Before borrowing from a friend," the proverb goes, "decide which you need most." How 16th century! In today's financial world, one would do well to substitute financial adviser for friend. Surprisingly enough, many investors in need of extra cash these days are taking loans out against their stocks, and the lenders are often the same people -- their accountants, attorneys or insurance agents -- whom borrowers trust to give them financial counsel. The practice, known as stock-based lending, has been going on under the radar for years, experts say. But with other forms of credit still scarce, many investors are tempted -- despite some not-so-obvious risks.
For starters, says Lee Munson, a financial planner in Albuquerque, N.M., such loans can often be more expensive and less transparent than the margin loans offered by brokers. When investors take out a margin loan, for example, they get a statement that shows their total market exposure. But for those who borrow against a stock portfolio, says Munson, the impact can be less clear. Take an investor who borrows $1 million against a $2 million stock holding, and then loses $1 million in the markets. He hasn't lost half of his portfolio, says Munson, he's effectively lost it all, because he still needs to repay the loan. What's more, says Seth Lipner, a law professor at Baruch College in New York, borrowers often don't realize that lenders can sell the shares underlying a loan if those shares fall below a certain threshold -- with the result often being an unexpected tax bill to boot.
To be sure, financial planners who arrange these loans say they can be a lifeline for borrowers at a time when bank loans are difficult to get. Scott J. Kaminsky, a financial adviser for Morgan Stanley Smith Barney in Philadelphia, says such a loan came in handy for one client who was buying a new home but had yet to sell the old one. Still, experts say, even in cases where there's a good reason to borrow, investors should be cautious. Generally, when financial advisers arrange stock-based loans, the advisers don't back the loan, but act as middlemen for third-party lenders, says Gerri Walsh, vice president for investor education at the Financial Industry Regulatory Authority. And some of those lenders, she cautions, are not regulated by either the banking or securities industries. Even when the lender is legit, experts say, such loans can put borrowers in an awkward situation with their financial advisers -- particularly when the borrowed cash is used to purchase a product, like a mutual fund or annuity, which the adviser has a financial incentive to sell. As Munson puts it: "These things are riddled with conflicts of interest."
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