More tough times ahead for margin lending

Boom years are long gone for the margin lending sector. Given that the improvement in the share market is one of the main catalysts for using margin loans, the sector is likely to find the going tough for a while yet, writes Janine Mace.

There is an old saying that if you put lipstick on a pig it is still a pig.

While the margin lending industry may have heard the saying, it is determined to prove it wrong. 

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After the debacle of Storm Financial and the negative perception around gearing created by the collapse of Opes Prime and Lift Capital, the industry has been busy giving itself a makeover.

With a fresh emphasis on customer service, more education, and new ways of looking at traditional product features, the industry is ready to once again begin wooing clients.

A new regulatory regime that has tightened the rules and made the loan application process tougher hasn’t hurt either.

All this reinvention and repositioning is necessary because margin loans have been in the doldrums.

As the latest Reserve Bank statistics show, the total value of margin loans in Australia at the end of the December 2011 quarter fell to just over $15 billion from a peak of $42 billion in December 2007.

From its top of 268,000 in December 2009, the total number of client accounts was down to 212,000 at the end of December 2011.

No more boom

It’s a long way from the boom times when a margin loan was the essential accessory for every barbeque conversation. 

Julie McKay, senior manager technical and research at Bendigo Wealth (whose offshoot Leveraged Equities is one of the major players in the space), admits times have changed.

“Take-up is lower than in boom times. But you would not expect people to think of margin lending given market expectation and interest rates,” she says.

According to McKay, the reduction in client numbers highlighted in the Reserve Bank statistics is not unexpected.

“There has been a lot of housekeeping going on over the past few months. For example, some people had two margin loan accounts and have reduced it to one,” she says.

“In our business, most of the account closure was around people rationalising their accounts.”

McKay believes this reflects a new prudence when it comes to investment.

“People are becoming more sensible about their total balance sheet and are rationalising it and doing housekeeping,” she says.

“When it comes to gearing, people are now doing it very cautiously through things like dollar cost averaging or regular instalments. We are not seeing insane levels of gearing,” McKay says.

Over at Core Equity Services, general manager Peter Steel agrees boom times will not be returning anytime soon to the margin lending business.

“Certain pockets of the industry have been hit quite hard in recent years,” he notes.

“There will not be a return to the previous heights.”

Adrian Hanley, head of margin lending at NAB Equity Lending, believes the slowdown in credit growth in Australia is also taking its toll on the margin lending industry. 

“Margin lending straddles both equity markets and lending, so the bank commentary that lending has slowed is reflected in margin lending figures. It is not just equity markets tracking sideways, it is also the influence of client deleveraging,” he says.

Deleveraging is clearly a factor, with average gearing levels reducing sharply as clients pay down debt. The average gearing level peaked at 52 per cent in 2003, Hanley says, but by December 2008 it had fallen to 51 per cent, and in 2012 it is currently 35 per cent.

“The yields generated from investment portfolios are creating positive cashflows for clients, so most margin lending clients are now positively geared, not negatively geared.

"This means they can retire debts, and we are seeing clients retire both types of debts – deductible and non-deductible,” he notes.

Sentiment changes

Although client deleveraging is hurting, Hanley is optimistic. “Clients are retiring debt, but many have left their facilities open and available for use later.”

He says the Reserve Bank statistics provide a snapshot of how the whole industry is tracking, but that the NAB Equity Lending business is “quite different”.

“Volumes have dropped, but not to the same extent as in the RBA stats.”

According to Steel, Core Equity Services has not been badly hit either. “We have done well from a market share point of view,” he says.

“The share market remains fairly subdued and we have seen several years of clients moving to lower their gearing levels, but we have also seen signs of clients regearing and we have gained some new clients,” Steel says.

Steel believes client and financial adviser views on margin lending are beginning to change. “We are seeing early signs of a turnaround in interest in margin lending.”

But everyone agrees the real key to seeing margin lending pick up is market conditions.

“Performance in the next 12-18 months depends on sentiment about markets in Australia. For financial planners, the key to margin lending usage is volatility in equity markets and client demand,” Hanley explains.

This view is bolstered by data in the December 2011 Investment Trends Margin Lending Financial Planner Report.

According to Investment Trends analyst Trent Hardy, the latest report highlights the importance of interest rates and share market conditions to the margin lending business.

It found the main catalysts for using margin lending are an improvement in the share market (60 per cent of respondents), an improvement in interest rates (60 per cent), and increased client demand (50 per cent).

McKay agrees: “Interest in ‘good debt’ depends on expectations of where the market is going and where interest rates are heading.”

Given these factors, the margin lending market is likely to find the going tough for a while yet.

The Investment Trends report found return expectations among advisers were much higher than those of clients at 7.5 per cent (including dividends), while client return expectations were only 2-3 per cent. “This is rock bottom,” Hardy notes.

Hanley is unsurprised by these findings. “The attitude towards margin lending is reflective of attitudes towards equity markets,” he says.

Market volatility has not gone away and has come in waves, and that causes uncertainty about markets and subsequently margin lending.”

Steel agrees market conditions have taken their toll.

“A lot of financial planners and clients have been burnt by the market, so part of the issue around sentiment towards margin lending is applicable to the market itself, and that will turn around when market conditions improve.”

Interest rates also affect the propensity to write a margin loan and advisers are expecting interest rates to rise by 40 basis points over 2012.

This is significant because interest rates have “a very asymmetrical influence on margin lending interest”, Hardy explains.

The report found if interest rates go up 1 per cent, the average number of new margin loans falls by half. If they go up 2 per cent, new loans go down 65 per cent.

“However, if interest rates fall 1 per cent, you will only see a 16 per cent increase in new loans,” he says.

Despite this, some clients appear ready to take the plunge.

“They see the market as an opportunity, given its current levels. There are people that are interested in taking a position as yields are seen as being attractive and valuations good,” Hanley says.

“We have clients who are retiring debt, but also others who believe the market is undervalued. In 2011, new activity was 15 per cent of the average loan book.”

McKay agrees clients are slowly coming around. 

“People are thinking about big financial goals such as retirement, so interest will return. Cash is good, but people are starting to think about how to achieve their goals,” she says.

“Now there is less concern about where interest rates are going, so this may encourage interest.”

Although some advisers and clients see opportunities, they are unlikely to move quickly, according to Hardy.

“The vast majority (90 per cent) of financial planners see stocks as being undervalued, but they also do not expect them to rise significantly in the near future,” he says.

“For those financial planners on the fence about using margin lending, 96 per cent said market conditions would need to improve before they will move,” Hardy says.

Regulatory changes

While investment markets may hold the key to renewed client and adviser interest in margin lending, when they do get back in the water they may find conditions a little different.

Since the GFC-related controversies, the regulatory system around margin lending has shifted significantly.

The changes to margin lending were part of the Corporations Legislation Amendment (Financial Services Modernisation) Act 2009 (the Modernisation Act) and formed part of the new national consumer credit regime.

While there was considerable handwringing prior to its introduction, now the system is firmly in place, most providers are fairly upbeat about its impact on their business.

“It is not really a dramatic change for the reputable players,” explains McKay.

Hanley agrees the regulatory changes “have not really had an impact on those operating in this space the way the legislation currently operates”.

“The way the legislation operates is the way our business always operated, so NAB could absorb the changes relatively easily. Suitability testing for clients was already being done, so we have been able to absorb it. We had to work on it, but it wasn’t too much of a problem,” he says.

The picture appears similar from the adviser perspective.

The Investment Trends report found the Modernisation Act and regulatory changes have not had a huge impact on adviser usage of margin loans.

According to Hardy, the survey found the key barriers to usage nominated by advisers were market conditions, which was cited by 85 per cent of planners.

In addition, 44 per cent cited risk, while only 27 per cent mentioned regulatory conditions as a hurdle when it came to using margin loans.

Tighter assessments

Although advisers may not be overly concerned, the new regime has had an impact. As Steel explains, the regulatory changes have led to an “uplift” in client requirements.

“Some banks have considered the new rules mean that assessing a margin loan application needs the same level of assessment as a home loan. This has led to more work for margin loan providers and for the client it is not as easy. The barrier to entry for a margin loan has been lifted significantly,” he says.

“The changes will have had an impact for some clients, but that is not necessarily bad. Greater convenience is not always a good thing.”

Steel believes the new regulations are working well. “The application process is more onerous, but overall, the regime is going well. The main thing is the client’s best interest is now first and foremost.”

McKay agrees the changes have had an effect, but she believes the new responsible lending rules are not really delaying the process for suitable clients. “They have not slowed down the lending process because the information required is not new or intrusive for clients.”

Hanley is also pleased with the new regime. “The rules are working reasonably well, and if not, we wouldn’t have seen the new volumes coming through. They have afforded both clients and lenders a level of protection they have not had before.”

The regulatory changes – particularly the rules around margin calls – have generated a more intense focus on client servicing, but Steel explains most in the industry have adapted quickly. 

“Good margin loan providers have taken the change as an opportunity to improve areas such as customer service, how they access a client’s loan and how they do a margin call,” he says.

McKay agrees: “The big scare for the industry was around the margin call process, but for us as a high service provider, we were already doing it.” 

She believes this highlights the importance of service when it comes to selecting a margin loan provider.

“There is a strong emphasis on price when it comes to any form of loan, but service is vital when you are approaching your buffer levels with a margin loan.”

Steel agrees provider service levels are important.

“We are working to ensure greater integration with financial planning tools. It is increasingly important for margin loan providers to provide streamlined processes to busy advisers.”

Hanley also emphasises the service aspect.

“It is important on the delivery side as financial planners want tools that allow them to deliver products to clients easily, such as cashflow tools, easier application processes and monitoring tools.”

It is little surprise customer service is now so important. 

Hardy says it is one of the key pieces of advice his firm gives to providers. “We tell lenders the main thing they can do to increase usage is to improve the ease of use of margin loans products through things like better application processes.”

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