Pledged-asset mortgages wrestle a bear market
By Michael D. Larson • Bankrate.com

The stock market's swoon has battered investors over the past year and a half. Thanks to so-called "pledged-asset mortgages," it's doing the same thing to some homeowners.

The mortgages allow customers of certain brokerage firms to buy homes without selling their portfolio holdings and putting the cash raised from those sales toward down payments. Instead, borrowers "pledge" a portion of those holdings to their brokers.

The maneuver allows investors to keep more money in the market, which is supposed to increase their returns. By not selling stocks and bonds, they can avoid certain taxes too.

But in a cruel twist of fate, stocks have plunged over the past months while home prices have gone through the roof. As a result, thousands of dollars that borrowers could have put toward building equity have instead vanished in a puff of Nasdaq smoke.

"These kind of programs work extremely well when the stock market is very bullish and the real estate market is very flat," says Anthony Sanders, John W. Galbreath chair in real estate at Ohio State University in Columbus, Ohio.

"But the equity markets are pretty much getting crushed at the moment and the housing market continues to be strong.

"That's the risk."

How it works
Pledged-asset mortgages have been around for a long time, but increased in popularity during the stock market rally of the 1990s. Fidelity Investments, for instance, rolled its product out in November 1999 at the height of the dot-com boom.

The programs work like this: Someone with a $100,000 portfolio pledges, say, $50,000 to the brokerage and gets a $200,000 mortgage to buy a $200,000 home.

The amount a customer is allowed to pledge depends on the mix of assets in the portfolio. A person with a conservative portfolio of bonds can usually get up to 50 percent of the portfolio's total value while someone with a portfolio of risky stocks would have a lower pledge limit.

Technically, the customer signs a margin loan agreement with the brokerage. But unlike with a traditional margin loan, the borrower doesn't have to pay interest on the amount pledged.

Under a traditional mortgage setup, the borrower would have to sell the $50,000 worth of securities and give the cash to the home seller. By keeping that money in the market, the customer avoids the capital gains taxes that come with sales of securities that have appreciated in value. The borrower also benefits from the fact stocks usually appreciate more quickly than homes.

Then the walls came down
Yet therein lies the rub. In 2000, the Nasdaq plunged 39 percent. Through the end of August, it had fallen another 25 percent. The Dow Jones Industrial Average, meanwhile, declined 6.2 percent in 2000 and another 6.5 percent in 2001.

Between January 2000 and July 2001, by way of contrast, the median price of an existing home climbed to $150,800 from $133,000 and the median price of a new home rose to $168,300 from $163,500.

Because of those disparities, pledged-asset mortgage holders are hurting while traditional borrowers are doing just fine. An investor with a stock-heavy portfolio who chose a pledged-asset mortgage two years ago, for instance, is now stuck with a larger-than-normal mortgage and thousands of dollars in market losses.

A conservative borrower who chose to convert securities into cash and put that cash toward a down payment, on the other hand, not only avoided a precipitous decline in the value of those securities, but also ended up with a smaller mortgage. That means the person has lower monthly payments and will pay thousands less in interest.

"It could be the right thing if someone has a significant amount of net worth in something that's very fast growing. It can work," says George McReynolds, a certified financial planner in Feasterville, Pa. "But leverage is a two-edged sword."

For example, if the value of a brokerage customer's $100,000 portfolio declines to, say, $70,000, and the person has pledged $50,000, the person can get a margin call. That's because brokerages set requirements on how much of the portfolio's value has to be the customer's own (i.e. unencumbered with a pledge). A firm might require someone to "own" at least 35 percent of the portfolio.

In this case, after subtracting the $50,000 pledge amount, the customer would only own $20,000, or 29 percent of the portfolio's updated $70,000 value. If the borrower couldn't come up with $4,500 in a few days, the customer could be required to start selling portfolio holdings in an attempt to convert at least 35 percent of the overall portfolio's value into cash.

"Why would you put all of that in jeopardy by taking more or unnecessarily risk?" McReynolds says.

No trouble for the savvy
Fidelity representatives counter that borrowers who use pledged-asset mortgages aren't having much trouble despite the market's malaise. They say not one borrower has gone delinquent on his or her payments to GMAC Mortgage, the company that actually originates the mortgages for Fidelity customers via a partnership. The Boston-based brokerage wouldn't say how many loan customers it has.

"It has actually continued to work well for us and for the customers. A big part of that is we've been careful when folks have inquired about the product to make sure they really understand how it works and what the risks are," says Scott Miller, a vice president at Fidelity Brokerage.

"The folks who are interested in it tend to be customers with higher levels of assets and in many cases they are already trading individual securities and using margin," he adds.

"They're comfortable with it. They understand it. And they have a fairly comfortable cushion with the amount they're pledging."

A typical customer might have $800,000 in assets -- rather than $100,000 -- and only pledge $50,000, Fidelity says. No one can say for sure whether real estate will continue to outperform the market either. If stocks rebound and the pace of home price appreciation slows, investors who stay the course will look like geniuses.

Nevertheless, experts say they hope consumers considering pledged-asset mortgages have learned a valuable lesson about risk over the past several months.

"I don't want to pooh-pooh it because the idea makes some sense," says Ohio State's Sanders. "If you finance the whole kit and kaboodle and you get a bigger deduction and if the stock market booms, your securities make a ton of money and you don't have to sell the securities and get your capital gains tax.

"All this is very good ... except in a time where the stock market is declining precipitously," he adds. "There are always tradeoffs and some of the tradeoffs are quite expensive for people."