In earlier articles, we set out the risks in margin lending, and how you can ensure your client owns the Black Swan event by stress testing the client’s portfolio under a number of scenarios.
We would like to now complete the circle by considering how you can stress test the client’s income and expenditure budget, and integrate this with the asset and liability portfolio.
If we go back to our previous article, we had a client with an asset/liability portfolio as seen in Table 1.
Let us now make an estimate of their income and expenditure (see Table 2).
This shows a surplus of $7,600 per annum after tax.
Let us now consider the double gearing scenario in our previous article (see Table 3).
We know from our earlier article that negative gearing from a margin loan will create a profit of about 1 per cent per annum after tax.
However, this includes the capital gains (after tax). If we leave out the capital gain, then the margin loan will produce negative cash flow of about 4 per cent after tax, and allow for dividend income and franking credits.
The extra housing loan of $300,000 used to purchase shares (assume an interest-only loan) will produce negative cash flow of about 2.5 per cent after tax, and allow for dividend income and franking credits.
Hence our cash-flow shortage as a result of the double gearing proposal is 2.5 per cent of $300,000 plus 4 per cent of $600,000, which is $31,500 per annum after tax.
This means our client will have to cut some living costs to fund this double gearing plan, or hope to take regular capital gains to fund the $23,000 annual after-tax shortfall.
The double gearing plan is already on thin ice.
The client could always capitalise the interest shortfall.
Let us now throw the Black Swan into the works (see Table 4).
As before, the ‘Perfect Storm’ is looking really ugly.
The investor has lost 44 per cent of their net worth, or $480,000.
The LVR on the margin loan is now 95 per cent.
In order to get the LVR on the margin loan back to 67 per cent, they will have to sell $540,000 of shares at the bottom of the market.
Table 5 shows the client’s position after the margin call.
Let us also cease all margin loan activity, and apply the net (non-super) share portfolio to reducing the mortgage by $30,000 after selling the $90,000 in shares and paying off the margin loan (see Table 6).
Let us now revisit the estimate of their income and expenditure.
Convert the interest-only part of the mortgage to credit foncier, or principal and interest.
The yearly mortgage payment goes up from $33,700 to $56,500 (see Table 7).
There go the holidays! The mortgage is up from $400,000 to $670,000.
Because the Black Swan has landed, let us now consider the loss of the second income (see Table 8).
No more private schools. No more holidays. Imagine the stress this family is under. A possible case of divorce and/or suicide. All because they entered a perfect storm without stress testing both assets and income and expenditure.
Black Swans do land. More frequently than you expect.
Stress testing
Anybody who is recommended gearing as part of their financial plan without stress testing of both their balance sheet and revenue and expenditure is being grossly misled.
We believe that such stress testing is a fundamental requirement of a proper financial plan, regardless of whether or not gearing is part of that financial plan.
Our previous two articles argued that:
- margin lending with Australian shares as an investment strategy is gambling; and
- double gearing is immoral and probably fails to meet the adviser’s duty of care obligations.
We believe that financial planners who do not stress test both balance sheet and revenue and expenditure are grossly failing their client.
We believe that a strong case exists under existing legislation for civil penalties.
Peter Worcester and Paul Resnik are industry consultants with over 70 years of combined practical industry experience. They both have firm views.
