Morgan Stanley Reaps Massive Profits from Margin Lending
Generally, brokers get paid a smaller percentage on loans than they do on commissions of similarly sized transactions; as a result, those loans are highly lucrative for the company’s bottom line. In order to incentivize its brokers to push these loans, Morgan Stanley began to tie broker bonuses to amounts of loans sold to clients. As a result, client liabilities hit a record high of $45 billion as of the end of the second quarter, 2014. These loans come in two main types: loans backed by real estate, such as a home equity loan, and loans backed by securities held in a brokerage account, called a margin loan. Morgan Stanley’s lending in these two areas are up 65% and 47%, respectively.
In of itself, a loan through a company like Morgan Stanley is not necessarily a bad thing. The potential problems from all this come from two main areas: (1) whether the clients understand the risks inherent in these loans; and (2) what is being done with the money. Sometimes people are encouraged to take out a home equity loan and use that money to purchase more securities. The theory is that if the securities earn larger returns than the loan costs, the client is making “free” money. Unfortunately, these schemes often fail, and when they do, the client now stands to lose their home.
In other situations, brokers have recommended their clients take out margin loans against an account for living expenses, business needs, or other financial needs, rather than simply selling off enough securities to cover the expense. Brokers may try to justify these strategies by claiming that it is a “bad time” to liquidate those securities, which are almost assuredly going to make large gains in the near future, or that the interest rate on the loan is so low that the gains on the securities will more than cover it.
The problem is what happens when the account goes down instead. If the value of the securities in a client’s margin account decline beyond a certain amount, this will trigger a margin call, meaning that Morgan Stanley will automatically start selling off securities in the account to cover the outstanding loan. Almost by definition, however, this means that securities that have just fallen dramatically in value are being sold off at tremendous losses that now cannot be recovered from, as the funds went to pay off the bank. In fact, the recent financial catastrophe in Puerto Rico is a classic example of the risks inherent in these kinds of recommendations. Brokers were recommending that their clients borrow against their brokerage accounts in order to invest those funds in the accounts, in an effort to boost returns. Unfortunately, when the local market began to fall, these accounts often ended in a death spiral of margin calls, where declining prices forced the sale of securities, whose sale dropped prices even lower, forcing yet more margin calls. Ultimately, many clients had their entire accounts wiped out in a matter of days or weeks as a result of this speculative strategy.
Only time will tell what the result of this new push of loans by Morgan Stanley brokers will be for its clients. If you believe that your broker or financial advisor improperly recommended you take out a loan against your home or brokerage account, contact us for a free consultation.