The rising tide of margin lending

The margin lending industry in Australia has continued to grow in both size and sophistication, and you only have to look at the most recent Reserve Bank of Australia (RBA) data to see what is happening.

The December 2006 data shows there are approximately 153,600 client facilities open, and the total amount of money borrowed is approximately $26.3 billion.

This represents an 84 per cent increase in client facilities and a 280 per cent increase in the total industry loan book in the six years from December 2000.

Interestingly, this growth has occurred over the same period where the RBA has changed interest rates 14 times, six reductions and eight increases, and the ASX 200 Accumulation Index has increased 77 per cent (source: Iress).

What is also important to note is that about $15 billion of the $26.3 billion in debt, or 57 per cent, has been drawn down in just the past three years.

These types of numbers inevitably raise a couple of questions.

The first is: does this mean investors have been consuming debt with reckless abandon and have geared themselves to the hilt?

From what we can see in our business, this is not the case.

Our margin loan book is currently geared to 47 per cent (despite the volatility in February and March this year) and particularly where someone is making decisions with a financial planner, gearing is typically set between 40 per cent and 60 per cent.

This is similar to the RBA data showing the average gearing level across the industry as at December 2006 was 41 per cent.

And secondly: is our share market then being artificially propped up with debt funded by margin loans?

The issue here is one of context.

The Australian share market currently has a market capitalisation of over $1 trillion, and even if you assume the entire margin lending industry debt of $26.3 billion was used to buy Australian equities, which is definitely not the case, this would still only represent less than 3 per cent of the total market capitalisation.

The reality is though, many of our clients’ portfolios show investments across a broad range of asset classes, which further reduces the amount being used solely to buy Australian shares.

Of course, these numbers do exclude other forms of debt being used, which include capital protected loans, structured product loans and home equity loans.

The figures around the growth in client facilities and the total amount of debt outstanding are all very interesting, but the more relevant question is why has this growth occurred? This may help us understand where the margin lending industry is going from here.

There are three main reasons that may explain the continued industry growth.

1. Wealth creation

At the core of this growth is the understanding and acceptance that the use of gearing to help build wealth has become an increasingly successful and sound approach to investing.

Gearing, though, is not an investment strategy in itself, it is merely a way of providing capital to sit underneath an investment strategy.

When the two components are able to complement each other, the amount of wealth generated is potentially higher than you could achieve just using your own funds.

This is the core reason why more people are using gearing in their portfolios, and the more they see positive outcomes the more inclined they are to use it in the future.

Additionally, there are secondary benefits to consider such as increased portfolio diversification and the potential tax efficiencies that may be gained where the interest paid on a margin loan could be a tax deductible expense.

Margin lending is no longer the sole domain of the high-net-worth, sophisticated investor.

A far broader range of clients is using margin lending, ranging from young accumulators (20-something-year-olds wanting to save for a deposit to buy a house in five years), executives who want to repay their mortgage as quickly as possible or exercise stock options, investors who are overweight in an asset class (for example, property) or pre-retirees who want to maximise their wealth creation outside of superannuation before they retire.

This means the size of the market has increased dramatically and the potential wealth creation benefits are well and truly available to the broader population.

2. Risk management

We have noticed an increased level of comfort among planners to think about and recommend margin lending in the appropriate circumstances.

As many correctly point out though, risk management is one of the most critical aspects of margin lending to get right, and the level of awareness in this area has increased dramatically over the years.

When you mention margin lending, and risk in the same sentence, there is usually a reference to a margin call.

The possibility of receiving a margin call is the single biggest barrier to using margin lending and this is something we consistently hear from the focus groups we run.

However, like most things in life, the potential impacts can be managed.

In some cases, the financial planners we deal with have been using margin lending for 17 years and, despite the various market cycles, none of their clients have ever received a margin call (note: this is not indicative of all planners or their clients).

Good education and having the right tools available is the key. Good education also doesn’t mean just identifying the risk, it means understanding what the potential risk mitigants are as well.

For example, if I want to invest $100,000 into blue chip shares and, although each share has a loan to value ratio (LVR) of 70 per cent, I choose to gear at 50 per cent, one of the potential risks is I might receive a margin call. I can manage this risk by diversifying my portfolio into five shares instead of one, my gearing level of 50 per cent says I need a 33 per cent fall in my portfolio before I receive a margin call, and if I do, I might choose to add more security, pay down the loan or sell a portion of my portfolio.

Additionally, instead of satisfying the margin call, our clients can now defer their margin calls by buying a put option over their direct share holdings. Armed with this information, the impact of receiving a margin call is now very manageable.

Good risk management is such a key component to margin lending that it is actually influencing product development.

Last September, we launched a specialist investment loan called the Macquarie Investment Multiplier that provides all the benefits of gearing into managed funds, but the margin call feature has been removed completely.

This product was launched in direct response to receiving requests to somehow give investors ‘the best of both worlds’.

I think this is an example of how margin lenders are responding to different risk management needs, and I don’t see this changing.

3. Change of product mix

When I joined the margin lending industry eight years ago, margin loans were available across the industry in a very basic form of an interest only loan secured against shares and managed funds.

Instalment gearing was a feature on offer, and the total value of loans under management for the 20 providers at the time was less than $5 billion.

Today it’s a very different story, and we have rapidly moved away from a ‘one size fits all’ product to multiple products with varying degrees of sophistication and functionality.

This doesn’t by any stretch of the imagination mean that the ‘basic’ margin loan is redundant; quite the contrary.

What it does mean though is that as investors become more used to debt and/or their needs change over time, they will need their margin loan to do more things.

The impact for financial planners, particularly those dealing with more sophisticated investors can, therefore, be quite large.

As an example, we deal with planners who have a range of geared clients.

On one end of the spectrum they have clients who are geared to 50 per cent into four managed funds, but on the other end, they have clients who have managed funds with a monthly saving plan attached, they actively trade in Australian equities and they use derivatives; and this all happens through one margin loan facility.

The feedback we get is that to be a provider of comprehensive margin lending services in today’s environment, you need to have a fully diversified offering of products to cater for an increasing array of needs. The catch is, to do this successfully takes a lot of financial and human resources, but more about this later.

So while ever there are wealth creation benefits in using gearing, risk management remains strong and investors are able to consume lending services that help them achieve their financial goals, I don’t see the growth in the margin lending industry stopping in the short to medium term.

We have now established that the margin lending industry is still growing, the product mix is changing and investors are becoming increasingly sophisticated in what they need. What do these trends mean for planners and margin lenders? Let me answer the latter first.

The largest impact on our business is the level of investment we are now making to improve our products, service and infrastructure. The amount of money we invested in IT and system development in 2006 was the largest ever, and it’s fair to say it is an ‘item of very significant interest’ in our business accounts.

This just reinforces the point that a margin lending business is about scale.

Unless you have a minimum loan book of between $500 million and $1 billion in size, it would appear hard to sustainably invest in product, service and system infrastructure to the level required to keep pace with industry growth. This leads to the inevitable issue of consolidation.

Over the past three years, three margin lenders (Challenger, JBWere and HSBC) with combined loan books of over $1.3 billion decided to sell their businesses as an exit strategy.

In JBWere’s case, this decision was made with a loan book in excess of $800 million, not an insignificant size, and all of this has happened on the back of some fairly strong share market growth.

What will cause further consolidation will probably be either, or a combination of, a current margin lender deciding to sell or outsource its back-office to secure the benefits of scale, or if (when) the share market does change direction and finally acquaints itself with negative returns again. Until then, in the quest to keep products, services and infrastructure best of breed, large amounts of investment will continue to be made in an industry that is already highly competitive.

What do these trends then mean for financial planners?

From the feedback we receive, it means advisers are becoming more selective in which margin lenders they use and their decision criteria is changing.

Historically, offering the lowest interest rate or the highest security LVRs was important and quite often the lowest price won the day. This approach made sense when only one or two clients in a financial adviser’s client base opened a margin loan because the administrative and service impact on their business was small.

However, with the growth in margin lending recently, we now work with planners who individually have 10, 20, 50 or 200 client facilities.

The key drivers here change from trying to get an 80 per cent LVR instead of a 75 per cent LVR, or an interest rate that is 0.10 per cent per annum cheaper, to those that recognise the criticality of the chosen margin lender providing business and administration efficiency.

That doesn’t mean to say that lenders can afford to stop being competitive in the areas of price and product features, but it does mean these items play a reduced role in making the ultimate decision.

In our experience, the last thing a financial planner wants is to tarnish their reputation by referring their valued clients to a margin lender that doesn’t aspire to achieve the same quality of service and professionalism they do.

In many cases though, service excellence doesn’t always come with the lowest interest rate.

This is why it is so important for a financial planner to think about what their needs and key drivers are — is it price, service or product, or all three combined? It is then far easier to conduct your research and ultimately select a lender that will complement your business.

The Financial Adviser Feedback Forums we run each year enables planners to have direct input into the strategy and direction of our business.

As a result, in addition to investing in product innovation, we have focused a large amount of our spending on delivering items that focus on the financial planner and their firm.

Sales strategy, client service, online reporting, data management, system connectivity and providing administrative efficiencies are now the vernacular of today.

The extent to which a margin lender is able to offer these as part of a total product package are the differentiators of the future.

A margin lender should therefore seek to be a seamless partner in a financial planner’s business, not just a product provider that charges an interest rate.

Peter van der Westhuyzen is division director of MacquarieInvestment Lending .