How a Trigger-Happy Banker Can Turn a Market Wobble into a 40% Reduction in your Wealth

Damien Laker CIPM, CompoundingHappens.com

7th August 2008

Executive Summary

When a margin loan is under maximum pressure in a falling and volatile market, the stakes are raised both for the banker and for the investor.

The scenario that we analyse is a "market wobble", where the market drops by 5% one afternoon, then rises back to exactly the same level by 10:30 the next morning.  We show that, if the bank implements a harsh margin call policy, the total loss of wealth for the investor can exceed 40% over a one-year horizon.  This loss would be purely to do with the intervention of the bank, and not attributable to market movements.

We have become aware that banks are becoming more inclined to exercise their maximum rights under margin lending agreements, regardless of the detriment that this can cause for individual investors and the market in general.  In a 5% market wobble, a bank exercising its maximum rights could conceivably sell 53.7% of the client portfolio.  This kind of disproportionate response flows directly from new "get tough" directives issued within banks.  The outcomes of this sort of tough behaviour can include:

1. Permanent substantial loss of the investor's wealth; and

2. Panic selling and a downward spiral in the market induced by the bank's harsh intervention.

We wonder whether central bankers and other regulators have considered these possible outcomes and decided that they are reasonable.

Introduction

We’ve heard a lot lately about margin lending and leverage.

What we haven’t heard much about is the nitty-gritty of how banks have the power to send individual investors, or potentially even whole markets, into a nasty downward spiral.  In the current market, banks are becoming much more ruthless in how they use this power.

In principle, margin lending is all fairly simple.  The investor provides some money to invest in the stock market, and the bank provides some extra.  The interest on the bank loan is tax deductible.  More importantly, in “normal” markets (where “normal” means that the stock market goes up due to economic growth and ever-increasing company profits), the investor’s return is boosted.

For example, consider an investor who provided $50 of their own money and borrowed $50 at an annual interest rate of 10% from the bank.  They would have $100 invested in the market.  If the market went up over the next year by 20%, the portfolio would now be worth $120.  The bank takes 10% interest on the $50 loan: $5.  Net of this interest expense, the portfolio value is $115.  The net gain is $15.  Because the investor earned this gain on a $50 stake, the rate to return to the investor is 30%.  Leverage has transformed a market return of 20% into a gain of 30%.  This is a pretty sweet deal.  It’s tax-effective, and it works very consistently, so long as the market goes up.

Of course, when the market goes down, the leverage also magnifies the downward returns.  Anybody who takes a margin loan should realise this.  It is a risk that one accepts in return for the prospect of making a bigger gain.

If markets go down far enough, the situation for the bank and the borrower can get a bit precarious.  This is where the word “margin” comes into play.  The bank specifies a maximum loan-to-valuation ratio (LVR) that they will accept on each security.  For blue chips, this is typically 75%.  If an investor asks the bank to provide more than 75% debt, the bank will refuse.  The remaining 25% is the “margin” between the market value, and the value of the bank’s loan.  Any losses will be at the cost of the investor, not the bank.  Most banks allow investors a “buffer” beyond the maximum LVR, before they require corrective action.  A typical buffer might be 10%.  What this would mean is that, if the LVR for an investor went beyond 85%, the bank would require corrective action to prevent a further downswing eating into their loan.  This point, where corrective action is required, is known as a “margin call”.  Typically, it means literally that the bank phones the client on the afternoon of a down day, and tells them that they have until 2PM the next day to take corrective action in order to restore the LVR.  There are two possible kinds of corrective action.  Either, the investor can use some spare cash to reduce the size of the loan, or (failing this) the bank will sell securities.

Whichever way you slice it, a margin call means that the investor is not going to have an enjoyable evening.  But, once again, anybody who takes a margin loan should understand this, and accept the risk.

The particular problem that is vexing investors at the moment is precisely what happens when they have to meet a margin call.  One day, your portfolio could be sitting uncomfortably near the top of the buffer, at (say) 84% LVR.  The next day, the market could have one of those mood-swings that we have seen so often in recent months.  What would happen if the market went down 5% in the afternoon, then back up to exactly the same point when the market opened again the next morning?

An investor might think that this would mean an evening of terror, then relief again in the morning, as the market returned to exactly the same level, with the LVR at 84%.  But not necessarily so!

Banks have recently been contacting their clients, saying that the fine print in the contract means that, as soon as a margin call happens, the bank can require the buffer to be completely eliminated.  In other words, 84% would no longer be acceptable -- the bank would require the LVR to go back down to 75%.  This has huge consequences for margin loan investors, and for society as a whole (as we shall demonstrate).

Remember, we are talking about a scenario whether the market swings down 5% one afternoon, then back up to exactly the same point on the following morning.  The net change in the market is zero.

But the net change for the investor can be huge!

Consequences for the Investor

If the bank forces the investor to sell securities during the market downswing, the starting point will be an LVR of 88.4%.  Selling down to the bottom of the buffer will require an LVR of 75%.  Every time you sell, the valuation and the loan fall by an identical amount.  When their initial ratio was getting close to 1:1, any maths student can tell you that it will take huge selling to reduce the LVR by any material amount.  As it turns out, one has to sell 53.7% of the portfolio to reach an LVR of 75%.

Having just previously been momentarily reduced 5% by a market mood swing, the portfolio thus gets king-hit by a forced sale initiated by the margin lender.  A $100 portfolio ends up at $46.32.  This can permanently cripple the investor’s chances of earning their wealth back, since they have now been mostly removed from the game.

To illustrate, if the market goes back up to its original position by 10:30 the following morning, the investor doesn’t end up in his original position.  More than half his portfolio was sold by the bank at the bottom of the down-swing.  The investor has 16.8% less equity than he had one day earlier, purely due to the bank’s onerous requirement of immediately selling down to the bottom of the buffer.

Even worse, consider a scenario where the market recovers from the bear market and goes up 30%.  If the investor had not been knee-capped by the bank, this would be a time of rich rewards.  But the investor who has endured the forced sell-down will have a portfolio worth 40.85% less than it otherwise would have been, purely because of one knee-jerk panic by the bank.

This is potentially catastrophic for individual investors.  I don’t think any of the banks were spelling out this horrible little scenario in their marketing materials before the recent downturn.

Any bank that had pretensions to being good with money or good with people could surely not be oblivious to the possible consequences of such a policy, you might think.  But you would be wrong. 

Last week I received a tip-off from a well known margin lender, indicating that a harsher policy will now be implemented, with few exceptions:

This would be rather laughable if it weren’t so serious.  Does the bank propose to instantly sell away more than 50% of many client portfolios just to meet this new hardline interpretation of the rules?

Market Stability Consequences

And what consequences for market stability will arise when margin lenders (who hold tens of billions of dollars of loans in Australia) all attempt to sell 53.7% of many client portfolios one morning after the market has had a mood swing?  That morning would not see a countervailing rally.  Indeed, the wall of forced sellers would generate a much worse day than the previous one, as billions of dollars of shares were rammed down into the market at whatever price it took to sell.

And so, in turn, the whole cycle would repeat itself, with another wave of margin investors whose positions had been slightly less precarious at the outset.

This would continue until the Allords reached zero, or every margin lending client in Australia had been sent into insolvency.

This madness passes for banking policy, at least at one bank we might code-name the “Trigger Happy Dragon”.  I do wonder what the RBA thinks of all this (or if anyone has told them).

Spreadsheet with Worked Example

Here is a spreadsheet that demonstrates all the calculations discussed on this page: Harsh margin lending policy calcs.xls.  You may find this spreadsheet useful if you are not used to doing calculations with leveraged portfolios.

It is easy to see how it can be good for the bank to require the investor to sell-down to the bottom of the buffer.  But it seems hard to find a reason why this could be in the interest of the individual investor, or the market in general.  Maybe the RBA or ASIC could consider this issue some time.

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