What is meant by the term margin lending?
Margin lending allows investors to borrow money to invest in stocks and other financial instruments while utilising the purchased investments as collateral. It is a sort of gearing in which money is borrowed for the purpose of investment.
Margin lending opens more investment possibilities for investors. It allows investors access to more funds for expanding their investment exposure that otherwise they may not be able to due to lack of funds. As a result, there is also a scope to diversify their existing portfolio and have higher returns.
The amount borrowed depends on the investor's financial position and credit limit. Another deciding factor is the loan to value ratio of the existing portfolio. The loan to value ratio is estimated by dividing the loan value with the market value of the shares or managed funds that are kept as collateral against the loan.Highlights
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What is the loan to value ratio?
Lenders use the loan-to-value ratio to estimate how much risk they are taking on with a secured loan. It calculates the difference between the loan amount and the market value of the collateral. A larger down payment and smaller loan amount is the easiest way to reduce the loan to value ratio.
To calculate your loan to value ratio, we divide the loan amount by the asset's value and then multiply the result by 100 to get a percentage.
Loan to value ratio = (Amount owed on the loan/ the asset's appraised worth) x 100
Suppose an investor avails the margin lending facility to buy shares worth US$ 100,000. The loan amount is US$ 75,000. The balance amount of US$ 25,000 can be considered as the down payment in this case. The loan to value ratio is the appraised value that is not covered by the down payment. In this example, the investor puts 25% down on the loan that covers the remaining purchase price, then the loan to value ratio stands at 75%.
Using the above formula, we can estimate that the loan to value ratio= (75000/100000) * 100= 75%
As the loan is repaid, the amount owed on the loan continues to diminish. As a result, the loan to value ratio also declines. Similarly, there is a decline in the loan to value ratio even when the asset's appraised value improves. But in case the value of the asset declines, then the loan to value ratio increases.
A loan to value ratio exceeding 100% is called a situation in which the borrower is "underwater" on the loan- this happens when the balance on the loan (as recorded in the balance sheet) exceeds the market value of the collateral securities.
Why is a margin lending facility advantageous?
Margin lending is a helpful facility made available. The margin lending facility is highly beneficial for investors to build their wealth in the long run. It is helpful for the investors to expand the size of their investments and diversify the portfolio. A diversified portfolio is a safeguard against market volatility too. In addition, borrowers can also enjoy tax deductibility on the interest paid on such loans.
The easy availability of funds for investments makes it easier to grab investment opportunities as and when they arise. Lack of funds could mean that investors would have to wait for their savings to accumulate and be enough to start investing. It is often beneficial for the economy to expand investments as the multiplier effect gets rolling and benefits the entire economy more than proportionately.
What is the essence of loan to value ratio for the lenders?
In the case of margin lending, there is always a risk of a decline in investment value, and repayment becomes difficult. Thus to safeguard themselves, lenders keep the investments bought with the loan as a mortgage. It is a known fact that the price of shares is prone to fluctuation. As a result, if share prices plummet, the shares could be much less in value than the loan- this creates a challenge for repayment, and there is a decline in security for the lender.
For such situations, the loan to value ratio is fixed by margin lenders so that they do not suffer a loss or face an increased risk when the value of shares falls.
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Suppose an investor X has borrowed $11,250 to purchase blue-chip shares of $15,000, then the loan to value ratio is 75%. However, if the stock market crashes and the value of the shares drop to $12,750 from $15,000, then the loan to value ratio becomes 85%. This would imply that the margin limit is breached. Immediately the lender will issue a margin call to the borrower. The borrower can then either pump in cash to restore the loan balance or add investments (as permissible by the lender) to increase the loan limit or sell a part of the portfolio and repay a part of the loan.
What are margin calls?
In the case of margin lending, it is imperative to sustain the loan to value ratio throughout the loan’s term. However, there may be times when there is a deviation. In such a case, a margin call is triggered. As a result, the borrowing investor must employ suitable measures to revert to the agreed loan to value ratio. For example, the investor may use a measure like they can increase the value of their portfolio (which is kept as collateral) by adding more securities, or the borrowing investor can reduce the loan's principal amount.
Suppose the borrower fails to meet the margin call requirements. In that case, the lender can sell the assets in the portfolio and use the proceeds to arrive at the agreed loan to value ratio. However, a challenge associated with meeting the margin call is that the higher the volatility of the instruments falling in value, the lesser the time left for the borrower to meet the margin calls. Similarly, if the volatility is high, the lender may also rush to liquidate the assets.
What are the risks to borrowers?
Borrowers availing of the margin lending facility are prone to market volatility. This puts them at a risk of margin calls being triggered and in turn, the threat of losing their asset that is mortgaged.
The trends in the market are never exponential, and it is always cyclical. Thus whenever there are dips in the market, the value of an investor's portfolio is bound to decline. If the decline is such that the loan to value ratio deviates from the agreed limits, the lender will certainly trigger a margin call to safeguard their interest.
Lenders also offer full recourse loans i.e. if the value of the portfolio crashes to zero, the borrower still must repay the entire outstanding amount. As a result, the borrower may be forced to sell off assets other than those in the portfolio associated with the loan.
The risk increases further if the margin loan is made on the basis known as "on-demand." As per such loan agreements, the lender can ask for repayment at any time.
The least risky deal from the borrower's perspective is in case the margin loan is limited recourse. Here the lender's security is confined to the extent of the portfolio's value held as the mortgage. However, the high risk that it poses, the due diligence by the lenders is very high in such cases, and thus the deal structuring and the mechanisms for enforcement and exit are highly stringent.
What can the borrowers do to mitigate the risk?
The general rule of portfolio diversification is a must to reduce the risks associated with market volatility. A mixed portfolio is always better than an investment in a single stock. As a result, the risk of margin calls is reduced. But in addition, the borrower must ensure that the loan is geared conservatively and that the market movements are constantly tracked. Under no circumstance can a borrower miss the change in the mark-to-market value of the portfolio. These measures will ensure that the loan to value ratio is maintained and there is no default at any point.
Seeking legal consultation on the documents related to the margin loan and the allied mortgage is crucial. The terms of the margin loan are an important focus area for negotiation between the two parties. The frequency of valuation and method used to evaluate is an essential criterion to be discussed, mutually and to be followed by both parties. This also helps the borrower have precise know-how regarding their obligations and the powers held by the lender. In addition, the borrower would know clearly the time frame within which they must address the margin calls.
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Margin lending usually happens on a variable interest rate. As a result, changes in interest rates will have an impact on the borrowing cost. When the interest rate goes up, consequently, interest cost also increases. This could potentially result in lower net returns. If the return on the underlying investment is lower than the increased borrowing cost, this could also result in negative returns. To avoid such situations, the borrower might have to ensure sufficient cash flows to meet the interest payment obligations. In certain cases, the borrower may also consider entering into a swap contract for the entire loan or for a portion of the loan. Through a swap contract the investor pays a fixed interest but receives interest at a floating rate. A borrower must ensure regular interest payment so that the outstanding amounts are under control- this along with conservative gearing reduces risk of default.
Dividend payments may not be made simultaneously at the same time as interest payments, or they may be reduced or discontinued, as witnessed during the COVID-19 first phase in 2020. Therefore, borrowers should ensure diversifying their investments across multiple industries to decrease the risk of their entire portfolio crashing at the same time.
What are the risks faced by lenders?
One of the main risks faced by lenders is the declining mark-to-market value of the portfolio. Due to market fluctuations, if a particular asset or a particular portfolio heads on a downspin, the lender may have to balance between having a good relationship with the borrower and own risk management. Lenders must guarantee that the collateral value offered as security continues to be sufficient to cover the borrower's outstanding debts. In such situations, a lender will have to make prompt decisions and issue a margin call, giving the borrower a limited time to respond. Once this time frame expires the lender takes further action to sell out the assets and recover the balance amount on the outstanding loan.
The lenders also face the risk that borrowers fail to meet the margin call. In a situation where the borrower cannot reduce the principal (by paying down the loan) or cannot top-up the collateral, the lender must take action. These actions must be following the provisions in the documentation between the lender and the borrower. In addition, there must be a thorough legal justification for the measures taken by the lender, and there should not be any prejudice or oral agreement based execution- this is because it is detrimental to the lender's recourse rights.
When markets are highly volatile, the lender will want to act at the earliest instance to minimise exposure and maximise recovery. The nature of the courts, too, is a factor determining what the lenders do. For instance, the English courts are more supportive of lenders regarding enforcement timings. As per English law, while the lender must allow some time to the borrower before enforcing an on-demand loan, the breathing space that the lenders extend may even be as less as two hours notice on a working day. On the other hand, in jurisdictions with legal systems based on civil codes, the concept of good faith takes precedence, and the courts allow a longer relaxation window for borrowers to clear the debt. Some courts have allowed a compliance window as long as two months too.
In addition to the risks mentioned above, the lenders also face the risk of borrowers going bankrupt. Mainly when troughs in the market cycle are in place, the pricing of these loans is indicative of the extent of risk, and lenders may need to use their rights rather rapidly.
Example to understand how margin lending works
Let us understand the concept with the help of an example. An investor has AU$ 1,000 and wants to invest in shares. The investor can use leverage to magnify the returns through margin lending. The margin lenders specify the loan to value ratio depending on the volatility characteristics of the shares used for margins. While it is usually 70%, it can be higher for stocks with higher volatility as the risk increases.
Let us assume that the margin lenders have specified the margin to be 80% in the current scenario. In other words, the maximum borrowed amount should be 80% of the total amount invested. The remaining 20% of the investment amount should be funded using the investor's cash or shares. In the given case, that implies AU$ 1000/20% or AU$ 5,000. To summarise, the investor can borrow AU$ 4,000, club it with his investment of AU$ 1,000 and invest a total of AU$ 5,000 in shares.
Let us assume that the investor has used the total amount of AU$ 5,000 to buy 100 shares at AU$ 50 each. However, as the share prices move, the margin with the lender will have to be adjusted. The adjustment can be done either through cash or by adding incremental shares.
Suppose the share price falls to AU$ 40. As a result, the total value of the shares is now AU$ 4,000. Consequently, the loan to value ratio, calculated as the loan's value to the value of the shares, is now 100%. This has breached the upper loan to value ratio limit of 80% set by the margin lender and needs to be adjusted.
The investor can do this using two ways. First, the investor can pay back a portion of the loan to get the loan to value ratio within the range. Since the current value of the shares is AU$ 4,000, at 80% loan to value ratio, the maximum amount of the loans should be AU$ 3,200. Since the current loan taken is AU$ 4,000, the difference between the two amounts, at least AU$800, must be repaid to get the loan to value ratio in the target range.
The second option is to adjust the total shares held. Since the loan amount is AU$ 4,000, the total value of the shares held should be at least AU$ 5,000 (AU$ 4,000 divided by 80%). However, the total current value of shares is only AU$ 4,000, so the investor should buy additional shares worth at least AU$ 1,000 using his/her funds to make the total portfolio worth AU$ 5,000. This effectively takes the loan to value ratio back to 80%.
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Now, let us look at another scenario where share prices go up. Imagine the share prices in the given case increases to AU$ 60. As a result, the total value of the shares is now AU$ 6,000. Consequently, the loan to value ratio, calculated as the loan's value to the value of the shares (AU$ 4,000 divided by AU$ 6,000), is now approximately 67%. Since this is well within the 80% limits, the margin lender would not have any issues. However, the investor can now choose whether or not to utilise the remaining margin. If the investor decides to utilise the entire margin, there are again two ways to adjust the loan to value ratio, similar to the earlier scenario. The first option is to sell some of the shares. Since the loan amount is AU$ 4,000, the portfolio's total value should at least be AU$ 5,000 (AU$ 4,000 divided by 80%). However, the current value of the portfolio is AU$ 6,000. Therefore, the investor can sell shares to bridge the difference, i.e. up to AU$ 1,000. Consequently, the portfolio's value will be AU$ 5,000, and the loan value will be AU$ 4,000, resulting in a loan to value ratio of 80%. Unlike the earlier scenario, it must be noted that the proceeds from the sale of shares are not used to pay back the loan.
The second option is to borrow more amount by utilising the remaining margin. In the given scenario, the total portfolio value is AU$ 6,000. Since the loan to value ratio is 80%, the investor can borrow up to AU$ 4,800. Since the current amount borrowed is only AU$ 4,000, he/she can borrow an additional amount up to AU$ 800 and keep the loan to value ratio within the range.