QUESTION
The topic of the assignment is Margin Lending. The relevant case study for this topic is the company known as Storm Financial. You are required to read the extract on p. 696 of your textbook titled ‘Risk manager warned BoQ chiefs’, and answer the follogquwinestions:(PLEASE see BELOW p.3-4)
There are many articles that you can read and a dedicated web site from ASIC:
See: https://storm.asic.gov.au/storm/storm.nsf
Question 1. Describe the circumstances of the collapse of Storm Financial.
http://www.businessday.com.au/national/stormdamage
http://www.moneymanagement.com.au/news/in-the-eye-of-the-storm
Question 2. Examine the main aspects of margin lending. Is it a popular form of investing?
http://www.rba.gov.au/publications/bulletin/2009/dec/2.html
Question 3. Analyse the risks of margin lending when share markets fall.
Question 4. Examine the relationship between the banks (Commonwealth Bank, Bank of Queensland and Macquarie Bank) with Storm Financial. What effect (if any) does this relationship have on Storm investors?
Question 5. In your opinion, is it the role of ASIC to protect the former investors of Storm Financial? Is your answer the same for
SOLUTION
Circumstances leading to collapse of Storm Financial.
With the fall of the world stock markets in 2008 the value of the portfolio of the investors including those who had leveraged themselves through margin loans began to fall. Storm financial advised the clients to invest more and more in the falling market and to average their cost and further leveraging themselves and maximise their gains. Every time the investor bought the shares, Storm Financial was getting its share of fee for advice, The Commonwealth bank which was banker to Storm Financial and many of its clients withdrew credit from Storm Financial’s business and its client as the value of their portfolio had fallen sharply. The clients did not get any time to arrange for margin on call and had no choice but to sell their shares at a loss causing a loss of $ 3 billion to the investors. As per Storm the bank could have continued or extended further credit and the collapse could have been averted. This could have given time to the investor to arrange the margin or hold on to the investments and sell them in the recovered market.
Question no.2
Introduction
Margin Lending or Margin Loan is a leverage instrument specifically designed to lend money to invest. Generally a margin loan is specifically set to lend money to invest in shares, stocks or managed funds. A Margin Loan provides a borrower to invest more than he could have done but for that loan and increase is holding in the market and probability of potential returns..Typically it is similar to investing in immovable property where a person has 10-20% of his own money and the rest is financed from a bank or a lending institution, Margin lending allows a borrower to invest as little as 20-25% of his own money and take exposure upto 4 to 5 times in the shares or managed funds. This in financial management terms is known as gearing or leveraging ones portfolio. Leveraging typically means taking advantage of others’ money. It is typically similar to a company or a business borrowing from the bank to invest or run its business.
More a person borrows more he is said to be leveraged or in other words he is highly geared if he borrows money to invest
In exchange of money so lent the bank or the lender would charge a specified interest rate and the shares so bought would act as security for the lender.
Aspects of Margin Lending
Benefits
Increased investment capacity – Margin lending can be used as a simple and flexible option to leverage or gear ones portfolio, allowing the investor to increase his overall stock market exposure with a relatively small of own money.
Diversification – If one has more money to invest he can spread his portfolio across variety of shares and managed funds shich may be diversified across various sectors and minimize the risk of being concentrated into fewer stocks. Losses in one investment can be offset by gains in another. Diversification can reduce the investment risk of a portfolio and make the returns less volatile. More the diversification less volatile is ones portfolio and therefore the risk gets minimized.
Higher Returns – By borrowing money, one can increase his exposure to the shares and there is the potential for increased returns by way of dividends and distributions and through capital growth. Many dividends are fully franked. This means the dividend has been paid with income that has already been taxed at the company tax rate and therefore it is not double taxed in the hands of the shareholder.
Tax Benefits – Interest paid on Margin Loan is treated as a deductible business expense and be considered while calculating ones profit or loss from the sale and purchase of such shares.
Risk
Margin money magnifies the potential for both profits or losses. While borrowing can increase the returns there is an equal probability of increase losses as well.
Popularity of Margin Loans
Margin Loans have been fairly popular in Australia with increase both in an Average loan size and number of loans outstanding. The average size of a margin loan increased from $80,000 in September 2000 to $ 1,90,000 in December 2007. There has been significan increase in not only the number of people opting for this option but also average size of a single loan has more than double over last few years the total no. of loans outstanding also increased from 84,000 to 200,000 over this period. The share of large loans as a part of the total loans also increased from 5% to 18% between mid 2002 to mid 2007. Large loans here means the loans on which the total amount outstanding was more than a million dollars.
Question No.3
Margin money magnifies the potential for both profits or losses. While borrowing can increase the returns there is an equal probability of increase losses as well. When there is a sharp fall in the market there is a risk not only to the borrower but also to the margin lender.
Risks to the borrower.
A large or sudden drop or fall in the market can bring the Loan to value Ratio ( LVR) to a level above a agreed limited between the lender and the borrower hitch may result in Margin Call.
When the value of ones portfolio drops too close to the value of margin loan, the lender may step in and make a “margin call” and request the borrower to restore the buffer zone by either of the following options:
- § Using his fund to reduce the loan which he may not be able to do so immediately as he is already leveraged.
- § Adding further security such as buying more shares to raise the value of his portfolio using his own funds thus bringing down the percentage of borrowing to overall portfolio value.
- § Selling a part of his existing portfolio to raise cash to lower the loan amount and increasing the margin money available with the lender.
A Margin Call occurs when the overall borrowing becomes greater than the agreed and the lender is looking to restore or increase his buffer zone.
Margin Lenders want to be sure that the value of an investment portfolio more than covers the amount borrowed to finance it. This helps to protect both the borrower and the lender:
- § It ensures that one does not lose everything that he has invested
- § It also ensures that the value of the portfolio is more than the debt owed on the margin loan and one doesn’t end up owing more than what he actually borrowed.
Risks to the Lender
- § A sharp fall in the market would bring down the overall value of the portfolio of the client leaving the lender uncovered of any margin. The borrower may not be able to honour a margin call immediately since he is already leveraged and may not have funds immediately available. This may leave no option but to sell a part of the portfolio at whatever price further raising the probability of default.
Question No. 5
Role of ASIC
As per the Australian Securities and Investments Commission Act 2001 the role of ASIC is to:
- maintain, facilitate and improve the performance of the financial system and entities in it
- promote confident and informed participation by investors and consumers in the financial system
- administer the law effectively and with minimal procedural requirements
- enforce and give effect to the law
- receive, process and store, efficiently and quickly, information that is given to us
- make information about companies and other bodies available to the public as soon as practicable.
The role of ASIC is though not to protect or bailout the investor of a troubled financial institution although one of its significant role being the regulator of the financial system is to promote confident and informed participation by investors and consumers in the financial system. The collapses such as that of Storm are directly or indirectly due to lapses in the financial system and the regulator has to own its share of responsibility and thus is responsible to protect the investors had used the information or the financial products authorized and available in the country’s financial system
Question no. 4
Relationship between the banks (Commonwealth Bank, Bank of Queensland and Macquarie Bank) with Storm Financial. .
Storm Financial was an equity planning group whereas the three banks had been lending margin loans to the clients of Storm Financial. As rightly said by BoQ, there is no formal relation between the banks and Storm Financial as the banks had neither promoted the institution, nor promoted the product offered by it or had any role in the management or was a shareholder or corporate banker to the institution, It simply provided home equity loans to its customers as a normal business product
However if viewed from the other side relationship between Storm Financial and various banks had an indirect relation and was mutually beneficially. Storm’s model required the bank’s financial backing and services, the banks arms took fees from the inflated sums being created by Storm’s geared investment strategies. Storm provided the banks with substantial amounts of business, and it’s speculated Storm received benefits such as extended margin call periods, as well as discounted interest rates.
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