Stock market margin lending - Free Financial Advice for Australians
The banks never give up
After watching a recent episode of the ABC's 4 Corners program which followed
the story of how some banks have forced loans on consumers who clearly can't
afford the repayments, my son received a letter from his bank with a nice glossy
brochure about margin lending.
At 23 he's just started a job and well understands money lending principles,
especially when they involve overseas travel and credit card debt.
Although he's not ready for a margin loan just yet I am sure there are a number of banks who would be only too willing to add him to their list of young clients they'd like to see with a margin loan.
Funny how things change. It's now the bank manager or mortgage broker who comes calling, cap in hand, asking you to take out a loan. Only a few short years ago for our parents a meeting with the bank would have been an important if not daunting event.
This demonstrates what I have been saying for years about banks and advice. How can you get unbiased advice from banks and financial institutions if the companies' profits, the advisers' careers and bonuses, are in the mix?
I met with a new client the other day whose previous adviser worked for a bank. He said he asked his former adviser why the managed fund he was invested in was in the bottom quartile of performance and had been so for 5 years. His adviser replied defensively "well we expect it to pick up". This bank adviser had not met the client before and had in fact taken over from a previous adviser who had not contacted the client in the previous 14 months anyway.
You can hear the sales meeting now can't you... "And if they ask about performance tell them it's the market and we expect it to pick up". Yeah, well that works! He had been in a bottom quartile fund for 5 years!
Bad business practice always backfires. The same with lending and advice practices.
Why does the rest of the industry make it so easy for us? I mean us here at Halogen. All we have to do is understand our clients' needs and goals, put in place the right strategies and asset mix to make it possible to meet those goals, and mange the process with straightforward coordinated advice. No it's not rocket science, so when will the industry realise how to advise and look after clients?
Figures from the Reserve Bank of Australia show that at the end of 2007 more than 200,000 investors had a total of $37.7 billion on margin loans outstanding. When the RBA started collecting data on margin lending in 1999 it reported that margin loan outstandings were a modest $4.7 billion. The market has had an eight-fold increase in eight years.
The RBA's data shows that the great majority of investors use their margin loans prudently. The aggregate credit limit is $76 billion. This means that outstandings are just under half the amount of credit advanced by lenders. The value of underlying securities in margin loan accounts is $92.8 billion, which means that the average gearing level is a modest 42%.
So how would I use a margin Loan?
There are 3 main ways to use a margin loan:
The first is simply to borrow to invest.
This means the bank will lend you up to a maximum of around 70% on selected shares (mainly blue chip or from the top 200 shares in Australia). They also lend on most managed funds. You could choose to only borrow 50% or 30% or 20%, it's up to you. You may have $50,000 of your own money plus $20,000 borrowed. The advantage of this of course is you own $70,000 worth of shares so you receive all the dividends on $70,000 worth of shares but have only contributed $50,000 of your own funds. As these dividends easily pay the interest bill on the $20,000 you've borrowed the loan costs you nothing from your cash flow. In fact with a $20,000 loan you would be cash flow positive.
So as you can see from this example you could easily increase your borrowings depending on your cash flow and risk profile. You may decide you only want to pay $150 per month on interest expenses from your cash flow so work out how much you could afford to borrow to achieve this result. Very flexible.
The second way to use a margin loan is to save money more effectively.
You decide an amount you can save each month, say $500, and invest it each month. You could kick it off with a $3,000 lump sum so the bank will match your $3,000 with $3,000 so you will have $6,000 working for you straight away plus your $500 savings per month matched by the bank so $1,000 invested each month. This is an accelerated way to save for school fees or a home loan or something in say 3-5 years time.
At the end of the saving period you sell your holdings, pay back the borrowings and take your savings back which in theory should be greater than if you had just saved without borrowing. You can stop and start with this set-up and you are not committed to the amount each month. Ideal for my son to start saving for home or travel etc.
The third way is to borrow money through what's called a protected loan.
This means the bank lends you an amount to invest in shares and all you do is pay the interest each month. If the shares tank or go down you walk away. No liability. Many people use this set-up to get started, to test the water with a small amount. The only downside is the interest rate. Banks charge high rates for protected loans, in the mid to high teens so a 16-17% interest rate. Also you are limited to investing in a list of shares approved by the bank who lends you the money.
Many people use the equity in their own home to get started with a line of credit. We would prefer individuals to use a line of credit for investment than for holidays or cars. You can then use the existing wrap platforms to invest and control any additional gearing.
So let's look at some of the questions that come to mind with margin loans.
What happens in a market correction? Would I lose more than if I didn't have a margin loan?
Yes you would is the short answer, but again it also depends on your level of gearing and when a correction occurs. But remember your recovery is quicker with a margin loan as you can take advantage of a rising market. The following table gives you an example of how a correction of 20% after a number if years would affect your returns:
How Gearing Can Affect Your Portfolio
Your investment of $50,000 (1st amount)
Your investment plus a margin loan of $50,000, so 50% geared (2nd amount)
After year 1 @ 15% return
$57,500
$115,000
After year 2 @ 15%
$66,120
$132,250
After year 3 @ 15%
$76,042
$152,080
After year 4 with a 20% correction
$60,832
$121,664
Net return
$60,832
$71,664
As you can see, even with a 20% correction you would be ahead nearly $11,000 with a margin loan.
Please note, these calculations take interest rates, dividends and tax benefits into consideration.
What about rising interest rates?
If we have a flat investment market and high interest rates the positive effect of gearing is reduced. We need a positive return to make the strategy work. Even with the tax deductions for borrowing, extremely high interest rates will reduce the effectiveness of borrowing to invest.
So what about Opes, weren't they margin lenders?
In most margin loans, investors borrow against the value of their existing shares to buy more shares, but they retain ownership of the whole stake so they have many individual accounts with different shares and different levels of gearing. In the fundamentally flawed business model pioneered by Tricom and picked up by Opes, the loans were made on the condition that investors signed over ownership of all their shares as security. Many Opes investors claim they were unaware of this fundamental difference, or of the great risk to which it exposed them if Opes fell apart, which it did.
Investors' ignorance ended when Opes Prime went into administration and its lenders, ANZ, Merrill Lynch and Dresdner Kleinwort, became owners of all the shares. As these lenders own the shares they are subject to margin calls. These institutions now want to try and get their money back and so they have started selling at the bottom of the market at further discounts for quick sells. This has left all the investors with only around 50% of their portfolio at best.
I heard the US investment bank Bear Sterns went under because they borrowed too much.
Bear Sterns were geared to 35 times. The bank had $11.1 billion of tangible assets supporting $395 billion in borrowings (which we know were a bit dodgy... as in sub-prime). If just over 10% of the $395 billion was in question then $40 billion would be discounted off the asset value. That would mean their entire equity was wiped out. This would have been OK in normal investment banking land under normal circumstances with high grade assets that don't lose value. But the market turned on them. Huge clients withdrew funds and no bank would lend to them (as many institutions were in the same boat).
Good night Bear Sterns and put the lights out. Enter the Federal Reserve with a rescue package.
Margin lending or borrowing to invest is fine if done at the right level to suit individual goals.
- 30-40% should be in Australian shares with an overweight position in resource funds.
- 60-70 % should be in international shares in China, India, Brazil and Vietnam, so Asian funds without Japan.
I would have no UK or US stocks for the foreseeable future. Global property is a hold for now.
At 23 he's just started a job and well understands money lending principles,
especially when they involve overseas travel and credit card debt.Although he's not ready for a margin loan just yet I am sure there are a number of banks who would be only too willing to add him to their list of young clients they'd like to see with a margin loan.
Funny how things change. It's now the bank manager or mortgage broker who comes calling, cap in hand, asking you to take out a loan. Only a few short years ago for our parents a meeting with the bank would have been an important if not daunting event.
This demonstrates what I have been saying for years about banks and advice. How can you get unbiased advice from banks and financial institutions if the companies' profits, the advisers' careers and bonuses, are in the mix?
I met with a new client the other day whose previous adviser worked for a bank. He said he asked his former adviser why the managed fund he was invested in was in the bottom quartile of performance and had been so for 5 years. His adviser replied defensively "well we expect it to pick up". This bank adviser had not met the client before and had in fact taken over from a previous adviser who had not contacted the client in the previous 14 months anyway.
You can hear the sales meeting now can't you... "And if they ask about performance tell them it's the market and we expect it to pick up". Yeah, well that works! He had been in a bottom quartile fund for 5 years!
Bad business practice always backfires. The same with lending and advice practices.
Why does the rest of the industry make it so easy for us? I mean us here at Halogen. All we have to do is understand our clients' needs and goals, put in place the right strategies and asset mix to make it possible to meet those goals, and mange the process with straightforward coordinated advice. No it's not rocket science, so when will the industry realise how to advise and look after clients?
Are margin loans still ok?
With all the negative talk regarding sub-prime loans and lending practices I thought it may be time to revisit the place for margin lending in investors' portfolios. Margin loans are now quite common place and can be used for many strategies.Figures from the Reserve Bank of Australia show that at the end of 2007 more than 200,000 investors had a total of $37.7 billion on margin loans outstanding. When the RBA started collecting data on margin lending in 1999 it reported that margin loan outstandings were a modest $4.7 billion. The market has had an eight-fold increase in eight years.
The RBA's data shows that the great majority of investors use their margin loans prudently. The aggregate credit limit is $76 billion. This means that outstandings are just under half the amount of credit advanced by lenders. The value of underlying securities in margin loan accounts is $92.8 billion, which means that the average gearing level is a modest 42%.
So how would I use a margin Loan?
There are 3 main ways to use a margin loan:
The first is simply to borrow to invest.
This means the bank will lend you up to a maximum of around 70% on selected shares (mainly blue chip or from the top 200 shares in Australia). They also lend on most managed funds. You could choose to only borrow 50% or 30% or 20%, it's up to you. You may have $50,000 of your own money plus $20,000 borrowed. The advantage of this of course is you own $70,000 worth of shares so you receive all the dividends on $70,000 worth of shares but have only contributed $50,000 of your own funds. As these dividends easily pay the interest bill on the $20,000 you've borrowed the loan costs you nothing from your cash flow. In fact with a $20,000 loan you would be cash flow positive.
So as you can see from this example you could easily increase your borrowings depending on your cash flow and risk profile. You may decide you only want to pay $150 per month on interest expenses from your cash flow so work out how much you could afford to borrow to achieve this result. Very flexible.
The second way to use a margin loan is to save money more effectively.
You decide an amount you can save each month, say $500, and invest it each month. You could kick it off with a $3,000 lump sum so the bank will match your $3,000 with $3,000 so you will have $6,000 working for you straight away plus your $500 savings per month matched by the bank so $1,000 invested each month. This is an accelerated way to save for school fees or a home loan or something in say 3-5 years time.
At the end of the saving period you sell your holdings, pay back the borrowings and take your savings back which in theory should be greater than if you had just saved without borrowing. You can stop and start with this set-up and you are not committed to the amount each month. Ideal for my son to start saving for home or travel etc.
The third way is to borrow money through what's called a protected loan.
This means the bank lends you an amount to invest in shares and all you do is pay the interest each month. If the shares tank or go down you walk away. No liability. Many people use this set-up to get started, to test the water with a small amount. The only downside is the interest rate. Banks charge high rates for protected loans, in the mid to high teens so a 16-17% interest rate. Also you are limited to investing in a list of shares approved by the bank who lends you the money.
Many people use the equity in their own home to get started with a line of credit. We would prefer individuals to use a line of credit for investment than for holidays or cars. You can then use the existing wrap platforms to invest and control any additional gearing.
So let's look at some of the questions that come to mind with margin loans.
What happens in a market correction? Would I lose more than if I didn't have a margin loan?
Yes you would is the short answer, but again it also depends on your level of gearing and when a correction occurs. But remember your recovery is quicker with a margin loan as you can take advantage of a rising market. The following table gives you an example of how a correction of 20% after a number if years would affect your returns:
How Gearing Can Affect Your Portfolio
Your investment of $50,000 (1st amount)
Your investment plus a margin loan of $50,000, so 50% geared (2nd amount)
After year 1 @ 15% return
$57,500
$115,000
After year 2 @ 15%
$66,120
$132,250
After year 3 @ 15%
$76,042
$152,080
After year 4 with a 20% correction
$60,832
$121,664
Net return
$60,832
$71,664
As you can see, even with a 20% correction you would be ahead nearly $11,000 with a margin loan.
Please note, these calculations take interest rates, dividends and tax benefits into consideration.
What about rising interest rates?
If we have a flat investment market and high interest rates the positive effect of gearing is reduced. We need a positive return to make the strategy work. Even with the tax deductions for borrowing, extremely high interest rates will reduce the effectiveness of borrowing to invest.
So what about Opes, weren't they margin lenders?
In most margin loans, investors borrow against the value of their existing shares to buy more shares, but they retain ownership of the whole stake so they have many individual accounts with different shares and different levels of gearing. In the fundamentally flawed business model pioneered by Tricom and picked up by Opes, the loans were made on the condition that investors signed over ownership of all their shares as security. Many Opes investors claim they were unaware of this fundamental difference, or of the great risk to which it exposed them if Opes fell apart, which it did.
Investors' ignorance ended when Opes Prime went into administration and its lenders, ANZ, Merrill Lynch and Dresdner Kleinwort, became owners of all the shares. As these lenders own the shares they are subject to margin calls. These institutions now want to try and get their money back and so they have started selling at the bottom of the market at further discounts for quick sells. This has left all the investors with only around 50% of their portfolio at best.
I heard the US investment bank Bear Sterns went under because they borrowed too much.
Bear Sterns were geared to 35 times. The bank had $11.1 billion of tangible assets supporting $395 billion in borrowings (which we know were a bit dodgy... as in sub-prime). If just over 10% of the $395 billion was in question then $40 billion would be discounted off the asset value. That would mean their entire equity was wiped out. This would have been OK in normal investment banking land under normal circumstances with high grade assets that don't lose value. But the market turned on them. Huge clients withdrew funds and no bank would lend to them (as many institutions were in the same boat).
Good night Bear Sterns and put the lights out. Enter the Federal Reserve with a rescue package.
Margin lending or borrowing to invest is fine if done at the right level to suit individual goals.
Has the market bottomed and can we expect a positive result?
There are now signs that the worst is known. What markets hate most are unknowns. This was demonstrated again this month when the investment bank UBS declared a huge loss of $11 billion, which actually resulted in a share price rise of 10%. All is known and it's not so bad. US mortgage-backed securities are now beginning to be traded again. The worst is seen to be known or over. The Australian market has had an over reaction. If we look at the chart below we are now well below our median market PE ratio. As we can see back in late 2002 when the PE was down to below 14 we were at the beginning of the last Bull Run. It is also worth noting that over the last 3 years we have not gone into high PEs as we have in previous runs. The market looks to have a solid base.So where to for 2008?
Well it's steady as she goes. As I said last month we are still in a resources boom that will continue for years albeit with a few corrections along the way. I think smart investment portfolios should be mixed to take advantage of international markets. We are very happy with the following mix to maximise returns:- 30-40% should be in Australian shares with an overweight position in resource funds.
- 60-70 % should be in international shares in China, India, Brazil and Vietnam, so Asian funds without Japan.
I would have no UK or US stocks for the foreseeable future. Global property is a hold for now.
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Margin Lending | Stock Trading | Stock Market Crash | Tips | Quotes | Property Boom | Baby Boomers | Mortgage Trust
Reduce Tax | Buying Shares | How To Invest | Investment Scams | End Of Financial Year | Building Wealth
Oulook 2006 | Investment Types | Property Trust | Market Investment