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Leverage
Weighing up margin loans and instalment warrants - part 1
Nick Renton AM - October 1, 2007
 If you have a spare $10,000 and invest it in shares which go up 10 per cent then you will have made $1,000. If instead you use not only your own $10,000 but also $40,000 of someone else's money then you can buy shares costing $50,000 and if they go up by the same 10 per cent then you will have made $5,000 instead of just $1,000.
This is known as "leverage". It can be achieved in various different ways, all of which have some advantages and some disadvantages. One way - the use of margin loans - is discussed below. Another way - the purchase of instalment warrants - will be discussed in part 2.
Stockbrokers frequently recommend margin loans to their clients, making them sound like money for jam. They gloss over the fact that leverage is a two-edged sword. In the example above, if the shares go down 10 per cent, then you will have lost $1,000 using just own money but $5,000 if you use $40,000 of someone else's money as well.
You should remember that a broker has a vested interest in giving you such advice - a bigger transaction means more brokerage, both on the original purchase and on any subsequent sale. There will also be fees involved in the loan part of the deal.
Just what is a margin loan? It is a special type of interest-bearing loan secured by shares. Such loans are available from banks, but they are also marketed by organisations associated with some stockbrokers. A minimum loan size is usually imposed.
Whether such a loan is suitable for you will depend on your circumstances. Margin loans are not really suitable for low income earners, inexperienced investors, undisciplined borrowers, speculators or investors with short term horizons.
How do margin loans work?
The precise details of such loans can vary according to the practices of the lender concerned, but the chief characteristics are commonly as follows:
1. The loan is secured over one or more specific parcels of shares. These can be shares already held or shares being purchased with the loan funds or a combination of both. The maximum loan granted is based on the market value of the shares pledged and the lender's views of their quality and the volatility of their share price. Typically 30 to 70 per cent of the value of a stock can be borrowed.
2. The shares will need to be those of companies on the lender's list of approved securities - basically non-speculative situations. Some unit trusts may also be acceptable.
The shares can be held in the names of individuals, companies, partnerships or trusts. The loan can, if desired, be in a different name from that used for the shares. The shares are registered in the holder's name through CHESS.
An attractive feature is that no other security needs to be provided and no credit checks are required. The facility can also be used as a revolving line of credit, with the outstanding balance moving up or down to suit the investor's convenience. It can be put in place ahead of the initial shares actually being acquired. A fixed term is not required.
The loan is granted on an "interest only" basis, but the interest rate is likely to be higher than in the case of loans secured by mortgages on property and with recourse to the borrower's total assets. The interest if the loan is used to acquire investments is tax-deductible. A choice of fixed and variable rates may be available. Various transaction fees will apply.
Margin calls
Now for the really nasty part. The market value of the total parcel of shares which has been pledged is monitored by the lender every day. If it drops so that the amount of cover falls below a defined ratio then the lender makes a margin call.
For example, if the original maximum loan was 70 per cent of the value of a parcel of shares then a call might be made if the "loan to value" ratio goes over, say, 75 per cent.
A margin call is a formal demand for some remedial action by you. This can take the form of "topping up" (providing more unencumbered shares from other parts of your portfolio, if these are available, and/or cash). Alternatively, the problem can be removed by your selling some of the shares held by way of security and applying the proceeds towards reducing the loan.
If you do not act appropriately to a margin call within a very short time frame such as 24 hours then the lender will exercise the power of sale granted by the loan agreement. This may have undesired capital gains tax consequences. It may also cause considerable mental anguish if the market fall which triggered the sale in the stock turns out to have been only a short term aberration.
More articles from this week's newsletter:
Stocks: Fund manager stock pick for the long haul: VDM Group
CS stock lab: Guide to analysing stocks - part 2
Superannuation: Does your super fund stack up?
CFDs: MF Global buys BrokerOne
Leverage: Comparing margin loans and instalment warrants
Stock of the week: Sirtex Medical stands out
Warrants: The commodities trader's no.1 resource
Smart investing: Neglect can lead to money regrets
Analyst report: LPTs still hot property?
Commodities: Miners not taking advantage of the gold bull
Whatever your views, you can discuss this article - or any of Nick's articles - on our message board Your 2 Cents.
Nick Renton AM is the founder and first president of the Australian Shareholders' Association. He is a consulting actuary, commercial arbitrator, company director and writer. He is the author of 62 published books covering shares, property, managed investments, taxation, wills, the Internet and the Australian economy. He has written books about more different topics than any other Australian author. He was made a Member of the Order of Australia in 2004.
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