Double gearing: what happens when markets fail?

There are no laws prohibiting the sale of petrol, matches, milk bottles or cotton rags individually. Separately, they offer little menace; combined as a Molotov cocktail and thrown by a political terrorist, they have proven to be lethally dangerous.

Similarly, gearing in the hands of financial terrorists has also caused a great deal of irreparable damage. This is particularly the case when the initial deposit for the margin loan is sourced from a home equity release.

It is of scant comfort to victims when the adviser claims the defence of ignorance: ‘It was a perfect storm! No one, least of all me, could have expected it!’

We believe that a sense of history and the merest dash of common sense tell us all we need to know about the risks in double gearing.

This article outlines the systemic risks in margin calls and illustrates via a case study the impact on an individual’s wealth of double gearing in a substantial market decline. It shows how stress testing a geared portfolio and explaining the consequences to a client would result in far fewer victims. If all advice carried the obligation for receipt of the client’s ‘properly informed commitment’ before proceeding to implementation, most clients would refuse to take on the risk of losing their home.

A short history lesson

Students of investment market history know that extreme market behaviour happens about once every 10 years. Going back to 1970, there have been four falls in the Australian equity market that exceeded 30 per cent (see table 1).

The global financial crisis rates third in terms of depth of fall. We suspect that many advisers do not consider such occurrences when putting together geared client portfolios. Communication of downside risk, if explored at all, would generally focus on nothing more than two standard deviation variations of historical returns.

The 1987 fall was very sharp, with an initial fall of 25 per cent in one day — 20 October, 1987. At the other extreme, the fall of 2007-08 was like a slow-moving train wreck, the biggest fall being 26 per cent over the three months from September to November 2008.

In 1987, everyone understood the rules had changed and where the rubbish was held (Bond, Skase, etc). This was a quick landing.

In 2007-08, when the claimed Black Swan came into view, people also knew what the issue was. It was sub-prime mortgages that had been packaged up into collateralised debt obligation (CDO) securities. However, nobody could ascertain the size of the problem, or, more importantly, which institutions held these securities on their balance sheets. Hence the slow-moving crash.

When a trauma to the markets occurs, it is almost certain that the following three events will take place:

1. clients panic;

2. institutional operational systems fail; and

3. stop-loss systems fail.

Client panic

We remember 20 October, 1987, clearly. Wall Street had had a huge fall the previous night and our share market opened down some 20 per cent. Clients panicked, fearful of losing much of their recent gains. The market had risen close to 50 per cent since 1 January alone.

Clients rang their brokers, instructing them to sell. Telephone systems clogged and fax machines melted. You could feel panic set in as clients invaded the lobbies of their stockbrokers, fund managers and financial planners. Few knew what advice to give, as the depth and type of such a fall had not been experienced before.

The vast majority of investors had only been in the market for a short while. Many were introduced to equity markets through managed funds, which had arrived in the market only after 1980.

All that many could think of doing was selling, which put more downward pressure on the market. Fund managers were forced sellers of their better, more liquid shares, as they had to meet client redemption requests.

Institutional Operational Systems fail in a panic

When subjected to a large market movement, you have to expect operational failures. Some will say that this shouldn’t [be allowed to] happen; this view is, of course naïve. A good analogy is the recent Black Saturday bushfires that killed 173 people in Victoria. Many will argue that we should have had more fire crews, but there can never be enough fire personnel for the intensity of a Black Saturday.

An example of a failure in operational systems in late 2008 was with margin calls. Consider this scenario:

• market falls 20 per cent;
• margin loan lender makes margin call to wrap account;
• wrap account calls dealer and financial planner;
• financial planner calls client; and
• client decides to inject more cash or, more likely, sell down the portfolio.

This scenario can (and generally does) work efficiently in normal times, but what happens when the sheer volume of margin calls overwhelms the participants? What happens when the financial planner is away at a compliance workshop? What happens when the client is on holidays? What happens when the client doesn’t understand what a margin call is?

Margin lenders are often reluctant to immediately sell down client portfolios, preferring clients have at least 24 hours to consider their position. Combine this with system overloads at the margin lender's office and margin calls can take weeks to be executed. By then the portfolio may have fallen another 10-20 per cent and the client is in even greater financial difficulty.

Stop-loss systems fail

Many clients and some advisers believe (did believe?) that a ‘stop-loss’ system can be put in place to limit downside losses in a client’s portfolio during a market fall.

An example of such a process might be: “Sell all of my portfolio should the market fall by 10 per cent.” This sounds quite reasonable, as the client and their planner might feel that the maximum losses to the client will be 10 per cent, an amount with which the client feels comfortable, taking into account their tolerance for risk and risk capacity.

However, stop-loss systems can fail due to a combination of two factors:

• market pricing gapping; and
• lack of liquidity.

Markets can ‘gap’; on 20 October, 1987, for example, the market opened at 20 per cent lower than its closing position at the end of the previous day. Clearly, executing a stop-loss plan to limit losses to 10 per cent would have been impossible.

Furthermore, when there is a significant fall in the markets, liquidity evaporates on the buying side. This means there is nobody ready to buy the stocks you wish to sell in order to satisfactorily execute your stop-loss strategy.

When markets fail, as they surely will, you and your clients will have to hang on tight and keep riding the portfolio downwards. History shows us we have no viable alternatives.

If your client is aged 45, there is a reasonable chance they will experience about three or more significant market corrections in their lifetime. Can they survive these crashes? Have you stress tested their portfolios? If not, have you done the best you can for your client?

Stress testing

There is a very simple way to stress test client portfolios: firstly, catalogue and detail the client’s current assets and liabilities, including their home, investment properties and mortgages.

Table 2 could be a fairly standard balance sheet for a couple aged about 45 to 50 earning perhaps $200,000 per year.

How do we stress test this portfolio? There are various ways, many of which may be appropriate. We believe, however, that if a financial planner is to properly involve their client in the portfolio construction and its stress testing, the simplest practical approach is best.

Therefore, based on past experience, assume the following falls in the various asset classes:

The client’s net worth has dropped about 20 per cent (see table 3). This should normally be okay for the client, provided they were aware in advance that Black Swan events occur with surprising regularity.

Let’s now go and borrow another $300,000 against the house, taking the loan to value ratio (LVR) up to 70 per cent (see table 4). Then throw in the same Black Swan.

At this stage, the client has lost 27 per cent of their net worth, and the LVR on the home has now risen to 78 per cent. Can they deal with the Black Swan? What if they lose their job? Can they ride out the storm?

Let’s now see what happens when the $300,000 mortgage drawdown is used to take out a margin loan facility of $600,000 (table 5).

This ‘perfect storm’ is looking really ugly. The client has lost 44 per cent of their net worth, or $480,000. The LVR on the margin loan is now 95 per cent. In order to get the LVR on the margin loan back to 67 per cent, we have to sell $540,000 of shares at the bottom of the market.

See table 6 for the client’s position after the margin call.

At least this client hasn’t lost their home. Yet! However, they have a mortgage of $700,000 on a $900,000 home. What about a loss of share value of another 20 or 30 per cent and a further drop in property values?

If the client’s total portfolio had been stress tested using historical numbers and the consequences explained to the client, it’s hard to imagine many would have agreed to proceed. We believe it should be mandatory for a client’s total balance sheet to be stress tested as part of the financial plan, particularly if it involves borrowing.

How can a financial plan be complete if it does not include stress testing? How can we allow a plan to be implemented without explaining the risks and asking for the client’s properly informed commitment?

In our previous article, we argued that margin lending with Australian shares as an investment strategy is tantamount to gambling.

We now argue double gearing is immoral and probably fails to meet the adviser’s duty of care obligations. We believe it’s a pity that financial planners who recommend double gearing are not subject to criminal penalties.

Nevertheless, we are hopeful that there exists a strong case under existing legislation for civil penalties. As a community, we successfully stopped the use of Molotov cocktails; perhaps we can do something similar with

double gearing.

Black Swan Events

A Black Swan is something we thought could not exist. A Black Swan event is something we think cannot happen!

There is much discussion at the moment as to whether the global financial crisis (GFC) was a Black Swan event.

Author Nassim Nicholas Taleb describes a Black Swan event as something we should be surprised about, that has enormous consequences and that we can rationalise later with the benefit of hindsight. Our view is that similar circumstances can result in one individual describing their experience in the GFC as a Black Swan event while another will more or less take it in their stride. This, we argue, is because the latter is better prepared; they understand what is possible and the range of consequences compared to the former.

“Before the discovery of Australia, people in the Old World were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence.” — Nassim Nicholas Taleb, The Black Swan (2007).

Peter Worcester and Paul Resnik are industry consultants with over 70 years of combined practical industry experience. They both have firm views.