Margin lending in practice
Margin loans, first introduced to Australia by BT in 1979, have grown in popularity amongst investors as a way of achieving greater exposure to growth assets such as shares and managed funds through the use of borrowed funds. As of March 2010, Reserve Bank of Australia (RBA) estimates put the total value of the 222,000 margin loans in Australia at around $19.17 million. With new conduct and disclosure requirements governing the provision of margin loan advice due to commence 1 January 2011, it is important for financial advisers to understand what margin loans are, how they operate, and the benefits for clients using these products as part of a wealth creation strategy.
After the introduction of margin lending to Australia in 1979, a number of product providers entered the market following deregulation of the Australian finance industry in 1983. In June 1999, there was less than $5 billion in borrowings using margin loans. By December 2007, there were 200,000 loans worth more than $37 billion. While the number of loans has since grown, the value of the outstanding debt has halved in the past two years.
For clients with the right risk appetite, borrowing to invest — gearing — can provide a very effective way of enhancing returns on investments, as well as potentially increasing the losses. Gearing allows an investor to increase the amount of money available to invest and potentially enhance or leverage the possible profit from the investment.
For example
Julia has $60,000 saved in a bank account and wants to invest in shares. If Julia were to borrow additional funds, she could increase the total available funds for investment. If she borrows $40,000, this will provide a total of $100,000 for investment.
Because the overall objective of gearing is for income and capital growth from the investments to outweigh the finance costs over the long run, investors have traditionally geared into growth assets such as shares and property.
Margin lending is a particular form of gearing, whereby an investor borrows money to buy financial products. These products are specifically designed to enable a client to invest in shares and managed funds on either a lump sum or instalment basis. In the same way as property investment may use an initial cash deposit in order to access loan funds, margin lending facilitates the use of share equity, managed investments, other equity or cash as deposit capital to borrow against for investment purposes.
The underlying products are used to secure the loan. The amount that the investor can borrow is dependant on a number of factors, including the loan to valuation ratio offered by the lender on the securities within the portfolio. If the level of the investment falls below the level agreed upon under the contract, a margin call will occur. In this case, the investor is required to return the portfolio and/or loan to the agreed limits set in the contract.
Structure of margin loans
Margin loans are contracts. As such, the investor and loan provider enter into a contractual arrangement and, as with all loan arrangements, the investor incurs obligations to the lender. If these obligations are not met, the lender has several contractual rights. The lender also undertakes a number of commitments.
Making the loan: obligations on lenders and advisers
A margin lending strategy consists of a credit component (the margin loan) and an investment component (the underlying investments). In cases where the investment component involves a financial product, the Corporations Act 2001 (Corporations Act) has always applied to that component, but until recently, the credit component of the margin loan transaction was currently largely unregulated.
Under reforms introduced by the Corporations Legislation Amendment (Financial Services Modernisation) Act 2009, Chapter 7 of the Corporations Act now captures margin loans as a ‘financial product’. Margin lending providers and advisers are now transitioning to the licensing, conduct and disclosure requirements in this legislation.
Additionally, the provisions of the National Consumer Credit Protection Reform Package as reflected in the National Consumer Credit Protection Act 2009 and National Consumer Credit Protection (Transitional and Consequential Provisions) Act 2009, have created a responsible lending obligation on margin loan providers.
This obligation requires that before issuing a loan or increasing the limit of an existing loan, margin loan providers will be required to make an assessment whether the loan facility is unsuitable for a retail client. If the lender determines, on the basis of the information provided, that the client is unable to meet a margin call or might not be able to if they suddenly faced financial hardship, the loan application would be assessed as unsuitable and rejected.
In making reasonable inquiries about the client’s situation, lenders may rely on information provided in a statement of advice (SOA) for the client, where the SOA recommends the margin lending facility, and it was prepared no more than 90 days before the day on which the margin lending facility is proposed to be entered into. In these circumstances, the provider is not required to verify the information. This reliance provision is intended to minimise the regulatory burden on lenders and the impost on consumers where the same information has already been provided to an adviser.
However, it does serve to highlight the importance of an adviser collecting all relevant information during the fact find interview and confirming details at the presentation interview.
The responsible lending obligation applies only to lenders, and not to advisers, however, the usual requirement for financial advisers to have a reasonable basis for advice continues to apply. The Corporations Act requires advisers to make reasonable enquiries and determine relevant personal circumstances, give reasonable consideration to and investigate the subject matter of advice and ensure the advice is appropriate.
As such, advisers may evaluate whether a margin lending facility will be reasonably likely to satisfy critical aspects of the client’s relevant personal circumstances, including the capacity to service a margin loan, investment goals and objectives, and the client’s risk profile.
Interest rates
Interest on the loan is the cost of borrowing money through the margin loan facility. Interest rates are often higher for margin loans than other borrowing sources such as home loans. However, this reflects the nature of the product which is specifically designed for clients investing in shares and managed funds. Interest can be paid in a variety of ways, such as monthly in arrears on the outstanding loan balance or fixed and prepaid a year in advance. Generally, the interest paid on money borrowed through margin loans for investment purposes is tax deductible to the taxpayer.
Loan security
A margin loan is secured by underlying investments. Even a basic margin lending facility will generally allow investors to use shares, managed funds or cash as security.
Where cash is provided as collateral for the margin loan, it may be used to purchase either shares or managed funds to establish the investment portfolio. Alternatively, an investor may already own shares or managed fund investments and these can also be used to secure a margin loan. Usually, shares and managed funds are secured by a mortgage. However, as there is no change in beneficial ownership, clients retain their rights attached to the investment, such as entitlement to distributions as well as any voting rights.
Loan to valuation ratios
Once the margin loan is established, investors are able to gear their portfolio by borrowing money to invest, increasing the potential returns compared with investing savings only. Investors can normally borrow between 40% and 70% of the value of the underlying investment. Investment options will vary depending upon the provider, as will the amount that can be borrowed against the securities.
Margin loan providers have a preset maximum proportion of an investment amount they will lend up to. This is known as the loan to valuation (or value) ratio (LVR). Loan to valuation ratios are used to establish the maximum size of the margin loan available and also when a margin call should be initiated. The LVR is based on the borrowing limit for the security and the investor’s contribution. Lending limits are usually
established for specific shares and managed funds and these dictate the maximum gearing ratios that are allowable.
For example
ABC Margin Loans is a margin loan provider. It sets its maximum LVR at 70%. This means that for every $1 of investment, 30 cents would be provided by the investor and the remaining 70 cents by the loan provider.
At this level, if an investment has a value of $100,000, then the maximum loan amount that can be attached to that investment is $70,000. An investor would have to maintain at least $30,000 equity in this investment.
Put another way, if the client has $30,000 in cash, they can borrow $70,000 from a margin loan provider to buy a share portfolio worth $100,000 — the LVR is 70%.
Lending limits are determined by:
> The investments offered as security and purchased using the margin loan facility. Different shares and managed funds have different risk factors and as such, margin loan providers specify a lending ratio for each investment that they are prepared to lend against. A blue-chip stock such as BHP Billiton may have a higher ratio at 70% compared with a riskier investment such as a small companies managed fund which may have a ratio set at 50%. Lending ratios can change at any time without notice and can even be reduced to 0%.
> The loan provider. They set the lending ratio of every eligible investment, which sets the level of the LVR as well as the related buffer. These vary from provider to provider.
> The level of diversification in the portfolio. The more stocks and managed funds held in a portfolio, the higher the LVRs generally offered for that portfolio overall. This is because a diversified portfolio presents a lower security risk for the loan provider than a portfolio that is dominated by a single stock.
> Fluctuations in the market. The LVR changes according to the value of the investment, increasing or decreasing in line with the value of the portfolio. The lending ratio is applied to the new portfolio value, so if the investment increases in value, the loan limit increases and additional funds are available for the client to use if they wish to expand their Portfolio. Conversely, if the investment decreases in value, then the loan limit will also decrease.
The LVR is an important concept. From a risk management perspective, the LVR also determines the lender’s exposure in the event of a default, as well as the level at which the proportion of the client’s deposit capital will fall below the minimum acceptable level to the lender.
The LVR is determined by firstly establishing the maximum loan amount using the following calculation:
Maximum loan amount = investor’s contribution × borrowing limit
(1 - borrowing limit)
For example
Virginia has $45,000 to invest and the maximum LVR is 75%. The maximum loan amount is calculated as:
($45,000 × 0.75) ÷ (1 - 0.75) = $135,000.
Once the maximum loan amount for the margin loan has been established, the following LVRs can be determined:
> The base LVR, which is set at the time the loan is established. It is the maximum loan amount, divided by the value of the security (net of entry fees if applicable).
> The margin call LVR, which is the level at which a margin call is triggered. It is also set at the time the loan is established and represents the base LVR plus a buffer. The size of the buffer varies with different margin loan providers, but is commonly between 5% and 10% of the portfolio value.
> The current LVR, which is the outstanding loan balance divided by the current portfolio value. The current LVR will fluctuate in value over time. If the value of the portfolio falls it will rise and vice versa.
If the value of the portfolio falls and the outstanding debt remains unchanged, there is a chance that the current LVR of the margin loan could move above the base LVR into the buffer. In such a situation, even though the margin call LVR has not yet been breached, it is advisable to take action to reduce the risk of moving into a margin call situation. Additionally, while a client is in the buffer, they will not be able to withdraw funds or make further investments using the margin loan facility.
For example
In July 2008, Chris invested $25,000 and borrowed an additional $50,000 through a margin loan facility to purchase shares. At the time the loan was established, the base LVR was set at 70%, the buffer is 10% and the resulting margin call LVR is 80%.
In January 2009, his portfolio was worth $100,000. His current LVR at that point was $50,000/$100,000 = 50%.
By December 2009, his portfolio had fallen in value to $60,000. His current LVR at that point was $50,000/$60,000 = 83%. It is likely that a margin call would be made at that point, as the margin call LVR has been exceeded.
Margin calls
As well as the obligation to pay interest, a client who has taken out a margin loan has an obligation to settle any margin call that may be made.
When a margin loan is issued, a base LVR is set and the loan provider will seek to ensure the loan does not increase above this level. During periods of market volatility and decline, a client’s portfolio may also fall in value, but they are still obliged to repay any outstanding loan. If the LVR is breached, the loan provider will take steps to restore the level of borrowing by issuing a request to the borrower to provide additional equity, cash or equivalent. This is referred to as a margin call.
Margin loan triggers
Margin loans have a built-in buffer to absorb minor fluctuations in the marketplace to minimise the trigger of a margin call as a result of minor market price falls. A margin call is triggered when the balance of the margin loan exceeds the loan limit by more than the allowed buffer.
A margin call may occur for many reasons, including the following:
> The client’s portfolio falls in value as a result of a decrease in the share price or value of the managed fund units held.
> The client chooses to capitalise interest payments, which results in the
outstanding loan increasing over time relative to the portfolio value.
> The loan provider reduces the lending ratio on one or more of the shares or managed funds held in the investor’s portfolio.
For example
Natasha holds three types of shares in her portfolio:
1. 10,000 FGH shares currently valued at $4 each with an LVR of 60%
2. 2,000 WQD shares currently valued at $15 each with an LVR of 70%
3. 30,000 JKL shares currently valued at $3 each with an LVR of 50%
Her portfolio is worth $160,000 and the maximum margin loan that Natasha could hold is $90,000. This is calculated as:
(10,000 x $4 x 60%) + (2,000 x $15 x 70%) + (30,000 x $3 x 50%)
If the margin loan provider reduces the LVR offered on FGH and WQD shares to 50% in response to uncertainty about the risk profile of those stocks, Natasha’s maximum loan allowed drops to $80,000. Despite her portfolio value remaining unchanged, Natasha may be faced with a margin call if she has borrowed at or close to the maximum LVR.
Managing a margin call
A margin call may be managed by:
> repaying some or all of the outstanding loan to reduce the margin loan balance to below the base LVR
> providing additional shares or managed funds acceptable to the loan provider as security for the loan — this will increase the base LVR
> selling some or all of the existing shares or managed funds and using the proceeds to repay some or all of the margin loan. If a margin call has occurred, it is likely that such a sale will occur when the securities have fallen in value and this may result in a loss to the client
If the margin loan is not rectified, the loan provider has the right to the shares and managed funds as mortgaged property. As such, it can sell the securities to restore the loan to within the required LVRs.
For example
Using an earlier example, Chris receives a margin call in December 2009.
To restore his position, Chris may choose to take one of the following actions:
1. Deposit funds directly into his margin loan account. He would need to provide $8,000 cash to reduce his outstanding debt to restore the base LVR. At that point, his loan would be $42,000, representing 70% ofthe portfolio value of $60,000.
2. Provide additional approved security for the loan facility. Assuming the LVR for the securities is set at 70%, Chris would have to provide at least $11,430 worth of shares and/or managed funds to restore the base LVR. His portfolio would then be worth $71,430 with an outstanding debt of $50,000.
3. Sell a portion of his portfolio to repay part of the loan. He would need to sell around $26,700 worth of his portfolio and use this to repay the loan to restore the base LVR. After the sale, the remaining portfolio
would be worth $33,300, with an outstanding loan of $23,300. The disadvantage with this approach is that Chris would likely be selling shares when the market is fallen, possibly incurring a loss.
Notification of margin calls
Margin loan providers usually require the gearing level of the margin loan to be restored to the agreed limits within 24 to 48 hours after a margin call is made. Under changes made to Chapter 7 of the Corporations Act, the onus will fall upon the margin loan provider to take reasonable steps to notify the retail client of a margin call and their obligations.
The law requires that when a margin loan facility goes into margin call, the loan provider must take reasonable steps to notify the retail client under the facility of the margin call. This can include contacting the client via a range of methods such as email, phone and SMS.
The client has the option to nominate an agent, such as a financial adviser, to receive the margin call notification from the loan provider. For this to happen, there must be a written agreement in place between the loan provider, the retail client, and another financial services licensee party acting as an agent, such as the financial adviser. If such an agreement is in place, the agent will receive communications from the provider in relation to the margin lending facility on behalf of the client.
In this case:
a) the provider must take reasonable steps to notify the agent (instead of the retail client) of the margin call, and
b) the agent must take reasonable steps to notify the retail client of the margin call in accordance with this section.
In these circumstances, if the adviser (acting as the agent) is contacted by the margin loan provider, the obligations to fulfil the reasonable steps to notify the client of the margin call, will fall upon the agent.
Pros and cons of margin loans
The number and value of margin loans in Australia has increased significantly since their introduction in 1979. Even after the market adjustments during 2008 and 2009 which saw portfolio values fall substantially and the number of margin calls hit an all-time high of almost 10 a day for every 1,000 borrowers in the December quarter of 2009, margin loans remain attractive to many investors due to their leveraging qualities. The ability to claim a tax deduction for borrowing expenses is also seen as an advantage of this strategy.
However, there are a number of risks associated with gearing, particularly margin lending, and these need to be considered by investors:
> The strategy is riskier than using own funds to invest.
> Borrowing to invest is only worthwhile if returns over time are greater than the interest paid on the borrowings.
> If the investments do not perform, the losses will be magnified.
> The investor needs to be able to manage potentially large fluctuations in the value of the investments.
> Tax advantages may vary if tax rates and/or government policies change.
> Investors may lose their total investment as well as the borrowed funds.
> Interest rates may rise or fall, in turn affecting the value of the arrangement.
> The interest on borrowings must still be paid, whether or not the investor is in a financial position to continue to do so.
> Prepaid interest generally will not be refunded, even if the loan is partially or fully repaid within that time frame.
> If a margin call is made and not rectified by the investor, the loan provider may sell mortgaged investments to reduce the loan and this may result in a loss as well as capital gains tax implications for the investor.
Practical strategies and considerations for clients
In recent times, financial advisers have had an abundance of choice in products and services available in the market. The issuers of products and services in the gearing area were particularly active in the past few years. One likely reason is the buoyant stock market conditions that existed until mid-2007. Others include high levels of investor confidence and, some would argue, greed. The growth of margin lending alone has been extraordinary and even though the overall level of borrowing has fallen by around 50% since its peak in December 2009, the number of margin loans has actually increased in the past year from 200,000 to 222,000 as of March 2010.
Margin loans are not for every investor, and when considering recommendations incorporating these products, financial advisers need to ensure that clients:
> have an appropriate risk profile — most experts recommend a moderately aggressive to aggressive tolerance of risk
> are prepared to commit to at least a five-year program
> have a sufficiently high and secure income — the level depends on the type of gearing strategy (e.g. instalment vs lump sum)
> implement relevant insurances such as income protection insurance
> are comfortable and informed of the additional risks inherent in such a strategy
> have adequate liquidity to meet potential margin calls
> plan a strategy for meeting margin calls so if a margin call does occur; they are in a position to act decisively and promptly
> have sufficient equity in the asset for the strategy being considered
> reduce risk by investing in assets with a sound cash flow (with preferably tax-effective income)
> consider that with the tightening of credit markets, lenders are likely to be more cautious about to whom they lend and on what conditions — for margin loan providers, this has been seen in reductions in maximum LVRs both overall and for approved securities.
> are aware that downturns do occur and gearing increases the risks of investing
> use conservative LVRs — do not borrow to the maximum
> diversify their portfolio by investing across a range of companies and industry sectors, as this can help minimise the damage that one poor performing share could have on a portfolio — diversification also helps to smooth-out fluctuations in the value of a portfolio and can also lead to better long-term returns
> pay interest regularly rather than capitalising it into the value of the loan
> monitor the portfolio regularly to ensure that that the level of borrowing is appropriate for the current economic climate and possible future movements
> direct dividends and distributions into the facility, or reinvest into securities using dividend reinvestment plans.
For existing clients with gearing strategies, both advisers and clients should seek to:
> improve their level of education about the operation of margin loans
> review the portfolio regularly
> look at actual LVRs and manage the loan effectively
> ensure insurances are in place
> ensure sufficient cash reserves are available to meet a margin call if required
> consider dollar cost averaging through the use of instalment gearing
> work with the loan provider business development manager to ensure the maximum benefit is obtained from the margin loan facility.
Client characteristics
Time frames and quality investments are one thing — the tolerance and patience to withstand falling markets are another. Recent experience has again highlighted just how important it is for clients to understand the risks of investment gearing. It is clear that emotions like greed and fear can lead people to buy high and sell low, and clients will often feel very positive about the use of strategies such as gearing during buoyant markets. The market performance of the past couple of years has provided a reality check which demonstrates that perhaps not everyone who has been using gearing should do so.
At least one financial planning group (and more than a few financial advisers) has been the subject of complaints and is under investigation as a result of client strategies involving margin lending. This is a timely reminder for advisers to keep in mind that clients need to have a genuinely high tolerance for market volatility and an understanding of the risks associated with gearing to use this strategy. From an adviser perspective, education and appropriate risk profiling is essential for both compliance and client service standards.
It is also important that clients have the appropriate financial backing and provisions in place to protect themselves during times of market volatility. Clients need to ensure that they have sufficient reserves to pay loan interest and to meet margin calls if they arise.
Using conservative LVRs
One factor is the amount a client has borrowed using a margin loan. The closer the loan gets to the maximum LVR allowed by the provider, the greater the chance of a margin call.
Below illustrates how adopting a more conservative LVR can provide a level of protection against a margin call, as the fall in the portfolio required to trigger a margin call increases when a lower LVR is adopted.
Changing LVRs and impact on ‘fall to call’
1 2 3
Initial loan amount $70,000 $50,000 $30,000
Initial security value $100,000 $100,000 $100,000
Actual LVR 70% 50% 30%
Maximum provider LVR 70% 70% 70%
Margin call LVR 80% 80% 80%
Market fall required to (12.5%) (37.5%) (62.5%)
trigger margin call
Security value to $87,500 $62,500 $37,500
trigger margin call (LVR (LVR 80%) 80%) (LVR 80%)
Most margin lending clients have traditionally geared at LVRs of 50% or higher, so given the recent performance of the financial markets — particularly during 2009 — it is no surprise that there was an increase in margin calls.
The problem is that many clients and advisers were not actively monitoring and managing their margin loans, nor maintaining their LVRs to avoid large margin calls. Some clients lacked sufficient liquid funds to meet margin calls when they occurred.
Conservative gearing levels, regular monitoring and the maintenance of a cash fund can help to reduce the risk of this occurring.
Lump sum and instalment gearing
There are two types of gearing associated with margin lending:
1. lump sum gearing
2. instalment (regular) gearing.
As the term implies, lump sum gearing involves an initial investment comprising the investor’s own funds and funds provided through the margin loan. The investor then benefits from the income generated and the increase of the value of the investment over time. Opportunities may exist for additional lump sum investments to be made to the initial amount in the future.
Instalment gearing involves establishing a set savings plan in conjunction with additional regular borrowings through the margin loan with the objective of producing enhanced long-term returns. Each month, clients provide a fixed equity contribution from their savings account and this is supplemented by a loan draw down from the margin loan. These funds are combined and invested in approved managed funds.
Instalment gearing is often popular with clients who have a smaller initial amount to invest and/or wish to invest in managed funds rather than shares. This strategy can provide the discipline required to create substantial savings and the ability to remove risks associated with market timing. By using instalment gearing, investors can achieve the same benefits of leverage by increasing their investment on a monthly basis, which also takes advantage of dollar cost averaging. While the total amount of borrowings increases, the gearing relative to debt remains the same, and in this way, the use of instalment gearing can reduce the risk of a margin call.
Wrap up
Margin lending can be a very effective tool for wealth creation for the right client. It is important, however, than advisers understand the structure of the product and the characteristics of clients suitable for strategies involving margin lending. Clients need to be aware of the risks and have the appropriate risk profile to accept such strategies. One of the key risks is that a margin call will be made, but it is possible to use a number of techniques to reduce the likelihood of one occurring, as well as to effectively manage the situation if it does arise.