MS Morgan Stanley

By Michael Wursthorn 

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (July 28, 2017).

Wall Street brokerages have been selling billions of dollars in loans backed by stocks and bonds, a trend that yields lucrative fees for the firms but poses risks for borrowers.

While banks don't always report these loans in the same way, these securities-backed loans total at least $100 billion for the biggest brokerages -- up exponentially since the financial crisis -- with several billions of dollars of additional debt held at smaller brokerages, banking analysts estimate.

Executives at Morgan Stanley earlier this month highlighted these loans to individuals as a big growth area and revenue driver, saying the loans helped expand the bank's overall wealth lending by about $3.5 billion, or 6%, in the second quarter. On Thursday, Goldman Sachs Group Inc. took a step toward expanding its securities-based lending business through a new partnership with Fidelity Investments.

The loans work a lot like margin loans. Brokerages lend against the value of an investor's portfolio. But unlike margin lending, customers don't use the debt to buy more securities. Brokerage executives say the loans can help clients avoid selling assets. The client can get cash without shifting their investments; they also avoid potentially locking in losses or incurring taxable gains, or missing out on future stock market gains. Clients are also able to borrow money at relatively low interest rates because the loans are secured.

"Securities based loans can be a valuable financial planning tool for appropriate clients," a Morgan Stanley spokesman said.

Critics worry that the surging stock market has made investors numb to the risks of borrowing against their investments -- a scenario that has played out before. In the runup to the Great Depression, the dot.com bubble of 2000 and the financial crisis, investors binged on margin debt that proved perilous when stocks tumbled.

Investors using these loans now could face a similar fate if markets tank and the value of their collateral shrinks, prompting the bank to demand repayment. If the margin call isn't met, the securities backing the loans are sold and the borrower is responsible for any remaining balance.

For brokerages, these loans have become a reliable source of revenue in the years since the financial crisis, as firms have begun moving from a business model of charging commissions for trading to a system of fees based on assets under management. The loans themselves help brokers retain these assets because customers don't have to sell stocks and other securities when they need cash. These loans have also become a big factor in brokers' compensation.

Several Merrill Lynch brokers said they have asked longstanding clients to open a securities-backed line 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 continuing payments for getting clients to tap credit lines, and those loan balances contribute to year-end bonus calculations, people familiar with the 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."

Merrill representatives say its brokers offer these loans to clients in a responsible manner, including disclosing the risks and fees.

"If people need the money, they should sell securities," said Terrance Odean, a professor of finance at the Haas School of Business at the University of California, Berkeley. "It's very risky to take a leveraged position in the market, and I don't think people are thinking about it that way."

Wells Fargo & Co. recently changed practices around how brokers pitch lending products. Starting this year, Wells Fargo stopped offering brokers bonuses tied to how many loans, including securities-backed debt, they opened for clients, executives of the bank have said.

As of the end of 2016, clients of Bank of America Corp.'s wealth unit, which includes Merrill Lynch and private bank U.S. Trust, had some $40 billion in such loans outstanding, up 140% from 2010. Morgan Stanley's customers had $30 billion in these loans, more than double from 2013. UBS Group AG and Wells Fargo also have made billions of dollars in such loans, people familiar with those banks said.

Morgan Stanley's finance chief, Jonathan Pruzan, said while discussing earnings this month that the bank expects more clients to take out loans in the months ahead. "That's been a real key driver of our wealth business," he said.

The growth of securities-backed loans has drawn the attention of regulators, who have questioned the brokerages' marketing and sales efforts as well as the suitability of the loans.

Merrill opened more than 121,000 such loan accounts between 2010 and 2014 with more than $85 billion in total credit extended, according to a Financial Industry Regulatory Authority settlement order last year. In the matter, Finra alleged that Merrill didn't fully explain the risks of securities-backed loans and used risky or concentrated investments as collateral.

Merrill settled its case without admitting or denying the allegations. Merrill reported its securities-lending oversight lapses to Finra initially and cooperated with the regulator's inquiry, according to Merrill representatives. They said the firm has improved its procedures.

In another regulatory action, the Massachusetts securities watchdog last year accused Morgan Stanley of developing a sales program that encouraged brokers to pitch these loans regardless of whether clients needed them. Brokers involved in the incentive program were given scripts coaching them to offer securities-backed loans to clients who said they needed to pay taxes or cover expenses for a wedding or a graduation party, or if they mentioned "purchasing a luxury item like a car or yacht," according to the regulator.

"It's not healthy for the industry," said William Galvin, Massachusetts' top securities regulator, who has been investigating how firms motivate brokers to push these loans. Brokerages "should be more concerned about this," he said, "but they're in favor of competition and seeing who can get more loans."

Morgan Stanley agreed to a $1 million settlement with the regulator in April without admitting or denying wrongdoing. A Morgan Stanley spokesman said Massachusetts found no evidence that any clients were harmed or that any of the loans were unsuitable or unauthorized.

"We have taken steps to strengthen and clarify our policies and controls around such initiatives," he said.

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com

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July 28, 2017 02:47 ET (06:47 GMT)

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