Margin of Error

There are severe risks attached to margin loans, so tread carefully.

One of the products that has been heavily pushed by lenders in the past couple of years is margin loans to finance the purchase of shares or managed funds.

Margin loans have been around for years and proven particularly popular with the highly paid seeking to cut their tax bills through negative gearing. But during the past couple of years or so, they have migrated to the middle ground as lenders convince more and more middle-income earners that they can fast track their road to wealth creation and high returns in a rising market by “leveraging” – using borrowing’s to finance share purchases – with the shares providing the underlying security for the loan.

The interest and fees charged on the borrowing is offset against the returns earned on the investment, so in a sense all taxpayers, whether they like it or not, are funding the tax deductions claimed by margin loan borrowers.

It's a great idea to finance the purchase of a growth investment in a growth market, particularly when interest rates are low. But as any Swiss-franc borrower of the mid – 1980's who lost the family business, their home or their farm will tell you, there are also severe risks attached to margin lending.

The Swiss-franc borrowers were lent up to 90 per cent of their underlying loans in Swiss francs. But as the Australian dollar plummeted in 1985, they found their debt soared and the underlying security had to be constantly topped up to satisfy bank demands.

Once there was no more security to be found, the loan was in default and the banks appointed receivers and liquidators to seize their assets and sell them, often for a fraction of their earlier valuation and their true value.

Mindful of that scenario, the Australian Securities and Investments Commission (ASIC) has taken a proactive view of this new wave of margin lending to middle-income earners. (At last count, it calculated that $4.2 billion of margin loans were on lender's books, a figure that has doubled over the past two years as the major banks convinced their customers that this was the tax-efficient way to climb into the sharemarket and “produce wealth”.)

ASIC has warned borrowers to think hard before they sign their lives away. It wants them to think about the risks attached to these loans in a scenario where interest rates are on the way up and the sharemarket is in a jittery state, awaiting a correction.

And as more and more financial products are sold on Web sites, borrowers need to be careful that they face up to the risks attached to investment in the same way as they would in a face-to-face meeting. In particular, they need to take into account that if the underlying security drops beneath that required by the lender, they will be required to meet a margin call – that is, to top up the security or sell some of the shares to pay back some of the loan.

As ASIC's national markets unit director Claire Grose points out, while borrowing to invest can result in higher returns, it also magnifies the losses if the value of the investment falls.

She advises that the intending borrower should obtain professional advice before rushing in and signing up for loans.

The financial adviser should be asked to explain a number of points, including when a margin call may be made under the terms of the loan.

Intending borrowers should also determine in advance how they are able to respond to such a call: do they have investments that they quickly liquidate to meet the call, or do they have other assets they can access to top up the loan? And if they have other assets, are they assets they are prepared to lose if there is a loan default?

Best of all, remember that lenders are quick to throw funds at new borrowers in a climate where they are hungry for market share, but they are just as quick to pull the plug and seize assets if they want to climb out of that market or the loan conditions are breached. And they don't mind in the least being ruthless about it.

Just ask the Swiss-franc borrowers feted by their bank managers in the mid-1980's before they took out their loans, and who later found themselves living in caravan parks.