateral can help get better bank rates. Bird, whose firm has $400 million under management and requires customers to have $1 million in assets, says he likes to leverage stock portfolios to get decent terms on bank loans. "Sometimes we're better off setting up a secured line of credit with a bank to get financing," Bird adds.
Not all wealth managers, however, like using collateralized loans from banks. They prefer to use margin loans because they are quick and painless. "Pledging an account is not always attractive," says Mark E. Balasa, a co-president of Balasa Dinverno Foltz & Hoffman, a fee-only firm outside Chicago with more than $490 million in assets under management. He regularly uses margin for bridge loans, but last year one of Balasa's high-net-worth clients was purchasing a large piece of land in the Chicago suburbs, and they went to the bank for a loan. The bank, however, tried to coax the client to move his stock holdings over for the loan. "I said, 'No, we're not moving anything. We want a collateralized loan.' We negotiated, and got the terms we wanted, but it was a tedious process."
For wealthy clients with large investment portfolios, there are few risks associated with borrowing on margin. Still, margin loans do require an investor to maintain 50 percent of the value of a stock portfolio. If the value of an investor's portfolio declines below the 50 percent mark--some firms require investors to maintain a 70 percent value--a margin call could kick in. That call requires the investor to restore the account to the minimum requirement. When investors can't meet the margin call, the firm has the power to sell some or all of the client's securities.
Brokers say calls on margin loans are unlikely when you're dealing with affluent investors. Some advisors, however, say you can never be too careful. "Brokers talking down the risk of margin loans is like McDonald's saying burgers aren't bad for you," Balasa says. In fact, a lot of wealth managers wouldn't dream of letting clients use margin loans for anything longer than a short-term fix.
"It's not really a good long-term money management technique overall," says Judith A. Shine, CFP, of Shine Investment Advisory Services of Englewood, Colo. "I look at it as a convenience, but I wouldn't want to see my clients holding margin loans for more than six months unless we were absolutely certain the margin has absolutely no risk."
Margin loan rates are usually near prime for loans equal to or greater than $1 million and a little more than 10 percent for loans under $50,000. But because brokerage firms are free to set margin loan rates, the rates range from firm to firm, with some offering enticing discounts and promotions. Generally, brokerage firms don't publish their margin loan rates, although some discounters do list them. At its Web site, Charles Schwab, for instance, offers investors a rate of 8.5 percent if they take out $1 million in margin debt, and a rate of 8.25 percent if they take out $2.5 million in margin debt. Meanwhile, Fidelity Investments publishes on its Web site the low rate of 6 percent for investors who borrow at least $500,000. Those rates compare to prime, which is currently 8.25 percent, according to Bankrate.com, and home-equity loans, which average 7.43 percent, according to the State of New York Banking Department.
With brokerage firms intensifying their marketing of margin debt, many wealth managers say their clients are increasingly interested in talking about these loans. In Los Angeles, Carol L. Fishburn, a CFP at the Brentwood Advisory Group, recently obtained a margin loan for one customer after he came to her with the idea.
"He's a developer, and he has a project in which he's building several homes," Fishburn says. "We took out the margin loan, and for him it was nice because real estate developers need flexibility. He got the money he needed right away, and he'll pay off the loans with the reimbursements he'll get once the homes are built. It would have made no sense for him to sell off his stock assets for a short period. If you can avoid it, you don't want your client to have to sell in a time like now when the markets are good."
Mark Francis Cohen (mfc@markfranciscohen.com), whose work has appeared in the Washington Post and the New York Times, is a Washington, D.C.-based journalist.
