One of the reasons why Chinese stocks suffered a sharp selloff in mid-October was the result of some 5 trillion yuan in stock-pledged loans issued against stock collateral, and which as a result of the sharp drop in Chinese markets, had gone underwater, prompting banks to remand repayment as LTVs rose above 100%.
The result was a broad liquidation of any unencumbered assets by the creditors, which forced Chinese authorities to intervene and demand that banks become more lenient in demanding loan repayment, effectively implementing yet another stealthy bailout of Chinese markets.
Commenting on China’s broad (ab)use of loans issued with stock as collateral, one month ago Goldman said that “users of financial leverage in equities have shifted from individuals to major shareholders in the form of Stock Pledged Loans (SPL)” this time around with “the risks revolving around SPLs being the major concerns in this market downturn.”
The bank also estimated that roughly 1 trillion in stock-pledged loans currently face a margin call risk, with the threat naturally rising the lower stock prices drop.
The reason we remind readers of this particular episode, is that soon it may be US markets that are affected by underwater margin loans.
According to Jim Steiner, head of Wells Fargo’s ultra-high-net-worth business, billionaires and millionaires in the U.S. are arranging scrambling to arrange the same kinds of stock-loans, to have funds readily available so they won’t have to sell off investments when the next market downturn comes.
“They always want to have lines in place for if markets do turn down and they get capital calls on private investments,” Steiner, who leads Wells Fargo’s Abbot Downing, told Bloomberg Television. “They want to be able to make those capital calls through use of the line as opposed to basically selling equities in the public markets.”
Steiner has the privilege of working at one of Wells Fargo’s units that has seen strong demand for its services: Abbot Downing has expanded into a $43 billion business since the brand started in 2012, and lending has increased by 5% in the past year. According to Bloomberg, Jon Weiss, head of Wells Fargo’s larger wealth and investment-management arm, said earlier this month that he plans to combine Abbot Downing with Wells Fargo’s private bank, which serves clients with at least $2.5 million, under one leader as part of his quest to streamline operations since taking over last year.
As Bloomberg reported recently, at a time when the middle class is generally sinking across the globe and leading to a wave of populism in politics, global personal wealth – which serves ultra high net worth clients – has ballooned to a record $201.9 trillion last year, boon for the private-banking industry. Morgan Stanley and Goldman Sachs are among the other firms seeking to lend more to the ultra-rich, pegging loans as a key area for growth.
So why the surge in demand for stock-pledged loans all of a sudden?
“All crises get more challenging if you have a lack of liquidity and then you also have leverage, and so I think they want to make sure that they’ve got some powder dry – that they don’t have to be selling equities into a down market,” Steiner said, bringing to mind some other vivid examples such as Elon Musk who has taken out hundreds of millions in loans pledged to his Tesla stock.
Of course, what he is describing is the ultimate BTFD trade, one where instead of selling one effectively doubles down with leverage to avoid liquidating assets. While such a bet may prove successful if stocks do indeed stage a rebound, it threatens to lead to even wider losses should a bottom for stocks not emerge, resulting in even broader liquidations as banks force their clients to liquidate the underlying stock collateral, accelerating the market crash.
For an example of just this, look no further than China.
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