No Stock Loan Should Require You to Hand Ownership to an Unlicensed Lender

Many people know nothing about loans that use stock or other securities as collateral for a loan. Fewer still know that until recently, financing secured by stock that had to be transferred to an unlicensed third-party lender was legal and that here had been no tax court rulings prohibiting such structures. In July of 2010 a federal tax court ruled that such loans were in fact sales at the moment the title transferred to the lender, and therefore taxable if capital gains where present precisely as sales. And in fact, that was appropriate, since most transfer-of-title lending required the sale of the underlying asset to proceed.

A sound, secure stock loan should require that the shares remain entirely in the client’s title, account and control – never sold. They should be Interest-only loans, and should allow clients may draw as much or as little as they wish and owe monthly interest payments only on the amount that they have actually chosen to draw in cash from their credit line – not the entire allotment.

A sound securities finance or stock loan program should ensure that a major household-name brokerage institution with fully licensed and regulated institutional account management is at the helm. It should ensure that the financing is through a licensed, regulated institution, accessible online 24 hours a day as most modern brokerages and banks permit these days, with statements printable on demand while their securities remain working for them as always. A simple lien should be all the lender needs to mitigate his risk of loss.

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When it comes to stock loan financing, many assume that the risks are great, yet many new stock loan clients have fallen prey easily to the siren song of “nonrecourse” loans in the past. There was nothing illegal about such loans in the past, at least not clearly so, as there had been no government ruling on their status until a tax court put the matter to rest in 2010. But the “nonrecourse” element — the part that stated you could walk away from repayment and fulfill your loan obligation by simply sacrificing your securities – required that the client borrower put all of their faith in the financial health of the signatory (lender) to their loan contract. If that unregulated firm went out of business, the borrower would be out of luck, but since these private financial firms offered their client no audited financials, the clients had no way to know just how healthy these transfer-of-title stock loan firms were.

The client who transfers title to their stock to an unlicensed third party in a nonrecourse stock loan is actually almost certainly also allowing the lender to sell some — or more likely — all of their shares on the open market, a right that stock owner gives to the transfer-of-title lender when signing the loan contract. That lender then remits, perhaps 80% of the proceeds of the sale back to the client, while keeping the remainder to himself as profit. If the lending system is handled properly, he would then put aside a portion to help repurchase shares in the open market when the client pays back the loan should he need extra cash to buy them back.

In practice, most nonrecourse lenders do not have enough financial resources to cover the return of their client’s portfolios. Rather, they hope their clients will simply walk away from their loan by exercising the nonrecourse clause of the loan agreement so that the issue need never come up. They do so because when the client walks away, the lender is relieved of having to buy any shares back to return to the client. His spread – the difference between the price received for selling the stock and the amount remitted to the client as a loan – plus any interest he makes before the client defaults, is his profit.

Now, that might all be fine if managed properly. Except that if a client with a large stock portfolio is lucky enough to have his portfolio’s value rise with higher stock prices, then such person will most certainly want his shares back at loan maturity and will not walk away. That person will pay off the loan, because in repaying, he would be receiving shares back that are worth much more than when he began his loan. However, in paying off the loan to the lender, the lender will not be getting enough repayment cash to buy the same number of shares that were originally pledged, because now the price of each share is much more expensive. Having sold all of the client’s shares, lender must then reach into his own resources to make up the difference and go into the market to buy the shares back to give to the client who has paid off his loan.

But what if the lender has no additional resources? Or what if the lender’s resources are woefully insufficient to cover the cost of buying back the same number of shares to return to the client as were originally pledged? Or if he has multiple loans maturing near the same time — all of which did well and cost more for the lender to buy? In that situation, the lender must provide excuses to the client. He may need to come up with a plausible reason for the delays, and he may feed those reasons to his brokers hoping they will believe there’s nothing wrong and persuade the client — who has presumably already paid off his loan –to keep calm.

For some of these nonrecourse stock loan companies, they do eventually return the shares as they trim their profit margins from other transactions (e.g., lower LTV’s for awhile) when new transactions come in so as to have more money to buy up shares to return to the client who is waiting to get his shares back. But sometimes the lender is bombarded with multiple portfolios that have risen dramatically in value, each one requiring the lender to dig ever deeper into his own pocket or more likely into his incoming loans to pay off the client who is awaiting his shares. It is this scenario that has prompted the IRS to call such systems ‘Ponzi Schemes’ when more accurately they are simply mismanaged nonrecourse transfer-of-title contractual stock loans.

These types of loans often involve several levels of withheld or incomplete or — in the worst cases — false information, as the nonrecourse stock loan lender does not want to alarm his brokers or marketing partners and it is not in the lender’s interest to reveal lender’s financial problems. It is these brokers and marketing partners, almost always kept in the dark and fed vague or incomplete information, who pay the price for the trust they place in the nonrecourse signatory lender, since many clients (wrongfully) will be unable to distinguish the two even as the brokers are equally victimized by the same inaccuracies that the clients themselves received. For clients, the problems are obvious. In addition to not being able to get shares back upon repayment, they often find themselves needing to refile their taxes, occasionally paying fines for capital gains due.

Oddly, people who would never even think of handing the full ownership of their herirlooms, their car, or their house to a stranger, often think nothing of handing over title and ownership of their equally valuable stock portfolio to an unknown private party whom they probably know little about. Few clients, for example, ever ask for financials, or ask point blank about the financial health of their nonrecourse lender, or even if they have any unreturned stock portfolios of their clients. Even a pawn shop is only a custodian of their client’s valuables unless they default, since the title remains with the owner.

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The modern financial consumer went through horrific experiences during the Wall Street meltdown, the recession, and its aftermath. It has been a time for many comfortable old ways of doing business to finally move into the history books. In the wake of the Bernie Madoff scandal, the dissolution of venerable Lehman Brothers, and the small-business-crushing recession, financial consumers have moved swiftly towards stability and security. The SEC and other regulatory agencies that have swung from the extreme of lax enforcement to what many consider to be intrusive and chilling over-regulation has also played a part. Joblessness too. Financial consumers today want stability, regulation, and certainty, but they also want client-friendly features, low costs, and flexibility from their banks, brokerages, and lenders.

Non-transfer-of-title stock loans have many advantages over stock loans where the client must give up title to his/her assets. For real estate investors, for example, a credit client of this type can be “mothballed” until it is needed. Since no interest is charged or due until cash is drawn, these credit lines can stand in waiting until it they are needed, thereby allowing the investor to act quickly.

For project financing clients who have potentially interested investors ready to support a project, but who do not want to liquidate their securities for one or another reason, the non-transfer-of-title credit line can prove to be the answer. A project investor could keep his/her stocks, bonds, mutual funds, government securities, ETFs (etc) in their own title and account. They could have their cash from the credit line fund the film, construction, business, or other investment project while they enjoy interest-only payments (the interest payments can be structured to come automatically from the line too, if the client desires, for no-maintenance financing.)

All the while, their securities can continue growing and working for them. If structured properly and the credit line is with a top-tier U.S. financial institution, they can also make use of their lender’s advisory support to help maximize portfolio value while they act as collateral.

For this reason those using this type of credit facility to fund projects can clients to keep their stocks growing while they enjoy interest-only repayment and can partake of an open-ended lending structure since these lines rarely have set maturity dates. In this project financing example if the investor’s investment was profitable, it could be used to pay off the credit line. Once repaid, the line would be available to use again. The investor would have enjoyed the profits of the investment, had his securities growing in value over that entire time period, and when done, would have the full credit allotment “refilled” and available to use again if he so desired.

If he did not make use of his credit line? There would be no charge, unless he chose to use the institution’s advisory services. If not, there would be no cost at all to retain the credit line in standby mode, ready to go. He could also, of course simply shut the credit line down in which case the account lien would be removed and the shares no longer encumbered as credit line collateral.

These programs also usually allow trading in the client’s account, with the only caveat being that the value and quality of the shares or securities traded must not dip below the release rate (the amount of credit allocation expressed in percent) minus approximately 5%. Combined with a careful intake policy that ensures a standard of securities’ quality right from the outset, these non-transfer-of-title, institutionally managed credit lines are transparent, provide full disclosure, and can be structured to make any collateral-to-loan call unlikely. If such a call does occur, shares typically can be sold mid-loan to bring the account into balance, the sell order at client’s behest. Lender flexibility is much more likely with these types of credit lines.

Are Student Loans Still a Good Bet

In the mid- and late-1960s, there was no doubt among U.S. public policy makers that the federal government should be encouraging more citizens to attend and graduate from college.

Bolstered by the success of the highly popular GI Bill, which paid college expenses for military veterans, federal student loans were hailed as a “GI Bill for all Americans.” These low-interest loans allowed students from modest means to attend college in numbers never before seen. The college graduation rate, which had hovered around 7 to 8 percent, steadily climbed to today’s rate of nearly 30 percent.

Backing the idea that higher education is nearly universally better than entering the workforce straight out of high school were statistics that showed that college graduates, on average, would benefit from as much as $1 million more in lifetime earnings than students who didn’t graduate with a post-secondary degree.

At the same time, however, the cost of a college education began to rise much faster than the rate of inflation, meaning that families began to have to devote more of their overall income to paying for college costs. With annual college tuition climbing into the tens of thousands of dollars, college expenses have outstripped even generous incomes, and students have had to turn increasingly to college loans to pay for their education.

Today, about two-thirds of college students take out student loans to help pay for their education. These students leave college with an average of $23,186 in school loan debt, according to FinAid.org.

This figure is less than the average cost of a new car in 2010 ($29,217), and most new car loans are paid off in five to six years, with an interest rate comparable to the rates on federal education loans.

So why are so many people concerned about the cost of college loans?

Simply put, not all college loans are created equal.

Federal education loans are issued directly by the federal government and carry a fixed interest rate, along with flexible repayment terms and multiple options for postponing or reducing one’s monthly payments based on one’s financial circumstances. Federal college loans are generally low-cost, low-pressure loans.

Private education loans on the other hand, which are issued not by the government but by banks, credit unions, and other private-sector lenders, are variable-rate, credit-based loans that typically carry higher fees and rates than their federal counterparts. Private student loans also offer much fewer, if any options, for financially distressed borrowers to be able to postpone or reduce their payments.

One major difference between a new car loan and a student loan is the deferment period. With a car loan, payments on the principal begin immediately. A portion of every payment is used to reduce the balance owed.

In contrast, all federal education loans and many private education loans allow students to defer making any payments while they’re still in school. The repayment of the loan can be delayed for years while the student finishes school – with no delay of interest charges, however.

Except in the case of subsidized federal student loans – for which the government will cover the interest while a student is in school and which are awarded only to students who demonstrate the most financial need – interest begins to accumulate on college loans as soon as the loans are issued, even if a student is deferring payments.

This accumulation may take place over months or years, quietly running up the balance on a student’s school loan debt to alarmingly high levels.

Families concerned with accumulating excessive college loan debt can always decline to take on any school loans. Federal college loans awarded in a student’s financial aid package are always optional; students can turn these loans down if they have another financial resource and don’t want to take on the debt of school loans.

Students forgoing their available federal college loans at the beginning of the school year, however, may end up passing on this government money only to see their financial circumstances change unexpectedly mid-semester. In cases like these, students may be forced to turn to private student loans to bridge the financial gap.

A good strategy for college students is to first seek out college scholarships and grants and then maximize their available federal student loans before considering a private student loan. Private loans should be considered only as a last resort and only for financial emergencies that arise during the semester that other sources of financial aid can’t cover.

Students should develop a clear and detailed plan for how they’re going to pay their college expenses for each year they attend classes, especially if they plan to decline the federal school loans in their financial aid packages.