Margin lending following Storm Financial

Margin lending has always represented a part of the financial planner’s strategy toolkit but the collapse of Storm Financial soured public perceptions of leverage. Money Management brought together a roundtable of leading planners and margin lending experts to discuss how the strategy has returned to vogue, albeit with greater caution and more client education.

Part two: Do enough financial advisers understand margin lending?

Mike Taylor, managing editor, Money Management: Welcome to the Money Management round table, with Bendigo and Adelaide Bank’s Leveraged Equities as our sponsor. We’re dealing with the topical issue - well, it was very topical actually around the time of GFC - of margin lending.

And the reason I say that is the opening question really revolves around the topicality that margin lending actually achieved at that time, mostly as a result of the collapse of Storm Financial and the strategies they advised, which I guess gave margin lending a bad reputation for a number of years.

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So I thought we’d just clear the decks on that particular issue, because it is an issue for many of our readers, and I’m going to throw the opening question to Wayne and ask: Did margin lending get an undue reputation out of what happened with Storm and the manner in which it was used with their advice?

Wayne Lear, Shield Wealth: Yes, certainly it did Mike. It’s just unfortunate that there wasn’t a real lot of education around that and instances like Storm certainly do put the rest of the industry in a bad light, when in actual fact, the best time to have gotten into a margin lending-type strategy was March 2009.

But everyone gets very, very scared, the Government gets scared, when lots and lots of people are unduly hurt by strategies that they should never, ever have gotten into in the first place. 

Alex Tullio, Leveraged Equities: Look, I think it’s an interesting thing actually, because only the other day someone said to me, “You know, it seems like margin lending is in vogue again”, and I thought, you know, that’s a really interesting comment to make because that sort of implies that it’s a bit of a fad or a trend.

When of course, what we’re actually talking about is gearing as a strategy, and whether you believe that gearing is a relevant strategy for wealth creation when used correctly. And if you look at if it has it changed pre-GFC, post-GFC - the fundamentals actually haven’t changed, have they.

It comes back to your point Wayne, it comes back to education, the client’s goals: do they have advice? Is there an exit strategy? Those sort of things.

So I keep bringing it back to gearing as a strategy. Margin lending, in fact, is just one way, I guess, to exercise that strategy in terms of a product.

Michael Dale, Fiducian: I think Wayne had two words that really says it all: education, and the bottom of the market in March 2009.

If you had a cash buffer you’d be wanting a margin call in March 2009 because you’d have bought in cheaply and you’d be laughing today. 

So, as Alex says, everything is about fundamentals and principles. It’s about knowing your client and then understanding everything that goes with it, because education I think is poorly understood. So that’s where I stand.

George Deva, Ord Minnett: Well, I don’t think we should understate what Storm did, and that was that people lost their livelihoods, their life savings and their homes.

But the consequence of that was that it really shed a light on the distinction between the quality and the appropriateness of advice, and then the infrastructure and the product, in this case margin lending, which was used to deliver that.

And the positives of that are that lending providers such as Leveraged Equities in Adelaide and Bendigo, to their credit, have put in provisions to make that product a lot more robust - responsible lending provisions, the communication of margin calls, and technology that allows more transparency between the advisor and the client on their margin.

In terms of the appropriateness of advice, I think it is incumbent upon the wider industry to make sure that something like Storm never happens on our watch again.

Andrew Mckee, Australian Unity: I agree with most of what’s been said. I think one of the important things for me that came out of the GFC really was that margin lending is not a secondary strategy.

It needs constant management and monitoring, and when markets are booming you need to manage the LVRs and de-risk portfolios effectively for the potential that they won’t always be booming.

That’s where I think good advice can come in and help clients make those decisions when otherwise they might make the wrong decisions at the wrong time.

So it’s providing that discipline for people. But you’ve got to be careful about margin lending. It does leverage the portfolio and leverage the risk, and the education side is helping clients understand that and then make the right choices.

Wayne Lear, Shield Wealth: If I could just add to that Mike: I think we all talk about margin lending as if it’s some remote and separate thing to what everyone else does in Australia with money, but really the principle of margin lending is exactly the same principle as what businesses use every day in running their business, what people use every day in buying properties.

And that is you get as much of somebody else’s money as you can, invest it somewhere and reduce the cost of that money to below what you can get from that investment, and that’s very simply what gearing is all about.

The problem we all get, or the problem most people get, is greed.

They get greedy.

The typical sort of Aussie response is that if this is good, well then we’ll get a real lot of it, so it’s going to be really, really good - without seeing the downside of it. And this is what Andrew’s saying: education, education, education, and also transparency.

And what Leveraged Equities do is communicate, because during the GFC we had 540 margin calls in six months over 140 accounts, and we managed it going down and our greatest key was that we communicated twice a week to everyone.

Obviously there was anxiety, but the communication, the education is absolutely critical in what Andrew was saying, in terms of making sure people know what they’re doing.

What did we learn from Storm Financial?

Mike Taylor, Money Management: Well one of the points that was mentioned by George, was the manner in which Leveraged Equities have set up their offering in terms of the lending, and one of the things that I know went very, very wrong, putting aside the strategy of Storm, was the back office of the loans that were actually being provided.

There seemed to be a failure to execute exit strategies simply because the back end was failing. Now, I guess there were an awful lot of learnings out of that and things have been put in place to preclude that happening again.

Alex Tullio, Leveraged Equities: And it comes back to the basics I think, and I think one of the things for Leveraged Equities is that I guess, post-GFC, the learnings from Storm and I guess the extra regulations that came about, was that in reality nothing much changed for Leveraged Equities from the processes we already had in place.

What we’re talking about here is communication. It’s working back to whatever time you needed to to make sure you let your clients and your partners know.

In our case we do the vast majority of our business for professionals such as stockbrokers and financial planners, so working with our partners so that their clients knew what was coming. 

Things like not changing LVRs on the stocks, you know, midstream and those sort of things.

So when the regs came in there was actually very little that we had to build or put in place as something new. 

And of course, the change in the industry was the responsible lending regulations, which to your point Wayne, you know, it’s really just looking at any form of lending and having a responsibility as to who’s borrowing money and all that sort of piece.

But in terms of our processes, you know, we really didn’t change much, which we’re proud of.

George Deva, Ord Minnett: Yeah, look we’ve always focused on the advice proposition and ensuring the education of our advisors, the quality and the appropriateness of their advice is consistent across client’s risk profiles, their objectives, their goals and so forth.

We really delegate the expertise of providing strong and robust product to providers such as Leveraged Equities in the space of margin lending. 

What we do is focus heavily on the education of advisors, and I think that’s a central theme here, and really ensure that they are circumspect where appropriate and where clients are aware of the risks, but also the tangible benefits that accrue when the appropriate product is put forward.

Michael Dale, Fiducian: There’s a great difference between theory and practice and what really happens.  You know, you could have investors around this table and they’d agree with everything that’s said, but suddenly there’s a big downturn next week and things change. 

So the relationship is so very, very important and there would be no anxiety or stress, as long as that communication is there and you know it’s the right kind of client that fits margin lending, because it’s not for everyone.

I guess the problem was, from 2003 to 2007 the markets just went up and so it would be easy to let that regular monitoring portfolio drift - so the GFC did it.

It brought us back to what we should have been doing. 

That’s really all it did. 

I think those people that have gearing structures in use today they fully understand and are aware of what’s happening, I guess that’s really what’s come out of the GFC for me.

Wayne Lear, Shield Wealth: Yeah, I think following on from what Michael was saying, here is a 25 year margin loan [shows diagram] where they start off with $40,000, they put in over $720,000 over that period with lump sum rollovers and what have you, and they’ve spent about $640,000, so there’s about $80,000 to $90,000 left of the original capital.

It’s $1.8 million with a $700/$800,000 loan. There’s the GFC and it’s during that period, as Andrew said, is when you start to get the shakes.  So you don’t borrow more. That’s when you’ve got to be very, very cautious.

Believe it or not, the average LVR at the top here for our clients was 48 per cent and we always educate people and show people what would happen if there was a 35 or a 40 per cent drop in the market and they’re still okay, but unfortunately we had a 50 per cent drop in the market.

This particular example tells a lot of stories. Number one, it says be patient. Don’t get too greedy, and just hang in there with the strategy and it will work.

This particular person’s been cash flow positive throughout the whole time. She’s always received a tax refund and she’s in her late seventies at the moment and we’ve looked at winding it up, and the last interview we did the numbers and after tax and the dividends on $1.8 million, there’s a lot of dividends, her net outcome was about 40-odd thousand dollars. 

And her response was, “So, I’m being paid 40 grand to use somebody else’s $800,000”, and why would you wind it up you see.  And that’s what can happen if you hang in there over time.

Andrew Mckee, Australian Unity: I guess I think that the last few years have probably made advisors and clients wary, but I think they should be wary. I mean, leverage does add risk and it’s only for clients who have the right risk requirements that it makes sense, plus they need to have time on their side, plus they need to have cash flow on their side, and they need to be able to borrow at a reasonable rate.

So all of those things need to be working in their favour and I think it actually is probably healthy that people have a wariness around gearing and leverage, because the danger is otherwise, when markets are booming, people make the wrong decisions.  

They get into gearing at the wrong point and they get excited by the returns, but they get excited by the returns too late - they’ve already happened.

They gear up and potentially they’re setting themselves up for a future problem. So I think a degree of wariness amongst the advisor community and the client base is actually a healthy thing. 

And then, adopting that strategy for the people that it suits, and that works and using other people’s money works if you can do it for long enough and if you’ve got the right sort of client.

Michael Dale, Fiducian: Yeah.  I mean, it will all happen again. Hindsight’s a wonderful thing. I mean, you look at if you’ve taken an Australian share fund December 2007, the unit price was $2.

It came down to 86 cents in March 2009 and people were so worried about this unit price, which encompassed the top 100 companies in Australia and they’re wanting to move into cash and a lot of people did. 

In hindsight, when you show that, what would you do now? What should you have done when the unit price was 86 cents? They would say, “Oh, I wish I’d have bought that.”

Now, next week if there’s a big downturn in the market and this current price is $1.52 and it moves to $1.10, do you think they’ll be saying, “Shall we buy today?”  They’ll be saying, “The world’s going to come to an end.  I heard it on the radio. My mate at the bowling club told me he’s moving everything into cash.”  So common sense and logic doesn’t always cut it. It’s emotions and sometimes, I mean it’s been happening for a hundred years.

Andrew Mckee, Australian Unity: But that’s part of the role of the advisor though is to take some of that emotion out and make the right calls.

Alex Tullio, Leveraged Equities: It underscores that importance doesn’t it, because as you say Michael, the benefit of hindsight is a beautiful thing.  But we know that a successful investor is a disciplined investor, but do I in the heat of it want to crystallise my losses? Have I got that exit strategy?

If I don’t have advice, then I don’t have someone making sure I have that discipline if you want to put it that way. 

And you know, not that you’d want to go into margin call, but isn’t that sort of the last line of defence in terms of having that discipline, and I guess that’s why you have advice, you deal with professionals and you deal with specialists in the area that have a depth of understanding of what can happen and help you proactively manage that risk.

Wayne Lear, Shield Wealth: The other really key thing here that we haven’t yet discussed is that why are they going into margin lending or why are we recommending it?

So you don’t recommend somebody going to higher risk just for the sake of possibly getting a few extra bucks. 

So whatever we as professionals are advising has to fall within their overall long term plan, and it’s all about not just their risk tolerance, but also their risk capacity, and I think the problem with Storm was that everyone thought they had a high risk tolerance, but their risk capacity was absolutely rock bottom because that just wasn’t there. 

So it’s really important, if anyone goes into margin lending, there’s got to be a reason for it as part of their plan.

An example of that, I have a young couple, professionals, both lawyers, wanting to save enough money up to buy a house and have a family, they’ve got their super and we’re looking at a ten year program - by all means, margin lending to build their wealth to get enough money for the property.

They did that, they sold out just before November ’07.  They were very, very lucky.  Bought the house, had the family.

A few years later, they did it all over again.  It’s part of a goal for them.  I think it’s a key thing that when we, as professionals, sit with people, then margin lending is only one of the many tools and strategies that we have in our kit bag to help them to get to where they want to go.

Andrew Mckee, Australian Unity: I agree with that and I think there are some people who can get to where they want to go without the gearing, and that’s perfectly fine.

Wayne Lear, Shield Wealth: Yeah, and it’s our role as professionals to tell them they don’t need it.

Alex Tullio, Leveraged Equities: And it’s not for everyone.  If I could just pick up on a theme and it’s, I guess, a combination of probably what you mentioned earlier Andrew when you said it’s good to have a level of wariness. 

Absolutely, in terms of whether you’re an advisor or an investor, in terms of you approaching strategies that have risk with all these things that we’re discussing taken well into account and making that assessment.

I’m just interested to know from the rest of you all here, how do you feel about some advisors at the moment saying, ‘we’re not going near gearing or margin lending strategies at all?’ 

Clearly, yes that’s wariness going to an extreme and I’m quite passionate about this because I absolutely agree, this is for the right person, trying to achieve the right goals, the right circumstances and if it’s right for them. 

But to say as a professional advisor, look, I don’t even advise on that at all, is that really in the best interest of the client if it potentially could benefit for them just to ignore that gearing as a strategy overall?

George Deva, Ord Minnett: I think the challenge for advisors is, you know Michael touched on this thing, is really being able to balance the logic and the sensibility of the gearing strategy against the emotion, which drives retail investors which is creating fear and trying to find a middle ground where you can educate, you can inform, you can strategise with the client.

But then looking at their best interests, sometimes even when its overwhelmingly in their best interests and you’ve explained everything to them and covered off their risk profiles, they’re still uncomfortable because they associated gearing and leverage with loss. Then maybe that’s the best interest of your client.

I know a lot of advisors continue to be reticent about any form of gearing, not just margin lending, and we’ve seen that in the reduction of volumes across option strategies, warrants, even into geared funds, and we’ve seen that trend downwards towards risk aversion. 

But I think Alex makes a really good point, can you cover your best interests with your client by you not advising them, or simply saying I’m not going to advise.

Alex Tullio, Leveraged Equities: Well the pros and cons I guess, you know, having the discussion.

Michael Dale, Fiducian: I think Andrew will agree that any professional financial planner would never categorically say, “I’m not getting involved in gearing”, because people come to see a professional financial advisor and its part of what’s on the table. 

It’s just all about that relationship and knowing the client, as George said.  You would know when someone comes into your office, within an hour, whether they were suited for this strategy, and as George said, sometimes no matter how good the education is, how logical and how much it makes sense that, you know, the first downturn they want to be out and the first upturn they want to be in again.

So I guess, we just have to learn from what’s happened and know that it’ll happen again.  I guess with Storm, I suppose, and I don’t think I’m just speaking out of school here, is that there is a danger sometimes that it’s one cap fits all and I think that’s the problem that happened there, is that this is a great way to gear everybody up, to create wealth, but while the market was going good, then it was, this strategy will fit everybody, and that was the problem.

Andrew Mckee, Australian Unity: Yeah, it was on the market continuing when, of course, it doesn’t always go up. But yeah, I’d agree. You can’t discount gearing. You can’t say it’s not part of my suite or the things that I will talk about, and then it’s up to the advisor to try and work with the clients that it’s appropriate for. 

And it might be a minority of clients.

Michael Dale, Fiducian: And when you think about this, sophisticated and very experienced investors and even finance journalists during the GFC were suffering and making outlandish statements about, “this is it, this is different”.

So if those educated, reputable, experienced, sophisticated people were saying that, what chance does the Australian public have?  When the news comes on we have letters saying we’re all doomed.

Wayne Lear, Shield Wealth: I think it really again highlights the absolute importance of truly educating the client, and indeed planners, because I’ve spoken to a lot of planners who really don’t understand margin lending. 

They just don’t understand the pros and cons of that.

I also think in the Australian financial services landscape there has been a move, the tectonic plates around this whole issue of borrowing to invest has moved from margin lending into the SMSF area.

I think where you see the boom in limited recourse borrowing arrangements, the massive boom as a result of the change of legislation around warrants, I think the really sophisticated investor has gone into their own fund and is still doing gearing, but it’s within the self-managed super fund, and I think the margin lending scenario, this is firmly I believe, in the space of the young professionals wanting to create a bit of wealth outside of what they’re doing, knowing that if they stuff up in the first few years, they’ve still got a lifetime, and high salaries, to make up for it.