Gear up for margin calls
While borrowing to invest magnifies gains, it also magnifies losses, so be prepared.
While borrowing to invest magnifies gains, it also magnifies losses, so be prepared. As the sharemarket descended into chaos early this month, lenders from Bendigo and Adelaide Bank's margin lending division, Leveraged Equities, were on the phone to about 1000 customers, asking them to take action to restore the debt-to-equity ratios of their loans. For those investors, the pain of watching the market fall was compounded by a margin call.A margin call is the big risk that borrowers take on with a margin loan it is the risk that the assets they have used as security will fall in value and they will be asked to provide additional security or pay down part of the loan.The margin call is what makes margin loans different from other investment finance and why it's important for borrowers to understand what a margin call means and how they can deal with it.WHAT IF THERE'S A FALL?The 20 per cent fall in the Australian sharemarket index, the S&P/ASX 200, between April and August was enough to trigger margin calls for borrowers whose portfolios were highly geared.Lenders allow a maximum loan to valuation ratio of 70 per cent on many stocks and funds.If the borrower's debt-to-equity ratio is 70 per cent, a 13 per cent fall in the value of the asset is enough to trigger a call.Many advisers now recommend low gearing levels, especially for investors using margin loans for the first time.The head of margin lending at Westpac, David Curry, says: "There is a place for gearing to help build wealth, if you take a conservative approach. A gearing level of 30 or 40 per cent would greatly reduce the risk of a margin call and would be a good starting point for many investors."If debt-to-equity is 40 per cent, the asset would have to lose 50 per cent of its value before the borrower faced a margin call.LEAVING THE BUFFER ZONELeverage increases access to markets and offers the prospect of higher returns but the benefits can come only with a commensurate increase in downside risk.A borrower receives a margin call when their loan exceeds the maximum debt-to-equity ratio. Lenders provide a "buffer" - if the value of the security falls and the loan value exceeds the limit by only a few percentage points, the account is "in the buffer" and no action is required.Most lenders have a buffer of 5 per cent, some 10 per cent. When the loan balance exceeds the limit by more than the buffer, it is time for action.In such a situation the borrower must do one of three things:- Provide additional security.- Repay part of the loan.- Sell the securities.Lenders say that in most cases, borrowers are able to settle margin calls by putting in extra cash. They also say there are positive aspects to a margin call. They see it as a safety net, in which the lender uses the mechanism as a way of ensuring borrowers address their situation while they still have equity left.And it prompts borrowers to review the situation and make a considered decision about whether the securities are worth holding on to.This is a very different situation from an investor who sits on a loss-making investment in the forlorn hope it will come good.STAY ON TOP OF THINGSBesides keeping gearing levels low, investors can do several things to reduce the impact of a margin call and ease concern about receiving a call.They should actively monitor their portfolios, keeping track of how their investments are performing and how their gearing ratio is moving. Gearing is not a set-and-forget strategy.Investing in a diversified portfolio reduces the risk that a big loss on any one security will do serious damage. Managed funds offer a wide variety of stocks.Investors should have a cash reserve (the amount will depend on the size of their geared investment portfolio) or other securities that can be tipped into the margin loan account if required, to restore its debt-to-equity ratio.Key points- The lender will contact the borrower to notify them that the loan is in margin call. The borrower must take action to restore the debt-to-equity ratio.- The borrower should have a mechanism in place for depositing cash into the loan account.- As an alternative, additional approved securities should be on hand to transfer into the account.- Selling shares to meet the margin call is the last resort. No one wants to be selling into a falling market.- Make sure the lender can keep in contact. The lender will try to make contact but if it can't it will take the appropriate action to restore the loan balance to the loan limit.- The time allowed to respond will vary but is usually one or two days. Beyond that point the lender will start selling shares. The lender must act quickly to ensure the debt-to-equity ratio does not get beyond the point where the sale of shares will cover the loan.- Consider alternatives to margin loans. Another popular financing technique for investors is to take out a home equity loan a line of credit secured against residential property. Such loans do not have margin call arrangements.