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Trouble Might be Brewing for Custom Loans to Wealthy Clients

By Miriam Rozen October 31, 2018

Custom loans to financial advisors’ high net worth clients bolster the bottom lines of broker-dealers’ parent companies.

That trend became apparent again this month when Morgan Stanley, UBS, Raymond James and Bank of America, which owns Merrill Lynch Wealth Management, all reported such loans boosted revenues, at a time when commissions-generated fee income continues to fall.

Bank of America’s Global Investment and Wealth Management unit, which includes Merrill Lynch, reported average loan balances increased 5% year over year to $162 billion for its most recent quarter, driven by residential mortgages and custom lending. It was the 34th consecutive quarter of loan growth for the company.

Similarly, Morgan Stanley reported loans for the same period climbed 7% in the past year to $82 billion, and interest income from them jumped 22%. UBS reported loans increased by 8% for that period. At Raymond James, net loans hit a record $19.5 billion, representing growth of 15% over September 2017 and 3% over June 2018, the company said.

“It’s really become second nature to introduce existing clients to the broader capabilities of the company. It’s just something that everybody is doing,” a top senior member of the Merrill Lynch team told reporters at a press conference after the company’s earnings were released on Oct. 15.

“We look for creative ways to unlock the power of our clients’ money and that includes margin-based loans for the purchase of other assets,” says Joe Birkofer, a financial advisor at RIA Legacy Asset Management in Houston, which has more than $500 million in assets under management and a brokerage and clearing arrangement with Charles Schwab Institutional.

“We have no compensation or interest income in those transactions. But we understand the power of leverage for our clients,” Birkofer says. “We don’t want to incur leverage other than for the pure economic reasons for leverage.”

Just this month, Birkofer opened up convenient accounts for two clients where each will “park significant amounts” of margin loans, he says. Legacy segregated those assets from the clients’ other assets and it will not charge AUM fees on them. “We don’t feel it’s appropriate to charge,” Birkofer says. The loans are underwritten by Schwab.

But Birkofer’s role in securing those loans helped him strengthen his ties to the clients, he says. “They are extremely sticky. And the client looks at you like a hero for getting them the money,” Birkofer says.

Howard Diamond, the chief operating officer and general counsel of Diamond Consultants, a New York-based recruiting firm, views the growth of loan revenues at wirehouses as a win-win situation for advisors and their employers.

“The wirehouses tend to offer better rates than commercial banks and the advisors take great pains to make sure their clients are getting the better rates -- they are working with the loan officers,” Diamond says.

Also, portfolio-based loans don’t necessarily make it more difficult for advisors, who want to switch employers, to move those types of borrowing clients with them, Diamond says. Often the advisors’ new employers offer their borrowing clients better loan terms to get them to move as well, Diamond says.

Might the incentives employers offer financial advisors to introduce clients to the loan officers create potential conflicts?

“Anything can create a conflict if you have unscrupulous advisors,” Diamond says. “But the fact that loans are good for the firm doesn’t mean they’re bad for the client,” he adds.

Danny Sarch, a recruiter and president of Leitner Sarch Consultants in White Plains, N.Y., agrees that financial advisors can secure better relationships with clients by securing them loans — both mortgages and portfolio-based borrowing.

But, Sarch says, “it’s important to distinguish” between those two categories. Portfolio-based lending has the potential to raise significant problems for advisors if market corrections dramatically decrease clients’ asset values. Such an scenario may put advisors in the uncomfortable position of asking clients to pay off loans at an unexpectedly accelerated pace and to sell investments at losses in order to do so.

Both mortgage- and portfolio-based loans may also make it more cumbersome for advisors to move clients to a new employer, Sarch says. The fine print in the loan agreements can require sales of assets to move portfolio-based loans. And for low mortgage rates, some banks require that the borrower also keep other assets housed with them — making an expensive loan refinancing a likelihood if borrowing clients seek to move their investment accounts to advisors’ new employers, Sarch says.

He also foresees potential conflicts between advisors and borrowing clients, particularly given the way Merrill Lynch has structured its compensation grid.

Howard Diamond

Merrill Lynch dings advisors’ pay rates if clients’ assets under management decline regardless of the reason, Sarch says. Under Merrill Lynch’s formula, advisors lose two ways if clients pay off loans with assets under management: the clients’ AUMs shrink and the loans disappear from Bank of America’s books. Both events reduce the advisors’ payouts.

If Merrill Lynch used more refined measures for evaluating when clients’ AUM shrink — identifying, for instance, whether the assets went to pay off a loan, rather than to a rival wirehouse — those potential advisor-client conflicts would not arise as frequently, Sarch says.

“Merrill Lynch can see if clients move assets out to Morgan Stanley, or to pay off a loan or a tax bill – something that the advisor doesn’t control,” Sarch says. Where clients move assets should be factored into advisors’ compensation grids. By including that data, Merrill Lynch management could prevent advisors from having their take-home pay dinged when clients have sound reasons in their best interests — such as paying off loans — to shrink their AUMs, Sarch concludes.