Friday, December 12, 2014

Pledgeable Vanguard accounts

When I see houses, I see collateral.

It's good for regular people to have access to some good collateral. Without good collateral, it's very costly to respond to income shocks, emergency spending needs, or an awesome business idea. You may have to resort to credit card borrowing or even payday lenders. So this is one point in favor of owning a house: it gives you a way to accumulate collateral--so emergency borrowing isn't insanely expensive--while also providing you with housing services and a way to accumulate wealth with a little leverage.

But a house is a really weird asset! Is it really optimal to have housing be the only source of collateral for regular people? I have wondered this for a long time. If housing is the only source of good collateral, I'm going to devote a lot of saving to the accumulation of housing when it might be better if I could devote that saving to more diversified assets with higher returns. But I don't have an easy way to use my Vanguard account as collateral. I don't mean for margin trading, which is way beyond my risk tolerance. I mean I want to be able to use my portfolio to take on some uncallable debt. Unlike a house, my Vanguard account is intentionally structured in a way that minimizes exposure to idiosyncratic risk. It seems like it would make pretty good collateral, particularly over a multi-year period. We could even stick to real estate and focus only on the REIT fund if you think stocks are too risky or whatever. But, to my knowledge, there's no way for me to pledge my Vanguard portfolio. The closest thing I can think of is the rule about taking out loans against a 401k, which is very costly.

So, for regular people, financial assets are not pledgeable. Why?

Joshua Brown reports on an "exploding" trend among wealth management providers:

Wealth management clients of the wirehouse firms keep millions of dollars in their taxable brokerage accounts, predominantly invested in stocks, bonds, and mutual funds. Advisors at the firm are encouraged to convince their clients to borrow against these holdings. Clients are offered an ultra-low interest rate, typically between 2% and 5%. And they can borrow between 50% and 95% of their portfolio’s equity (cash) value, with the bond-equity mix of the account being the primary determinant of the loan’s size.

The only rule is that clients cannot use the loaned funds to purchase additional securities, like a margin loan. Instead, these borrowings are meant to allow clients to smooth out cash flow at a small business, fund the purchase of artwork and real estate, or refinance higher-rate loans like mortgages. The beauty of securities-based lending is that these are not underwritten loans nor do they require extensive due diligence because the assets are already sitting there at the firm and public securities are thought to be extremely liquid.

This is what I'm talking about! So it's a thing, but apparently it's only available to really wealthy people. Moreover, Brown describes a bunch of other problems with it. Apparently the loans are typically callable, so the lender can liquidate the collateral at will. And there are likely some systemic risks associated with the way this is being done (sort of like, you know, home equity borrowing).

So this isn't quite what I'm looking for. Housing will still carry a large liquidity service yield. If I want to accumulate a lot of collateral, it means accumulating a lot of housing inventory--maybe even more housing inventory than I need. Practically every homeowner I know holds more housing inventory than they need. That's like owning a stock but throwing away half of the dividends. But it's a pretty natural outcome when housing is seen as the best mechanism for accumulating wealth and collateral (obviously that's not the only reason people accumulate extra housing). I would rather live in a house that provides exactly the amount of housing service I need--and put my excess savings in other assets whose production I can capture in its entirety. That strategy would be less costly if my Vanguard account were pledgeable.

The aggregate consequences are less clear. Brown argues that the current trend toward collateralizing financial assets for rich people causes systemic risk. But if financial assets became pledgeable, maybe people would live in houses that are less leveraged. The net effect on systemic risk isn't clear. It might also free up resources that are currently tied up in unproductive spare bedrooms, providing more savings for productive assets. Maybe the quantitative magnitudes on that notion are pretty small. But the point is: It's not obvious to me why we have a system that so dramatically favors housing as collateral.

UPDATE: My friend Jared Larsen points me to some details about a similar service provided by Charles Schwab. The minimum credit line is $100,000, so it will still be mostly available to the well-to-do. You can borrow up to 70% of the value of the collateral. The line is subject to collateral calls, and CS can sell your collateral without your consent (or even awareness). This is available in taxable accounts. So I find this pretty interesting--the thing I'm asking for is available, more or less, but I wish it were available at smaller dollar amounts.

3 comments:

  1. First line makes me think of a tag line for a movie about an oddly insightful finance person: "I see debt, people." Maybe call it "The Sixth Cent"

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  2. Asking why you can't borrow against your Vanguard account seems to me like asking why you can't borrow against your checking account. If you have liquid assets you don't have to borrow, you can cash in your assets and consume them. Instead of paying back the loan, when money starts to come in you can easily buy more Vanguard.

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    1. But stocks aren't as liquid as checking accounts! So it depends on how the transaction costs for getting the loan would compare with the transaction costs for selling/buying stocks. The latter involves taxes.

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