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Margin Lending: Has the Bubble Burst?

Is the current market downturn the end of margin lending? Will anyone ever again use this method of lending to invest into the share market?

I think so – I cant see why people are so worried about them. Yes the lenders have a set margin and they enforce this margin without hesitation. But these downturns can be managed and they should be.

Let me give you an example of a margin loan I am managing at the moment. This client came to me in August last year with $50,000 cash and I recommended they invest using a margin loan.

Now I am not the most aggressive planner in the world and the client appreciated this – I only used a 50% margin, (Margin is calculated by dividing the loan about by the investments value) this meant that I took his $50,000 added another $50,000 to it from the margin lender and purchased $100,000 of stock.

OK, so its not working out as it should – The market is down 50%, not moving up as I has mentioned to her. But it will, over the long term the market will perform as it has over the last 100 years – It will meet its long term average.

So how do we manage the process? By understanding what is happening and by working closely with your adviser and your margin lender. If you speak with them things can be done BEFORE you get a margin call.

What happens when you are “Called”. The margin lender generally phones you and tells you that you have a call – and they will tell you two other things at this time, the amount of the call and the time you have to meet it. If you miss this deadline they will SELL your stock.

Now think about this, when is the worst time to sell – when the market is down right? So having them sell your stock should be the last thing we should do. Or is it? I’ll get back to this in a second.

There are a few things that can be done to avoid the call in the first place. They are:

Add additional security to the investment. That is, if you have other stocks that aren’t being used as security at this time, add them to the security mix, it increases your borrowing ability and makes a margin call less likely (Doesn’t mean you wont get one – just gives you more buffer )    Add cash to the “cash account”. Most margin lenders allow you to have a high interest cash account attached (Or one that isn’t so high) and they usually allow this to be at a much higher margin – 100% in some instances but as low as 90%. This is still much higher than stock, so any cash injection is taking the pressure off the margin.    Add your House to the Mix. Most of us have equity in our homes. So why not use it to protect you stock investment. You can either give it to the margin lender as security (If they will take it) or seek a line of credit from your bank and add some of this as cash to the margin loan

A quick note on adding cash:I have not suggested buying more stock with the cash, or even repaying the loan. I have some reasons for this, but I don’t want to get off track

The above steps are the first port of call when looking to manage a margin loan. But the question has to be answered – What happens if I don’t have Cash, Equity or other stock?

And this is exactly what happened in the case of my current client. She is young and is just starting out.

Well we have to sell some stock!

And NO this isn’t a bad thing – it’s a management process. But it did take some explaining. Let me try explain it for you.

The margin lender has a maximum loan amount per stock. Good stocks get 75% and most margin lenders have a 5% buffer (buffers are very important, and when managing margin calls they are VERY useful.

So in the case of my client I had some extra buffer by not taking her to the maximum lend – and in high markets like we had before the crash, I would never recommend taking a margin loan to the maximum. This meant that when the market started to fall the client was still “safe” until the market dropped about 34%. Ordinarily that was a long way down, especially looking at recent history, 1987 and 2001. But as we know we are past this point and at 34% I had to make some decisions.

I discussed with her the cash, house equity or other shares and after finding out that she didn’t have any of these I told her my plan.

Sell on the way down and buy on the way up!

This is a crazy statement and usually sends people into fits of laughter – can I be serious, shouldn’t it be buy on the way down and sell on the way up?

Well yes it should, but the best way is to buy on the way down AND buy on the way up!

But we are margin lending and we don’t have this luxury. We need to manage the margin on the way down and buy the stock back on the way up. This way we replace the stock we sold – and if the market conditions are right we will keep buying as the market expands.

My client has been margin called twice already and is deep into her buffer at this time, but we do have the plan to buy this stock back when the market bounces. What this does for us, is we will make more money than if the client didn’t use a margin loan. How? The non margin lender is in a holding pattern – their $50,000 investment dips to $25,000 and then rebounds to $50,000 no growth but maybe some income in this time. But with the margin lender, they will sell on the way down, and we will buy on the way up. This well managed buy back of the sold stock means you are buying more of the same stock at lower prices such as the case with Docker lending guides, and as the market expands you are making more money as you hold more stock.

Paola

Paola Garcia lives in Jakarta Indonesia. She is an associate professor in University of Indonesia and also managing Scoopinion at the same time. She is also fond of watching theatrical plays.

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