What Is Securities Based Lending?

Understanding financial matters can be a challenge, especially when the stock market is involved. We can be confronted with jargon, complex assessments of how to make and avoid losing money, and uncertainty as to what sources to trust. There is a lot to be gained from coming to grips with this stuff, though. Securities based lending is relatively new, but can potentially offer a lot to investors of all income brackets.

Securities based lending is discussed in greater detail below. See FindLaw's Securities Law Basics section for more articles and resources, including Securities Law: An Overview and Basic Terms for Shareholders and Investors.

Overview of Securities Based Lending

The basics of securities based lending are straightforward. Financial firms loan money to existing investors whose securities are already managed by the firm. These securities, such as stocks and bonds, in turn serve as collateral for the loan. Using collateral to secure a loan has long been common practice in the financial world. It's the use of stocks and bonds as collateral that is new.

These loans have recently surged in popularity. Since the securities serve as collateral in case of default, firms can offer lower interest rates and make larger loans. This makes securities based lending an attractive source of cash. Investors can use the value of their investments to receive cash without having to sell stocks, bonds, or other investments. Meanwhile, businesses and entrepreneurs can obtain capital for new ventures or startups at lower interest rates. Major purchases that require a loan, like real estate, can often be made using securities based loans to receive more favorable terms than traditional loans.

Advantages of Securities Based Lending

Securities based lending has proven attractive to financial firms. Banks and brokers generally receive fees for managing their clients' investments and assets. Offering loans tied to their existing business increases revenue in the form of interest payments. There's some sound business sense involved here. A bank or broker already holds the collateral, the existing customer is a known quantity, and investors tend to stick around if they become borrowers too. For all of these reasons, financial firms have made a big push in recent years to increase securities based lending. Many firms reward employees who make them with lucrative bonuses.

These loans can benefit borrowers just as much as lenders. Most people hold stocks, bonds, and other securities to accumulate wealth for retirement, kids' college tuition, real estate purchases, and similar purposes. Securities based lending allows investors to raise cash quickly while both benefiting from a secured loan's favorable terms and keeping the underlying stocks and bonds in a portfolio. The mixture of collateral, an existing relationship with the bank or broker, and favorable loan terms offer real value. The main question is whether these loans are right for you.

Disadvantages of Securities Based Loans

There are disadvantages to securities based loans too. First, there's an important string attached to them. The cash received cannot be used to purchase additional securities. This distinguishes them from margin loans, a close relative in the financial world. Second, there's the potential for the lender to call in the loan early or demand increased collateral. The loan is tied to securities, and the price of securities fluctuates with the market. If the value drops enough, firms can call in the loan or demand increased collateral from the borrower. This can leave borrowers in a pinch, needing to raise cash or sell stocks.

Finally, securities based loans share the same disadvantage as all other loans: the amount received must be paid back with interest. This costs more in the long run than relying on wages, savings, or investment income. Those options are also less risky.

As securities based lending has grown, so too have concerns about them. Financial commentators have speculated that securing loans to the stock market may pose large risks to the financial system. Should the stock market rapidly decline, banks, brokers, and financial firms offering them could call in these loans. That could force borrowers to sell securities to raise cash, which would further hurt the market. Farsighted forecasts of the financial markets are, as we know, notoriously difficult. However, the risk of securing loans with assets whose value can fluctuate is a real one. A similar problem created the subprime mortgage crisis and housing bust.

Conclusion

Securities based lending offers cash at low interest rates. That's appealing to many people. However, it's important to understand the terms of the loan and the risks involved. If you're considering taking out a securities based loan, consider speaking with a financial advisor, securities law attorney, or other knowledgeable source.

Next Steps

Contact a securities lawyer to assist with any issues related to securities laws and financial instruments.

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