In this blog, we will explore 10 risks of using a Securities-based Line of Credit (SBLOC) and how to manage them.

A Securities-Based Line of Credit (SBLOC) allows an individual to use their investment accounts as collateral for a line of credit.

The SBLOC can be used to fund almost anything, except to buy additional securities. 

There are many reasons an entrepreneur and their family might want to open an SBLOC with their wealth advisor. 

Most common client needs:

• Expanding a business
• Real estate investing (commercial & residential)
• Home Renovations
• Startup / Seed Funding
• Tax Obligations
• Funding an emergency
• Debt refinancing / Consolidation
• Luxury purchases
• Investment fund capital call
• Diversify family investments
• Cash management

Here are 2 quick examples:

Example #1:

A local San Francisco Bay Area entrepreneur has a great idea for a startup and needs $25,000 in seed funding. They leverage an SBLOC using their family trust account at Pershing BNY Mellon to access the $25,000 and start their successful venture.

Example #2:

A local Bay Area real estate investor wants to purchase a 20-door apartment complex in Petaluma. She and her family are considered a high-net-worth family but being a real estate investor, their assets are fairly illiquid. She is in the process of selling a replacement property to 1031 the proceeds into the new apartment complex. She leverages an SBLOC as bridge financing for the 20-door apartment complex. Once the replacement property sells, she uses a reverse 1031 exchange and repays the SBLOC.

While there are numerous benefits to an SBLOC, this blog is focused on the risks associated with them.

If you want to take a closer look at the benefits, check out our blog, “What is a Securities-Based Line of Credit?”

Terms and Definitions

Before we get started, let’s quickly review a few terms and definitions. 

Having an understanding of these will make the discussion of risk easier.

Collateral Maintenance Requirement

A collateral maintenance requirement is a ratio between the pledge account(s) value and the outstanding line of credit.

For example, let’s say a Lender places a collateral maintenance requirement of 60% on a line of credit. This means that if the outstanding loan is 60% of the assets in the pledged account(s) then there will be a collateral call.

Collateral Call

A collateral call is when the value of the pledged collateral falls below the collateral maintenance requirement and the borrower has 3 days to respond. The borrower can either add more assets to the account, pay down the outstanding line of credit balance, or reallocate the assets in the account to a higher lending asset.

With those definitions and terms under our belts, let’s take a closer look at the risks associated with an SBLOC.

Risks of an SBLOC

You Can Lose More Money Than You Deposit

If the value of your pledged account declines to less than the SBLOC balance, you could be responsible for any shortfall and associated interest.

This risk can be managed by borrowing less than the approved line of credit and making sure the securities in the pledged account are low-risk assets.

Market Risk

Generally, Lenders will only allow lending against liquid, marketable securities, and these assets are typically subject to market risk. Market risk is the possibility that the account will experience losses related to factors that impact the overall performance of financial markets. This is important because if the value of the pledge assets falls relative to the outstanding line of credit, a collateral call could be issued.

This can be managed by leveraging a well-diversified portfolio of assets in the pledged account (s). A clear investment management process that takes advantage of in-depth market research, continual account monitoring, and preventative measures such as lowering equity exposure during volatility could also help to manage this risk.

Interest Rate Risk

Interest rates could go up and this could impact the borrower in a few different ways. An increase in general interest rates could lower the value of the assets in their pledge accounts and it could also increase the borrowing cost on the line of credit. 

It is important to have a backup plan for repaying the loan if it becomes too expensive. Pay close attention to interest rates and where they are projected to go. Conduct some stress tests on your use of the line of credit to make sure you will be ok if interest rates go up. Make sure to examine different potential worst-case scenarios. Also addressing market risk, as mentioned above, can also help manage interest rate risk.

Time Horizon Risk

Time horizon risk is the risk associated with how long there is an outstanding balance on the SBLOC. The longer the outstanding balance is carried, the more the loan will cost and the more unknowns you could face in the market.

Make sure that you carefully evaluate how long you will need the SBLOC and what the estimated total cost of the loan will be. This would include incorporating any predicted interest rate hikes from the Federal Reserve or increased spread rates from your lender.

Return Risk

There are no guarantees that the pledge securities will earn a return higher than the borrowing cost of the securities-backed line of credit. 

If the cost of the loan is greater than your returns, this is known as a “negative cost of carry”.

To help manage this, borrowers and their advisors should diligently track the returns of the pledge account as well as the cost of borrowing on the outstanding line of credit.

However, there are situations where a negative cost of carrying is not an issue.

Let’s say an investor has a bond portfolio and needs bridge financing for a real estate deal. They decide to leverage an SBLOC with an interest rate of 4%. The average annual return on the bond portfolio has been 3%. Technically, this loan would have a “negative cost of carry” however, if the alternative bridge financing would cost the investor 6%, the SBLOC might be the better option.

Asset Reallocation Risk

The release rate or advance rate is the percentage of a security the institution will lend you in the form of a securities-based line of credit. A lender might have a 95% advance rate on U.S. Treasury Securities but only 5% on a penny stock. Each lender varies.

If the borrower is actively trading in the pledge account (many institutions allow this), they could reallocate their account in a way that dramatically impacts the overall advance rate of the pledge account and could cause a collateral call.

For example, let’s say an entrepreneur has a $1,000,000 pledge account with an overall advance rate of 50% with an outstanding line of credit of $250,000. If the pledge account was rebalanced such that the overall advance rate was lowered to 25%, a collateral call could be issued. 

Pay close attention to the release rates on securities that an account will be reallocated into. Or if you have an active watch list, have the lender tell you the advance rates on each security on your watch list before you incorporate them into the pledge accounts.

Collateral Release

When a borrower has an SBLOC on an account or multiple accounts, typically the lender will limit the ability of the borrower to transfer assets out of the account. 

This transfer of assets out of the account is known as a collateral release. 

Lenders understand that a borrower might need to access the assets in a pledge account. Some lenders will release assets within 24 hours or even the same day. 

The risk is that a borrower’s access to those assets is limited and if a borrower needs fast access to those assets, they may need to pay down their loan or even pay it off before the lender will release funds.

This risk can be managed through careful planning and having a backup plan in place to pay off or pay down the loan in order to access the pledged assets.

Lender Can Change Collateral Maintenance Requirements Without Prior Notice

If a lender decides to change the collateral maintenance requirements on an SBLOC it could require the borrower to pay down their outstanding line of credit, add more securities to the pledged account, or reallocate the account into securities with a higher release rate.

One way to manage this is to make sure that you ask your lender or your financial advisor questions about how often has a lender changed collateral requirements without prior notice and if so, why did it happen. This is a good reason to check out a few lenders first before making a decision.

Other ways to manage this are to not borrow the maximum amount and always have a backup plan.

Lender Can Sell Securities or Other Pledge Assets Without Notice

If a collateral call is issued and the borrower does not respond within the given time period, the lender can sell securities to bring the pledge account or accounts into good standing. 

Most lenders will attempt to notify you but often, they are not required to. 

The best way to manage this risk is to do all you can to manage the risk of a collateral call. If there is a collateral call, respond before the deadline. 

Also, make sure that you ask your lender how often they have had to sell assets without notice. At Clear Creek, we know lenders that have had to do this and we know lenders that have never had to do this. 

Finding the right lender for your unique situation is critical because not all lenders are not the same. 

The Sale of Securities Can Create Tax Liabilities

If a collateral call is issued and the borrower does not respond within the given time period, the lender can sell securities to bring the pledge account or accounts into good standing. 

The lender is not required to allow you to indicate which securities to sell. The lender can sell any asset in the pledged accounts. This means that if the lender sells an asset with a low cost basis, capital gains tax liabilities could be created.

The best way to manage this risk is to do all you can to manage the risk of a collateral call. If there is a collateral call, respond before the deadline. 

Also, be sure to ask if the lender has a defined process around what securities they pick to sell. 

Clear Creek Conclusion

A securities-based line of credit can be a great option for certain investors. It is definitely not for everyone. However, knowing the risks associated with these types of loans can help an entrepreneur or family decide if this is the right type of loan for them.

In this article, we reviewed 10 potential risks related to SBLOCs. This is not a comprehensive list of risks associated with an SBLOC. 

The U.S. Securities & Exchange Commission issued an investor alert on SBLOCs. I always recommend that individuals read this bulletin. You can read it HERE. It is full of good information about securities-based lines of credit.

If you are curious if an SBLOC is right for you and your family, reach out to us and we would be happy to explore your situation.