A warning about the perils of margin lending

Bernie Ripoll warns about the return of margin lending into the financial sector, and the dangers the practice poses for unwary investors.

Before the global financial crisis (GFC), margin lending had well and truly become the new wealth creation vehicle of choice. It was widely regarded as an infallible tool of leverage using someone else’s money, multiplying the upside of share trading and setting out to get more from investing less.

Sounds pretty good. It seemed to the converted and their advisers that this system of leveraged borrowing against a share portfolio was the new secret weapon of the masses, wrested from the rich under a new economic era of growth.

During the heady years of global growth and seemingly ever-rising markets, very few could or wanted to see a downside.

We were looking at a new economic paradigm unseen in history, where the market cycles of past generations were just history. In fact, those not ‘onboard’ with margin lending and high loan-to-value ratios were simply missing out.

So blinded by massive commissioned returns and self-conviction, some spruikers shouted their message to anyone with a heartbeat and a bank account.

The pressure to get on board was enormous, if you didn’t then you weren’t serious about your family’s financial future.

Then came sub-prime, Lehman Brothers, the GFC and everything else that followed.

The disastrous awakening for so many unsophisticated investors, stranded on wafer thin margins against a downturn, was that you cop massive leveraged losses on the way down just as easily as the paper gains were magnified on the way up.

The old saying, you don’t lose any money if you don’t sell at the bottom, is also true in reverse; you don’t make any profit unless you sell at the top was a tough lesson for those on pensions, small incomes and retirement savings.

High leveraged investments through margin loans looked great on paper as long as the market always went up and you had the appropriate advice, time and cash to react to adverse conditions.

As many discovered, their tenure over share portfolios held by banks through margin loans was more complex than expected and carried misunderstood liabilities.

The biggest trap for unwary punters was when their portfolio value fell into margin call rapidly without proper and full management.

The experience for thousands was that the sell down at the bottom of the market created a complete loss of investment, with the debt remaining in full and, of course, no means of income to support the massive loan.

This is exactly what happened to ordinary mum and dad investors and, as a result, they lost their life savings and family home.

The banks didn’t get off lightly here either. Their zeal to sell a loan in any form through overbearing partners and branches meant that people got margin loans into the millions with no capacity to repay without the portfolio itself.

In a downturn this will spell disaster. No one it seems understood the debt ratios or paybacks for these loans, not even the banks.

With so much pain fresh in the minds of the public, the agents and parliamentary inquiries that followed, surely no one could repeat the mistakes of events so recent and tragic.

But the promised high returns of leveraging into risky products is tempting and back in vogue since markets have bounced back spectacularly from the lows of the GFC. Spruikers have reignited the flames of fortune for those willing to take a punt. For them, there is no downside accepting bigger commissions and bigger portfolios.

The most vulnerable are always the first targeted. This fact is more than evident from the thousands of low income and aged investors who irreversibly lost their life savings and homes just last year.

Data from the Reserve Bank of Australia highlights the rise in the total dollars of margin lending since September 2009, and the startling evidence that the total number of clients in a margin loan is now higher than before the GFC should be of concern to banks and regulators.

As confidence marches its way back from obscurity and the spruikers come back in force — beware of what sounds too good to be true. Bragging rights over paper gains never quite match the horror stories of real losses.

Not unlike violent behaviour and compulsive gambling — changing habits is very hard to do.

During the Storm Financial inquiry I heard sickening stories of disaster and loss. These stories must form part of the lessons to be learned. Taking big risks on thin margins can still leave highly leveraged portfolios perilously exposed when markets shift quickly.

The Rudd Government understood early the problem that irresponsible margin lending can cause and has taken steps to ensure better practices from lenders, whilst the Corporations and Financial Services Committee I chair has also recommended a number of reforms.

But the best consumer protection will always come from good advice, well-informed decision-making and realistic investments that are affordable.

For any good to come of the GFC, it must be the experience and the ability of investors to protect their life savings and family home and carefully build a nest egg for retirement.

Let us not repeat the mistakes of the GFC and prove once again that a fool and their money are easily parted.

Bernie Ripoll is the Federal Member for Oxley and chair of the Parliamentary Joint Committee on Corporations and Financial Services.