Margin financing, friend or foe?

EVERY week before I choose a topic to write, I weigh between the topics I enjoy writing versus an urgent need to address a pertinent issue in the realm of economics, finance or policies. After much thought, I decided to focus on this issue as it would be a great disservice if I do not use this column to raise awareness on the pitfalls of margin financing for retail investors.

What prompted me to do so is because a renowned investor blogger recently strongly encouraged retail investors to take up margin financing to invest in a steel trading small cap company called AYS Ventures Bhd. He cited his optimism in the company’s prospects as well as his past success and experience as a founder of several listed company.

In my humble view, such promotional and misleading writing is terribly dangerous to retail investors, especially those who are new and inexperienced.

Regardless of his intent, which I do not intend to dwell upon, I think it is important to first understand the concept of margin financing and how it functions. Only by understanding the nature of margin financing, both its strength and weaknesses, one can make a truly informed decision.

Margin financing is a facility provided by investment banks or brokerage houses where they provide credit lines based on the shares pledged to them as collateral.

As the share prices rise, the value pledged to the bank increases, this in turn increases the facility amount. With additional credit facilities, investors would have more funds to make investments in the stock market. However, margin financing does not come free.

For the facility granted, the investment banks or brokerage house charge a fixed interest per annum, which is usually within the range of commercial loan rates.

It becomes a healthy recurring revenue stream for the banks and brokerage houses which compensate for the fall in income from transaction fees due to competition.

This will also help sustain operations of the dealers and brokers. You can compare the margin financing rates of different investments banks in which are subject to respective banks’ internal approvals (see table).

Now, all is well and good when the market is on an uptrend and the stock market is roaring. The problem comes when the tide turns.

Before cryptocurrencies came about, the forex markets were often considered one of the most volatile investment asset classes.

The equities market is a close second. For that reason, the stock market is not for everyone as the frequent fluctuations in share price movements makes it especially hard for emotionally driven investors.

When the stock market fluctuates, it means the share price would not move up in a straight line but rather go through wild swings. Those who use margin financing would then be subjected to two very dangerous situations. One, is the interest rate to be repaid and two, is the potential risk of a margin call.

Margin calls happen when the value of the shares pledged to the bank, falls below the lowest threshold allowable by the bank.

When this happens, investors will need to top up the difference in order to maintain the facility and keep the pledged shares. In the event one is unable to top up, then the bank has the power to ‘force sell’ the shares pledged in the open market to recover the monies owed.

However, the losses for the investor does not stop here. If the losses incurred coupled with interest owed is more than the amount recoverable from the force selling of the shares pledged, the bank has the power to embark on legal recourse to recoup the monies owed.

This was why many retail investors went into bankruptcy during the 1997 Asian Financial Crisis including the late Lim Tee Keong, the eldest son of Genting Group’s founder, Tan Sri Lim Goh Tong, who had a debt to the tune of more than RM200mil at the time of his passing. The idea of borrowing money to invest is one that does not sit well with common sense and rationality.

To begin with, even before investors can make decent returns from the stock market, they are already in the negative due to the interest owed. Imagine going for a race but your starting line is further from the others.

Starting at a disadvantage will cause many problems including the psychological pressure to get better returns. This subconsciously affects the decision making process including the investment horizon and ability to withstand up and down cycles.

During the 2020 influx of retail investors, I personally know of retail investors who wanted to join in the bull run and decided to take credit card cash withdrawals at an interest rate of 7%.

This effectively means, an ordinary investor who borrows at 6% will need to at least have a return of 10% (where 7% is used to repay the bank or credit card company interest and to beat fixed deposit rate of 2%) to make the investment worthwhile. Just for context, our country’s FBM KLCI is one of the worst performing stock exchanges in the region currently, which is down -6.47% year-to-date at 1521 points as at Nov 17, 2021. Under such market conditions, investors who relied on margin financing must do the extraordinary to outperform the index and also the interest rate threshold.

Although there are arguments for pledging assets in return for credit lines including in the world of business, the margin financing concept for retail investors is not the same. When building a business, the risk is calculated and the business plan needs to be viable before the banks even provide loans. Alternatively, the facility approved by the bank for the value of assets pledged will be substantially lower in order to cover the potential risk of default by the borrower. Most importantly, businesses have a gestation period and it is not fluctuating daily although subjected to the same economic cycles.

The stock market on the other hand, faces greater market irrationality which may or may not make sense at any point in time such as politics, geopolitical tensions, policy changes and other factors. The ultra-rich opt to pledges shares to banks as collateral for funding to avoid tax implications from drawing high salary or paying out huge dividends. This eases their access to financing with minimal costs. Clearly, this is not the case for the mom and pop retail investors.

There is no doubt that there will be a handful of brilliant people in this world who can use leverage and margin financing to succeed in life, be it in business or the stock market. Yet, more often than not, there are other elements in play in the background. Most common retail investors would not have the same access, be it information, understanding or savings, to withstand a margin call in the event their investment backfires. We have seen many instances of margin calls happening to big time players such as China’s Evergrande Group and Bill Hwang’s Archegos Capital, amongst others.

With that, I hope retail investors avoid being caught up by false idolatry and end up losing hard earn savings due to a moment of greed or naivety. Always invest only with spare funds and excess savings. For those who continuously propagate margin financing loudly, it is wise to take a step back to consider the implications to retail investors. It is the least a responsible individual can do for the betterment of the stock market.

Ng Zhu Hann is the author of “Once Upon A Time In Bursa”. He is a lawyer and former chief strategist of a Fortune 500 Corp. The views expressed here are his own.

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