Share Loans Boom Despite The Slump
Sun Herald
Sunday May 28, 2000
The slump in T2's share price has resulted in margin calls, yet margin loans have never been more popular. Belinda Gibbon reports.
THE correction in the sharemarket has, perversely, made margin lending less risky. By not paying inflated prices for shares in the first place, the prospect of a fall big enough to trigger a margin call a demand by a lender to supply more assets (cash or shares) often within 24 hours when an investment drops in value diminishes.
Say you want to buy $40,000 worth of securities, but have only $20,000. Your cash flow is good enough to borrow the other $20,000, so you take out a margin loan for that amount. As with all loans, you pay the lender interest, generally about half a per cent more than for a regular home loan. Then, in theory, you can sit back and enjoy dividends and perhaps tax advantages, as you watch your investment grow.
Well, that's the theory, one which has seen a rush of people jumping into the sharemarket with borrowed money in the past two years.
Michael Migro, managing director of Westpac Financial Services, said: ``The margin lending business was, and mostly still is, the domain of investment banks and stockbrokers. However, over the past two years traditional lenders have started to make it available to their customers."
While most, if not all, lenders suggest clients seek financial advice before taking out a margin loan, it is not, of course, compulsory. This creates a danger for all who use a margin loan to get rich, without first doing their homework.
The combination of demand and accessibility has seen the value of margin loans on the books of major banks and stockbrokers double in two years. Last November that rush by investors led the Australian Securities & Investments Commission, to issue a warning to investors about the risks involved.
A margin call is made when the value of your shares falls below an agreed level. It is a demand to reduce the loan to value ratio (see box), often within 24 hours. To do this, you must find extra cash, transfer custody of some other shares to the lender, or sell part of the investment, often for a substantial loss.
The best way to avoid the likelihood of a margin call, is to keep your gearing level, or loan to value ratio (LVR), low. Depending on the shares in question, your LVR may be as low as 40pc or as high as 70pc.
If you borrow, say, the full 70pc and the investment falls in value, you will need to bring the LVR back down to 70pc. But if you gear to only 50pc, stock prices will need to fall much more dramatically before you are asked for a top-up.
``People always think of negative gearing, but should consider neutral or positive gearing," said Laura Menschik, of Millennium Financial Services.
With negative gearing, your outgoings (interest payments) are greater than the income from your investment (dividends), which can be tax advantageous.
This can be a great way to create wealth by using someone else's money, as long as the investment grows in value and interest rates do not skyrocket.
With neutral gearing the amount coming in meets the amount going out. ``With positive gearing," said Ms Menschik, ``you invest $80,000 and borrow $20,000. You get a positive cash flow and less risk of a margin call.
``At this point in time we are generally recommending people do not borrow more than 50pc."
Another important consideration is the ``margin buffer", which varies from about 5pc to 10pc.
Assume you are geared to the maximum, and your investment falls by 6pc. If you have a margin buffer of only 5pc (less than the fall), you will get a margin call. If your buffer is 10pc, you have more room to move with daily market fluctuations.
Of course, investors should also be very wary of volatile stocks.
Fortunately for the would-be punter, banks will usually not lend against stocks they consider to be risky and if they do, the gearing will be very low.
Each lender has a list of approved securities; some offer about 500 and others as few as 200. Lenders suggest savvy investors have a diversified portfolio so that, if one stock falls, hopefully another will rise to balance it out.
An easy way to achieve diversification is by investing in managed funds, which typically have a mix of bonds, cash, property and shares to help balance market fluctuations.
While the ability to meet a margin call is a big worry for some investors, it is, of course, the long-term investment value which should be the primary concern.
``Always look medium to long term investments," said Ms Menschik. ``It could, for example, be inappropriate for you to sell in two years' time and use the money as a deposit." No-one wants to sell when the market is low.
There are other concerns, too. For example, if you have a variable rate loan, your repayments will rise in parallel with rising interest rates. You need to ask yourself if your cash flow will allow for that.
There is always the possibility that your personal cash flow is reduced to a mere trickle because of sickness or disability. ``We always recommend if you undertake borrowing to take out income protection insurance," Ms Menschik said.
``You need to consider your personal tolerance to falls in the investment, movement in interest rates, changes to taxation rulings, how much liquidity you have to meet a margin call or what else you might be able to sell, and personal circumstances such as job loss."
You must also consider your emotional tolerance to financial risk. In the long term the fear of a margin call could be just as hazardous to your health as the call itself would be to your finances.
You can, of course, save to buy securities outright. Other options include using a personal loan, an overdraft, a home equity loan or a line of credit secured by the equity in your home.
With these loans, you will never receive a margin call, no matter how much the market plummets. The interest rate should also be about 0.5pc lower.
So, why are many people choosing margin loans?
According to Mr Migro, the major reason is ``the convenience of a facility which you can isolate for investment purposes".
How a margin call works
SAY you want to buy $30,000 worth of shares and the lender will gear to 66pc only (loan to value ratio of 66pc).
1 YOU put up $10,000 and borrow $20,000 = 66pc gearing (loan $20,000 / value $30,000 = 66.6pc).
You may receive dividends, and/or be able to offset the cost of interest payments against your taxable income.
2 THE value of those shares drops to $25,000, meaning your loan to value ratio has increased to 80pc (loan $20,000 / value $25,000 = 80pc).
The lender may then request $3,500, within 24 hours, to bring the loan to value ratio back to the agreed 66pc (loan $16,500 / value $25,000 = 66pc).
You can:
Transfer cash;
Transfer custody of approved securities to the value of $3,500; or
Sell some shares.
If the lender cannot contact you or your chosen representative (stockbroker or financial planner), it may sell shares without consultation.
© 2000 Sun Herald