An investment borrowing practice that contributed to investors losing their homes and share portfolios during the global financial crisis (GFC) is still readily accessible today.
This practice, known as double gearing, involves investors borrowing against one asset, typically their family home, using the borrowed money to buy shares and then using those shares as collateral for margin loans to buy additional shares.
The GFC provided an almost textbook illustration of the high risks of double gearing. Among the worst-hit investors were those who practised double gearing when share prices were near their pre-GFC high. And the subsequent plunge in prices led to the forced sale of their shares and their homes to try to meet their double debts.
Sadly, some critical investment lessons reinforced by the GFC – such as the high risks involved with double gearing – can fade from our memories over time.
As reported recently by the Thomson Reuters Superannuation & Financial Services Bulletin, a review by ASIC of six margin lenders, covering 90 per cent of the market, found that five were approving double-geared loans.
Following ASIC’s review, one of the lenders decided to stop offering double-geared loans. And the remaining lenders still providing double-geared loans agreed to take steps to reduce risks for borrowers.
These lenders assured the regulator that double-geared borrowers would be subject to extra buffers to allow for interest rate rises or changes in expenses, lower maximum loans and lower loan-to-valuation ratios.
Under amendments to the Corporations Act in the wake of the GFC, margin lenders have been legally required since the beginning of 2011 to assess whether a margin loan is unsuitable for a retail investor. And a lender must assess whether an investor can meet their loan obligations without suffering substantial hardship.
Further, margin lenders are required to make reasonable inquiries about whether would- be borrowers would be double geared if a loan application is approved.
The enthusiasm of investors to borrow to take margin loans to buy shares tends to follow the ups and downs of sharemarket. The higher the market, the greater the willingness of investors to borrow.
It is hardly surprising that the latest-available statistics from the Reserve Bank show that the total owed through margin loans is much below its pre-GFC high.
By the end of December 2015, investors owed $12.1 billion in margin loans used to buy shares. This is almost $30 billion less than its $41.6 billion all-time high in December 2007 near the beginning of the GFC. The S&P/ASX 300 was then close to its record high, recorded on November 1, 2007.
In short, the total margin-lending debt was almost three and a half times higher late in 2007 than late last year. And there is little doubt that more investors would be reluctant to take margin loans given the market’s rocky beginning to 2016.
Yet no matter the prevailing market conditions, investors should always be reminded of the risks of gearing, particularly double gearing. And when the market does recover, investors should not be ready to jump into gearing without fully understanding the risks.
Some investors whose family home may have markedly increased in value in recent years may now be tempted to use their larger home equity as the foundation for a double-gearing venture into the sharemarket.
As the accurate and much-repeated adage goes, gearing magnifies gains when share prices are rising yet magnifies losses when prices are falling. And double gearing truly magnifies the consequences.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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