A wide margin of safety

Anyone looking to identify the gambling streak that reputedly characterises Australians as a people would be hard pressed to find evidence of it in the margin loans sector.

Three years into a booming stock market, few of the country’s 150,000 margin loan holders are aggressively gearing against maximum available loan-to-value ratios (LVR), depending on underlying securities.

Average borrower gearing ratios are currently about 40 per cent, despite the 12 main lenders offering LVRs of up to 75 per cent on stocks, and more on managed funds.

This is also despite the $20 billion sector growing at about 30 per cent a year, both in terms of loan volumes and average loan size, which in turn has helped to reduce margin calls to historically insignificant levels.

“The reality is the industry remains very conservatively geared on average,” according to St George head of margin lending, Andrew Black.

The average gearing ratio on the St George margin loans book is only 37 per cent, which means clients on average are “only taking up about 60 per cent of their available gearing”, Black says.

Most clients are geared in the 60 to 70 per cent range, he says, although the bank has lent up to 75 per cent on a “portfolio of about a dozen securities”.

A conservative approach

This conservatism is partly because “most of our clients go through an adviser, and are being taught that one of the strategies to mitigate risk is to be conservatively geared”, Black says.

“Their main advice to clients would be that they should not gear right to the hilt, and be diversified, especially these days, when we have got very competitive LVRs on individual stocks.

“So many of the companies you can invest in are paying 4 and 5 per cent dividend yields. If you are receiving a 5 per cent dividend yield on a stock (on a margin loan at 8.35 per cent, the headline rate on the smallest loans), a 30 per cent rebate on franking dividend, and you get half the interest back in a tax deduction, then you are actually positively geared if you are geared at only 50 percent, as opposed to going up to the 65 to 70 per cent that is available to you.”

Average gearing ratios in client portfolios have “definitely fallen over the past 12 months, and that’s a function of two things”, according to Bassem Jammal, managing director of boutique lender Lift Capital.

“Firstly, many investors have benefited from the rising share market. By default, if the market value of a portfolio is going up and borrowings are roughly static then gearing ratios will be down. In addition, investors remain conservative by nature, reflecting the way margin lending is sold in the marketplace,” he says.

Avoiding a margin call

The average client is leaving a “very healthy margin between what their security is worth and how far this would need to fall before we made a margin call”, John Daley, ANZ head of margin lending, says.

In the case of a typical client geared at 40 per cent and permitted to borrow 65 per cent, the market would need to fall by 43 per cent before there would be a margin call, according to Daley.

“Most customers are leaving themselves with a big cushion so that even if the market were to fall by as much as 25 to 30 per cent, they can maintain the same level of borrowing and wait for the market to eventually go up again.”

With a diverse portfolio, Daley adds, it’s “really tough to lose all your capital through a margin loan. You have to be spectacularly unlucky for a portfolio of say 10 different stocks to fall by substantially more than the market, and there is only so far the market can fall”.

Clients usually end up in trouble only when they have “borrowed against just one stock, and that stock goes out of business”, he says.

“This could occur, for example, if a client borrowed solely against HIH. Such a customer may effectively lose all their security, and end up owing money on the loan.”

There’s also a greater understanding generally among investors now that margin calls are “not an event of default but rather a risk management tool”, he says.

“They’re simply a mechanism of the product to ensure you don’t end up in a negative equity position, where you owe more money than you have got in collateral to support it.”

The rate of margin calls is currently as low as it has ever been in the industry, running at only 0.15 calls per account on average per year, according to Daley.

Of these, 90 per cent of ANZ customers resolve their position “without us doing it for them,” he says.

“Beyond that percentage we make a number of forced sales of stock, to restore customers to an appropriate equity balance.

“Very occasionally we sell all the stocks we hold on behalf of a client and he or she still owes us money. We then ask the client to pay that back, and they are technically in default if they do not pay at that point.”

Negative equity

Daley says it’s a “very, very small number of customers who wind up in negative equity positions, and in fact we have had only one customer in the past two years who has ended up in default.

“While margin lending has its risks, for most customers the rewards exceed the risks, particularly if customers manage those risks well through diversification and prudent borrowing.”

Market conditions

A booming stock market for three consecutive years has created an ideal environment for margin lending, according to Black.

“There’s no doubt that if the stock market had to slow you wouldn’t see the current industry growth levels of 30 to 35 per cent,” he says.

Growth is occurring “through two mechanisms, both of which are probably equally shared in achieving that growth”, he says.

“One is through capital appreciation of the underlying assets supporting the existing loans, giving people more capital to reinvest. The other is a result of a rising market attracting new customers into it.”

Black says the St George margin book size has grown by 34 per cent over the past 12 months.

“I think you’ll find all the main lenders would be up in that 30 to 35 per cent bracket. Our book is currently at $1.8 billion, so we grew by about $600 million over the last year.”

He says that while St George’s average margin loan is about $140 000, in line with the industry average, new loans are coming in at about $170,000.

“The size of the average margin loan is definitely increasing.”

Funding a loan

Any increase in both the volume and size of loans has not been accompanied by an increase in the cost of acquiring a loan.

Black says interest rates have been relatively stable against the Reserve Bank (RBA) cash rate over the past few years, ranging from 7.95 per cent to 8.4 per cent, including a margin of about 2.5 to 3 per cent on top of the cash rate.

In a “very competitive pricing market”, according to Cannex financial analyst and sector manager Harry Senlitonga, “the margin between highest and lowest interest rates offered by lenders has not been a differentiating factor for investors”.

By contrast, investment options offered by lenders have become a differentiating feature, Senlitonga says.

“Some lenders offer investors more than 500 stocks against which they will lend, and others only 300. The difference is even more marked for managed funds, with some lenders offering 1,900 different managed funds, and others offering less than 1,000.”

Product features

Product flexibility is another differentiating factor for investors and advisers, including improved reporting features, such as alerting clients that they are near their borrowing limit or even extended transaction capabilities, making it easier for a client to meet a call or adjust a portfolio.

There have also been some structural product changes, such as widening the set of assets held as security for margin loans, and increasing buffers to margin calls, designed to accommodate small amounts of day-to-day market volatility.

The channels through which clients acquire margin loans are changing along with the sector’s growth, suggesting that margin loans are starting to acquire a much broader market appeal.

“The direct channel is increasing quite quickly and certainly faster than the financial planner channel,” Daley says.

As a result the “absolute dollar value secured over managed funds is continuing to increase, but not nearly as fast as over shares”.

If the share market slows, the number of “clients coming direct would probably slow, while the number coming through planners would probably slow also, but not quite as much”, he adds.

Buying shares direct

An interesting development, according to Black, is that “we’re now starting to see planners putting margin loan clients into direct equities as well as the managed funds market”.

He says the amount of direct equity supporting St George’s book has grown from 62.5 per cent to 67.5 per cent in the past year, whereas managed funds supporting its portfolio has decreased from 37.5 per cent to 32.5 per cent.

About 45 per cent of St George’s margin loans book is sourced through financial planners, 28 percent direct, and 23 percent through stockbrokers.

A longstanding misconception the growth of the market is helping to correct, according to Daley, is that a margin loan is “only for me if I am trading every day”.

Daley says the customer base is divided between traders and investors.

“Some people trade day-to-day and have a margin loan to support that. Then there is another group of clients, investors, who take a long-term view, leveraging to 50 per cent rather than 75 per cent as they sensibly build a diversified portfolio.”