00004 Special Topic: Systemic Risks You Must Know About Securities-Backed Lending! Know the Risks; Understand the Risks; Control the Risks!

Related Materials

• Previous presentation: November 27, 2023 Recalculation: The Very Different Fates of Buying and Renting After Thirty Years, Second Edition
• Next presentation: 2x and 3x Leverage

Document Text

How to Avoid Bankruptcy Risk From Securities-Backed Lending

Some people believe that spending only 3% of assets per year means the money will never run out. Others worry that 3% may not be enough, and that a market decline could create risk. The same issue looks different from different perspectives.

In my observation, people who question 3% spending fall into two groups.

The first group is truly wealthy. When assets exceed hundreds of millions of US dollars, or tens of billions of Taiwan dollars, they may find that spending 3% per year is too little and cannot be spent in a lifetime. Wealth at that level can withstand past, present, and future market risks.

The second group is ordinary investors, for whom 3% of assets is just enough to support retirement. Those who worry that assets may be exhausted, or that systemic market declines may create risk, usually have fewer assets.

Some friends are now in the second group. In the future, I hope everyone becomes the first group, wealthy enough that money cannot be spent.

Charles Schwab's pledged lending interest has two components:

One is the spread, which depends on asset size and is fixed after approval.

The other is SOFR, which fluctuates with central bank interest rates.

So Today's Spread Can Be 2% Plus SOFR at About 5.5%, or Roughly 7.5%

If assets are smaller, the spread may be 4%. With SOFR at 5.5%, interest is now about 9.5%.

I have said before: only use PAL when assets exceed US$1.5 million.

For smaller assets, applying for PAL can be an emergency backup, but try not to use it.

Our recommendation is that even if you can borrow, do not repay unless you must. If objective conditions change and force you to repay, that means you should not have borrowed at the start. It means you did not truly have the ability or conditions to borrow. Before borrowing, everyone must evaluate asset conditions, risk tolerance, and personal circumstances. Securities-backed lending risk is very high. It is not a very safe loan, but if controlled well, it can be a very useful financial tool.

The safest borrowing is usually real estate mortgages or, in Taiwan, unsecured personal credit loans, because as long as you make fixed repayments, there is no liquidation risk. Securities-backed lending is different; market fluctuations create risk.

Whether you invest in the Nasdaq 100 index fund or the S&P 500 index fund, and whether you spend 2% or 3% of assets per year, it is difficult to avoid changes in the external environment. If interest rates reach 8%, 9%, or higher, or if the market falls more than 80%, these are not risks we can control.

For example, if you retired at the 2000 market peak and began borrowing against stocks, the market fell from 2000 to 2003. After only three years, 3% annual spending plus interest could make debt equal to about 12% of the original retirement assets. The market later rose before the 2008 financial crisis and bottomed in March 2009. Over roughly nine years, additional spending might reach 24% of the original peak assets, plus the earlier 12%, for total debt near 36% of original assets. If the market fell 80% from the 2000 peak, assets would be only 20% while debt was 36%, meaning bankruptcy. That is the risk of securities-backed lending.

You can start with the method we discussed before: begin by spending 2% of assets, and only gradually increase spending after assets have grown for several years. For example, if you have US$1,000,000, start with US$20,000. If you have US$3,000,000, start with US$60,000 per year. If you have US$5,000,000, start with US$100,000 per year. After that, keep annual spending fixed at the starting amount.

To Avoid Objective Systemic Market Risk, Keep Cash Equal to the Debt Amount, Because Cash Does Not Fall No Matter How the Market Falls

After five years or longer, if assets have increased, slowly raise spending. This can prevent borrowing from accumulating too much and exposing you to systemic market risk. Even then, borrowing may exceed 20% of pledged assets. From 2000 to 2009, because the market bottom came many years later, this was a major risk. The danger occurred around late 2008 and early 2009, so everyone must be careful.

Even if borrowing is below 20% of pledged assets, objective systemic market risk is still hard to guarantee against. If the market falls more than 70%, 80%, or even 90%, and interest exceeds 10%, that is beyond our control. To avoid that risk, use the following method.

This is why Buffett keeps a relative cash position. Buffett also borrows money like us, but he keeps a lot of cash. His cash position is almost equal to debt; by my calculation, cash is about 5% higher than debt. This is approximate data. Borrowing and holding cash complement each other; neither should be missing.

Your Investment BETA Will Be Between 0.8 and 1.0 Depending on How Much You Borrow

If you keep cash greater than or equal to debt, you do not need to fear objective systemic market risk or interest-rate risk.

Even while holding cash, we can use leveraged funds to keep overall investment beta at 1.0.

Leveraged funds' decline converges over time. In a long bear market, their long-term decline is less than their leverage multiple might suggest.

Holding leveraged funds and cash does have side effects, such as volatility decay, but this is a necessary cost of controlling risk.

US investors can keep cash in a ROTH retirement account equal to the PAL borrowing amount, and hold an equal amount of QLD. If uncontrollable systemic market risk appears, at least the cash in the ROTH can be transferred to a regular investment account to avoid liquidation.

If US investors do not have enough retirement assets and most funds are in a taxable brokerage account used for PAL, then the regular account must hold 20% cash and 80% index funds. If long-term capital gains can be used for adjustments, that is acceptable in a taxable account. Even if you use pledged borrowing, you must always keep 20% cash or cash equal to the pledged loan amount.

The portfolio beta will be between 0.8 and 1.0 depending on how much is borrowed and whether 2x leveraged funds are used. Because you do not need to sell large amounts of stock every year, the tax savings are still worthwhile. This is a compromise for people without retirement accounts. It is imperfect but acceptable. Having no cash position is actually very risky.

If you are still working, as long as borrowing does not exceed 20% of pledged assets, or 20% of all account assets, and salary income can continue adding to assets, the risk may not be especially high.

The real risk is for retirees with no income whose borrowing after several years approaches 20% of assets or more. Systemic market risk could cause account liquidation. Remember to keep enough cash to resist systemic market risk.

If you are in the United States and do not have a ROTH account for cash, keep cash equal to or greater than borrowing in a taxable investment account. Selling in a taxable account may create capital gains tax. But for retirees with no other income, long-term capital gains may have a US$50,000 exemption for singles or US$100,000 per year for couples. When you need cash, you can convert stock index funds to cash as long as annual capital gains do not exceed the tax-free amount.

After Discussing How to Avoid Systemic Risk From Excessive Pledged Borrowing, Let Us Discuss Spending

Taiwan investors can use 00864B and 00670L: keep 00670L equal to the pledged borrowing amount and keep 00864B cash equal to or greater than the pledged borrowing amount, maintaining beta 1.0.

There is no conflict between spending appropriately and the rule that annual spending should only be 3% of assets.

If you have NT$10,000,000, or US$1,000,000 in the United States, and can only spend NT$300,000 or US$30,000 per year, spending more creates risk.

When NT$10,000,000 grows to NT$50,000,000, or US$1,000,000 grows to US$5,000,000, you do not need to spend NT$1,500,000 or US$150,000 per year, but spending around NT$1,000,000, or an appropriate US amount, is reasonable.

The key point comes when you have NT$1 billion or NT$10 billion, or in the United States US$100 million or US$1 billion. If you spend less than NT$30 million or NT$300 million per year, or less than US$3 million or US$30 million, do not restrict yourself to only a small amount. At that level, you should begin trying to spend. Spending money becomes moral.

When Money Is So Abundant That You Cannot Spend It All, Spending Becomes Moral

When you have so much money that market declines are no longer a risk, you should begin giving money away, starting from those closest to you and moving outward. Spending is not only moral, but in line with the natural order.

But spending money does not mean wiring cash directly into someone's account. You must understand what that person actually needs. Sometimes spending money to help requires thought. Hungry people need bread; old things may need replacement; poor young people may need tuition. Do not simply put cash in someone's account. Many people cannot manage money, and cash in their account may harm them. When helping others, do not just give cash; give goods, travel, medical expenses, or tuition. Wiring US$1,000,000 directly is not helping but harming.

Investment audiences need risk, risk, risk: know risk, understand risk, and control risk.

Knowing how to spend and help others requires thought. Donating money is often inefficient, and wiring money into someone's account can be the worst method. You should think about the recipient's needs, use goods or specific payments to solve problems, and use money to help solve those problems.

Directly Wiring Money Into Someone's Account Is the Most Direct Way to Harm Them

We should plan to spend our wealth completely, even to the point of leaving debts in heaven.