Margin lending: margin squeeze?

Over the past five years, a lot of the fat has been trimmed from profit margins for banks on home loans. At the same time, profit margins for margin lenders re-main robust. However, WM Mercer principal Geoff Walker reckons financial plan-ners should be asking margin lenders to justify their mark-ups.

Over the past five years, a lot of the fat has been trimmed from profit margins for banks on home loans. At the same time, profit margins for margin lenders re-main robust. However, WM Mercer principal Geoff Walker reckons financial plan-ners should be asking margin lenders to justify their mark-ups.

Five years ago, banks' housing-loan margins were three per cent. Since then, we have witnessed intense competitive pressure drive down margins so that nowadays the price of housing-loans is about 1.5 per cent over the official cash rate.

So are there any other bank products which might be susceptible to a competition induced margin squeeze? One possibility is margin lending where current lending margins of about three per cent are at the same level that housing lending mar-gins were before competitive forces emerged.

A critical determinant in whether competitive forces emerge is the extent to which excess profits are being made by lenders at current interest rates. If so, what would then be needed is a lender, perhaps a new player, willing to undercut significantly the current market level of pricing to a level which would still deliver normal profits.

The purpose of this article is to suggest why current interest rates on margin lending might generate super profits. In particular, it will consider the propo-sition that rates contain far more than an adequate allowance for the risk of loan loss.

The personal financial press features frequent articles on margin lending. Com-monly, when loan pricing is discussed in these articles, a comment is made to the effect:

"The greater risk compared with lending against property means margin lending interest rates are higher".

On the surface, such a statement seems quite unexceptionable. After all, there have been any number of occasions when the value of shares in a badly performing company has collapsed to or near to zero.

In contrast, the value of unencumbered real estate will rarely collapse to zero.

However, it is a big step from accepting that investing in shares is riskier than investing in real estate to being able to claim validly that lending against shares is riskier than lending against real estate.

If all other things were equal, it would be self-evident that lending against the security of shares is riskier for the lender than lending against the secu-rity of real estate, but this article will show that other things are not equal.

Therefore the claim of margin lending's relative riskiness needs to be tested to see whether it can withstand critical analysis.

One test, and perhaps the ultimate test, is to compare the loan loss experience on margin lending with that on housing lending.

Another test is to compare the respective loan management processes. The systems that the lender has in place and the speed with which the lender can act once a loss is looking likely need to be considered. Together, they will dictate the extent to which the lender is able to contain potential losses.

Loss experience

There is no doubt that, overall, housing-loan loss experience is low. Yet, the anecdotal evidence from a number of margin lenders is that there have been few cases where margin calls have not been met and that actual losses are virtually non-existent. Hence there are grounds to suspect that the loss experience of margin lending is comparable with, or perhaps even lower than, housing lending.

However, margin lending is a relatively new product in Australia compared with housing lending. Margin lenders could argue, possibly with some justification, that the loss experience to date may not be indicative of long term expecta-tions. Margin lending has been growing strongly from a low base in recent years, and it may be the case that the initial favourable loss experience will worsen in the longer term.

Further, both stock market conditions and interest rates have been relatively benign in recent years and a pronounced fall in market values or an increase in interest rates may expose some procedural weaknesses in lending practices, with a consequent additional deterioration in loss experience.

Nevertheless, it would be useful to consider whether there are forces at work that might logically explain the current low levels of margin lending losses - especially if these forces can be expected to continue regardless of market con-ditions.

A useful starting point is to examine the impacts of any differences between the respective loan management processes.

Loan management processes

A typical loan loss arises as follows: The lender becomes aware of a default and demands its remedy. The borrower is unable to remedy the default and so the lender takes possession of the asset pledged as security and puts it on the mar-ket. The sale of the asset yields the lender less than the amount outstanding under the loan.

We will look at each of these stages in the loss process in turn.

Lender's awareness of default

Virtually every secured loan contract specifies at least two events of default. The first is that the borrower fails to make the required payments of principal and interest.

The second is that the borrower fails to remedy a breach of the loan-to-valuation ratio. Such a breach most commonly arises when the value of the secu-rity asset falls below its originally assessed amount.

The typical default under a housing loan is brought about by the failure of the borrower to keep up the required repayments, for example, due to a job loss or an increase in interest rates.

It is relatively rare for a housing loan default to arise initially from a breach of the contractual loan-to-valuation ratio. This is because housing lend-ers typically fail to monitor changes in the value of the real estate pledged as security. This is because the housing market is relatively inefficient when it comes to value discovery compared with the stock market. It is a slow and expen-sive process to obtain an up-to-date house valuation.

In contrast, the typical default on a margin loan is caused by the borrower's failure to remedy a breach of the loan-to-valuation ratio. Again in contrast, margin lenders revalue shares held as security daily. They can do this easily because of the simple and cheap price discovery mechanism for securities quoted on the share market, and, to a lesser extent, in the managed investment trusts market.

Hence, margin lenders will be aware normally of a breach in the loan-to-valuation ratio within one business day. This enables the lender to act to pre-vent the situation worsening, thereby reducing the likelihood of the security's value falling to less than the loan amount and hence a loss on liquidation.

Thus, even if house prices are less volatile than share prices, the long time frame between house valuations creates the potential for a greater adverse price movement to emerge than between two consecutive daily share valuations.

Lender takes possession of asset

Assume now that the lender is aware of either a breach of the contractual loan-to-valuation ratio, or of the borrower's debt servicing requirements.

In the case of margin lending, the ensuing process is straightforward and rea-sonably uniform across different lenders. Once the lender is aware of the breach, typically the day after the breach occurs, it contacts the customer who has until a specified time on the next business day to remedy the breach if the lender is not to automatically sell the shares held as security.

Thus, the typical length of elapsed time from the lender becoming aware of a loan to valuation ratio breach until selling up, is one business day.

The situation with housing lending is totally different. A considerable period of time often elapses from when the lender becomes aware of a default until it is clear the default is not going to be remedied. The lender then has to take physical possession of the house, often not a simple matter. It then has to go through a typically lengthy house sale process.

The whole process could easily t