The great margin lending gamble

Last month, Australia’s investment watchdog fired out a missive to investors alerting them to the dangers of the margin lending market. Samantha Walker asked the in-dustry whether advisers are taking too much of a gamble by recommending margin lending in the present buoyant climate.

Last month, Australia’s investment watchdog fired out a missive to investors alerting them to the dangers of the margin lending market. Samantha Walker asked the in-dustry whether advisers are taking too much of a gamble by recommending margin lending in the present buoyant climate.

To say margin lending is undergoing a surge in popularity is something of an under-statement.

Whereas a few decades ago, gearing was only associated with investment property, now shares and managed funds are increasingly the focus of wealth accumulators.

And why not? Financial planners would be well aware that shares are known to out-perform almost every other asset class over the long term. It has never been more obvious than now. Economists fill our newspapers and television screens with breathless accounts of the latest local and US share market surges. The growth has been so strong for so long that they seem at a loss to explain why a correction has not taken place.

Margin lenders have responded to the increase in demand for shares by offering more investors access to gearing facilities. In fact, the Australian Securities and Invest-ments Commission (ASIC) says that in the past two years alone, the loan books of margin lenders have doubled to about $4.2 billion.

Margin lending has traditionally found its source in stockbrokers and financial plan-ners. Yet, today, you can log on to the Internet and source margin loans direct from groups such as Commonwealth Securities. Banks wishing to mine their mammoth customer databases are also starting to offer margin loans directly to their customers.

When Money Management spoke to BT Margin Lending's Gillian O'Mulloy last year, she estimated the margin lending market had grown from three operators in 1993 to 20 operators six years later. And new entrants continue to crowd the market.

Last December, Westpac Financial Services launched its own margin lending facil-ity. And earlier this month, Challenger International announced it had bought Citi-bank's loan book for about $80 million. Business in the margin lending market is clearly booming.

While returns on share markets are good, everyone is happy. However, as all plan-ners are aware, the recent good fortunes of the Australian Stock Exchange (ASX) won't last forever. And what happens when the bubble bursts?

At a recent address to the US Senate Banking Committee, Federal Reserve chairman Alan Greenspan expressed his concern at the explosion in margin lending products. Greenspan told the committee the Federal Reserve was considering several options to curb this trend.

“I don’t want to suggest we’re about to do anything but obviously we’re concerned about the whole process,” he said.

It is this very concern which recently prompted ASIC to release a consumer alert on margin lending. The consumer alert pointed to recent volatility in the ASX as indica-tive of the risky nature of the product. It also queried whether all of the investors us-ing such gearing facilities would know how to react in the face of a margin call.

"Borrowing to invest can potentially result in higher returns. But it also magnifies the extent of any losses suffered if the value of your investments fall," said Claire Grose, director of ASIC's national markets unit, at the time.

However, it is not just Grose who has expressed alarm at the increased use of margin lending products.

The Australian Consumers' Association's senior policy officer Dan Coyne says many investors are moving into gearing "too deep, too fast".

"Many consumers are taking on a lot of leverage...current factors are combining to create a volatile risk for investors. Just consider how easy it is to trade online. Buying shares is as easy as clicking a mouse button," he says.

Hillross Financial Services' managing director Jonathan Harrison harbours concerns over the risky nature of margin lending, particularly for the less sophisticated inves-tor.

"On the capital side, there is a real risk of total loss of capital in margin lending. In 1987, I remember the New Zealand stock market fell about 40 per cent in a short space of time. People who had geared heavily in this market lost almost all of their capital. The rate you lose money is faster with gearing," he says.

There are also concerns that some of the more recent entrants to the margin lending market have been focussing their efforts on illiquid investors. If these investors are unable to meet a margin call, they realise greater losses than if they had the cash to meet the call.

Coyne says many investors need to learn more about the intricacies of gearing before they enter into loan arrangements.

"People need to stop and consider what they're doing," he says.

Harrison agrees it is too easy for investors to gear into shares and says margin lend-ing is not for everyone. He argues margin lending is a "tricky business" which re-quires investors to seek financial advice rather than go it alone. If an investor is thinking about gearing into managed funds, for instance, they should be aware that not all asset classes are suitable for gearing. Likewise, many managed funds are al-ready gearing their own investment portfolios, he says, creating an "alarming level of gearing".

In fact, Harrison says that Hillross' less experienced advisers are required to have any gearing plans internally vetted "because it has been so problematic" for the group.

Joint managing director of ProQuest, Paul Resnik, says it is all simply a matter of having an accurate risk profile of investors in place. In order for this to happen, he says, margin lenders need to take on board “the spirit of CLERP 6” — that is, they should implement strategies to know their client.

“Even in the case of offering a product, to some degree there is a form of advice in-volved…Margin lenders have a moral obligation and a business obligation to know their client,” he says.

Westpac Financial Services says that while they aim their margin lending product to the medium end of the market directly, they still recommend investors seek financial advice. The bank has also recently made the service available through its inhouse broking service.

“We strongly recommend advice and we market to customers who we believe to have aggressive risk profiles. We recommend in our marketing that they see an ad-viser. We show customers illustrations of the potential upside, and potential down-side of geared investing,” a spokesperson for Westpac says.

Compounding the issue is ASIC's lack of direct regulation over such products, cre-ating what Coyne sees as a "regulatory black hole".

ASIC's director of the office of consumer protection, Peter Kell, confirms that not all areas of margin lending can be directly regulated by his organisation. Margin lending products are both a lending facility as well as an investment product. While ASIC regulates the investment part of the product, jurisdiction over the credit components still fall under the Trades Practices Act.

While share markets remain buoyant, many in the industry remain concerned at the levels of gearing among those investors who have yet to see a full investment cycle. As such, they say they support the step ASIC has taken in issuing its warning on margin lending, particularly in regard to margin lending products purchased without professional advice being sought.

Despite the warning, however, Dan Coyne still predicts a great number of investors will get their fingers burnt when the markets inevitably fall.

“The warnings are good, but until the market turns and until there’s a bit of suffering, people still won’t pay much attention,” he says.