It could be the worst nightmare of every financial planner who ever has counseled a client about a pledged-asset mortgage. After a client pledges securities instead of cash toward a down payment for a mortgage, the stock market tanks and there is a margin call.
This bad dream has hit home. One of America's bravest, a firefighter in North Palm Beach, Fla., has filed an arbitration claim with the NASD against Merrill Lynch and one of its brokers. The firefighter, Robert Kellogg, says he almost lost his home after loading up on tech and telecom stocks at his broker's suggestion-after he had pledged part of his portfolio as collateral for a Merrill Lynch mortgage. The market's subsequent decline allegedly triggered an automatic sale of all his stocks at market bottom.
Kellogg says he was never warned.
"The terms of the mortgage were clearly communicated to Mr. Kellogg, who understood the need to maintain collateral in his account," Merrill spokesman Bill Halldin, countered in one media account. Halldin said Kellogg definitely was notified of the risks.
As the S&P 500 dipped more than 40% over the last 21/2 years, pledged-asset mortgages may not be the darlings they once were. After Merrill pioneered its "Mortgage 100" product in 1992, other brokerages and mortgage companies quickly jumped on the bandwagon. They were touted as a dream way for investors to have their house and grow their stock portfolios too. Borrowers simply pledge securities in lieu of cash, often as a down payment.
Now, however, the tune has changed. NASD statistics indicate that margin-call arbitration claims in general are on track to hit a record. With 195 claims through June, they threaten to surpass last year's record of 375. In general, margin loans peaked at close to $300 billion in March 2000, the NASD reports, before beginning a descent to $154 billion at mid-year.
Bruce Katzen, Kellogg's attorney and a Miami-based securities litigator with Kluger, Peretz, Kaplan, & Berlin, says he sees two major potential abuses with securities-linked mortgages. However, he does not believe the abuses are very widespread.
Brokers, he says, risk marketing the product to people for whom it is inappropriate. For example, say the mortgage involved has a flat interest rate for five years and then rises, triggering an increase in monthly payments. Meanwhile, there is no reduction in principal after five years. This, he notes, should not be sold to a retiree, who gets sucked in with a low rate and has trouble meeting payments after that.
The other type of abuse, he says, directly affects the linkage of mortgages to securities. An account may be liquidated "without regard for the customer's interest," he says.
Roderick Powell, senior equity analyst for Weiss Ratings Inc. in Palm Beach Gardens, Fla., says brokerage documents and brochures for these products too often gloss over the possibility of the brokerage firm actually liquidating their accounts. "You see one sentence in very tiny print," he says.
Some issuers, in the wake of the market's ills, have put these controversial mortgages on the shelf. Published reports indicate MortgageIT.com, the online retail lending division of MortgageIT Inc. in New York, once hoped to make pledged-asset mortgages popular on the Internet, but the company now disavows that it ever had any affiliation with them. "We have never done these types of loans," declares Norm L. Merritt, president of MortgageIT.com. MortgageIT's predecessor company, IPI Skyscraper, did a few very large loans. But Merritt says "it has never been a significant part of their business nor is it part of their strategy. We're very concerned about our customers making sure they don't get themselves into situations that can be tough for them."
GMAC Mortgage of Horsham, Pa., which once offered a "Pledged Asset Plan" with Fidelity Investments, has pulled the plug. "We discontinued the program a year ago," said GMAC mortgage spokeswoman Erica Stoddard. The company cites a redirection in strategy to portfolio retention and affinity-based businesses.
And Wells Fargo Home Mortgage in Des Moines, Iowa, has been reported to be piloting the product at least as far back as September 2001. It is continuing that pilot with UBS PaineWebber. But Wells Fargo spokeswoman Ahnalee Luchtel declines to talk much about it. "We're not backing off from the product as a result of the market environment," she says. "However, there has been a drop-off in demand for this product from consumers."
Despite the stock market slump, these products are far from dead and buried, and actually still have many fans. "We're currently in the process of looking for another vendor to offer it to our customers," says Fidelity Investments spokesman Jim Griffin.
Ralph Melbourne, director of national corporate sales for Citimortgage in St. Louis, says its "Preserved Asset Mortgage" still is an important offering, sold by brokers of affiliate Salomon Smith Barney. It is available on virtually all mortgages except FHA and VA loans. Citimortgage retains the mortgages in portfolio.
Melbourne acknowledges that volume has dropped, but not, he says, due to the declining stock market. The culprit is the fact that the market has switched to refinances rather than mortgages used to purchase property. "As the percentage of refinances go up, we do less Preserved Asset Mortgages," he says.
Melbourne says that Citimortgage kicked off its mortgage business with Salomon Smith Barney in mid-1998. The Preserved Asset Mortgage debuted about six months later. It lets borrowers pledge up to 100% of the home's value as securities. Say a customer wants to borrow $500,000 and put down 20% in securities.
Under the program, Citimortgage would take the standard margin maintenance requirements-50% for stocks-and add a 15% cushion.
Brokers selling the mortgage carefully scrutinize securities that are pledged as well as the concentration in any one sector, he says. Melbourne estimates that between 15% and 20% of the nearly $200 million in mortgage volume that Salomon Smith Barney generated in 2001 was in Preserved Asset Mortgages. The product had peaked at as much as 30% of the brokerage's annual mortgage volume. Although there may have been margin calls on the loans in line with the market, Melbourne said, there were no defaults.
Melbourne believes that as the market shifts from refinances to purchase mortgages, sales of the product quickly will bounce back to 30% of total volume. Charles Schwab, which has been rumored for some time to be looking at a securities-linked mortgage, still is examining it. "We have a vendor relationship with E-Loan (Inc., Dublin, Calif.) which offers mortgages at Schwab," explains Schwab spokesman Lance Berg. "Our spending has been impacted given market conditions. Top priority projects are receiving funding today."
While some advisors long have warned about the risks of linking securities to mortgages, at least one says he is eagerly awaiting the Schwab pledged-asset mortgage. In fact, Richard Stone, CFP and owner of Salient Financial Corp. in San Rafael, Calif., says that he has been using a modified version of the product in the last year. He has been advising certain clients to do a cash-out refinance on their homes or take out a home equity line at low rates to invest in the beaten-down stock market.
"Loan rates are very low," he explains. "You can get 4.5% for a home equity credit line. That's a wonderful opportunity." Stone says that he only uses this aggressive strategy with clients who have substantial assets and stable income. The borrowed money is invested in a globally diversified portfolio of index funds for the long term. He acknowledged that at this writing, the strategy was under water.
If your clients take advantage of this opportunity for leverage, he warns, you need to watch for a prepayment penalty on a loan. "This is not a strategy recommended for everybody and widows and orphans," Stone says. He estimates that he uses the strategy only on about 5% of his client base.