How to avoid a margin call

Some margin lending may be more marginal than you think. And that's where many of the clients of Opes Prime and Lift have come unstuck.

But there are plenty of other investors who have used margin lending and to date have had no regrets.

Margin lending has grown in popularity over recent years as a way for many Australians to help fund their retirement.

According to figures from the Reserve Bank, total investment lending as at December 2007 stood at $37.8 billion, almost double the $19.9 billion as at December 2005 and three times the level of $12.5 billion at December 2003.

But despite its healthy growth over the last four years, margin lending is not a new-fangled investment strategy but merely a mechanism for funding an investment that has been around for many a year.

It's basically a means of gearing not dissimilar to taking out a mortgage on your home — you are putting down a deposit and borrowing the balance to fund the investment.

The key difference is that with margin lending for shares you may — as the name suggests — be asked to make a margin call.

This occurs when the loan to value ratio (LVR) — the amount of borrowings versus the amount of equity in the total investment — rises above a certain level. Say you have $3000 and want to buy shares at $10 each, you could either buy 300 shares or perhaps borrow a further $7000 and buy 1000 shares instead.

That would give you a loan-to-valuation ratio of 70 percent which is traditionally has been the maximum amount that lenders will let you borrow for margin lending.

If the shares in the above example were to fall to $9 a share, your LVR would increase to 78 percent and you would be asked to make up the shortfall to bring your LVR back to 70 percent. This can be achieved by simply making the payment but it might be that you have to sell some of your shareholding to fund the shortfall.

In a falling market, those already at the top end of the LVR range have found themselves subject to margin calls, particularly those who used the strategy to invest in companies outside the top 300 stocks on the Australian Stock Exchange.

And this has been part of the problem with the likes of Opes and Lift, although it has been compounded by further actions that passed over ownership of the shares.

Those investors who have been more conservative have not necessarily been affected.

Indeed Peter van der Westhuyzen division director at Macquarie Investment Lending, says that 99 percent of Macquarie's margin lending clients have not had margin calls in the latest quarter despite the market losing ground.

"Some 99 percent of our clients have not had margin calls in the last quarter," says van der Westhuyzen. "And we have had clients who have had loans for 10 years and been through two market cycles who have never had to make margin calls. They have been conservatively geared with good quality stocks and diversification in their portfolio and understand their cash flow requirements so pay off their interest as it's due. These people have been very effective at creating wealth."

In contrast Opes and Lift have allowed investors to borrow less conservatively to invest in stocks outside the top 300.

Van der Westhuyzen says in order to break into the established brokerage markets, some smaller players have been willing to offer a higher LVR, a broader range of securities and at lower interest rates.

"We didn't think that this model was sustainable in all market conditions," he says. "You should never use margin lending to borrow against a small company with a market capitalisation of $10 million for example."

But at the end of the day, always read the small print when making an investment — it can be the difference between a good and a bad outcome.