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How Margin Loans Work

Discussion in 'Articles' started by Simon Hampel, 16th Aug, 2005.

  1. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Introduction

    What are Margin Loans

    Margin loans are a useful tool for gearing into share or managed fund investments. Fundamentally, they operate as a loan secured against a share or managed fund portfolio, where the lender is protected from falls in the security value by utilising a technique referred to as a margin call.

    A margin call is a mechanism whereby a margin lender “calls” on the borrower for more money or additional assets to maintain the ratio of the loan-to-valuation of the portfolio. As the value of the investments drops, it increases the risk to the lender that they will not be able to recover their capital if values drop even further. To prevent this scenario – they insist on maintaining a buffer between the value of the portfolio and the outstanding debt. If that buffer becomes too small, they insist that the borrower increase it by either providing cash, additional assets, or by selling down part of the portfolio and using it to pay off some of the debt.

    Borrowers typically “dread” a margin call, especially if the lender is forced to act by selling down part of the portfolio – it results in an erosion of capital currently invested, and can have the side-effect of crystallising losses in a dropping market. However, with some careful planning and advice, and a good understanding of how margin loans works, these margin calls can usually be prevented. Allowing you to choose the timing of your asset sales is important to your planning – having a lender force that upon you due to a margin call, is usually not a good thing.

    As an aside, there is a counter argument that a margin call in a falling market is not such a bad thing – as it enforces an effective stop-loss mechanism, selling down assets before the capital is eroded too far. With outstanding margin loans, this is even more important – since you really don’t want to be left with a debt to service but no asset. But these arguments and strategies are beyond the scope of this article, so we’ll leave them for another time.
     
    Last edited: 17th Oct, 2009
  2. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Margin loan terminology

    Margin loan terminology

    Margin lenders have a specific set of terms they use to describe the loans, portfolios and ratios. Terms you may come across include “gearing ratio”, “LVR” (Loan to Value Ratio), “Margin Utilisation”, “Loan Utilisation”, “Maximum Gearing Ratio”, just to name a few. Unfortunately some of these terms are used interchangeably, and they can cause a bit of confusion. Hopefully I can dispel some of the confusion for you and explain how it all works.

    Margin lenders usually use the terms "gearing ratio" and "LVR" interchangeably – they generally mean the same thing. I prefer the term gearing ratio when considering an individual share, while using LVR for the overall portfolio. It doesn’t really matter what you choose – so long as you understand what it means.

    [​IMG]

    Typically, the MGR (maximum gearing ratio) is used to determine the maximum amount that could be lent against a single share or fund. Examples might be 70% for a blue-chip share, or 50% for a growth fund. These percentages vary between different types and classes of share, and they also differ between margin lenders – so it does pay to shop around. A 10% MGR means that for every $900 of your own money or assets you put in, a lender will loan you $100, for a total investment of $1000

    [​IMG]

    Usually, you know how much money you have available to invest, the lender will tell you what MGR they will offer against a particular share or fund, and you want to work out how much they will lend you, and then what the total investment amount will be. The way to work this out is to use the formula below. Let’s call L = Margin Loan amount, C = Capital you are investing, MGR = Maximum Gearing Ratio

    [​IMG]

    ... or from the example above,

    [​IMG]

    So, if the lender will lend us $100 and we have $900, then the total amount to be invested is $1000, and the MGR = 100 / 1000 = 10%.

    Similarly, for a 50% MGR, if we have, say, $1000 to invest, then the margin lender will loan us another $1000, giving a total investment amount of $2000.

    [​IMG]

    However, it may be prudent to work backwards and work out how much you actually want to borrow for a given amount of capital. You generally don’t want to borrow the full amount that the lender will possibly lend you – because then you simply don’t have enough of a buffer to avoid a margin call in the case of a market downturn. We’ll explain how to work those buffers out in detail later. So, let’s start thinking “gearing ratio” rather than “maximum gearing ratio”. Just because you can borrow the money, doesn’t necessarily mean you necessarily should!

    If you know you have, say, $1200, and the margin lender will loan you up to 70% against a particular share or fund, but you decide to take a more cautious approach and limit your gearing ratio to 40%, then the maximum you actually want to borrow (using the formula above) is: (0.4/0.6)x1200 = $800. This would give you $2000 in total to invest.

    The important question is – how do we know how much buffer to allow? Unfortunately there is no easy answer to this question – the size of the buffer does not matter, until there is none left! What I mean here is that you may choose to take a risk and work with a very small buffer, and if your investment value never drops low enough to cause a margin call, then you never have a problem. But there’s the catch – you are making a prediction about the future performance of your investment, and unfortunately, nobody I know has a crystal ball that works anymore. So, to be prudent, we may want to determine what the ramifications are of choosing a particular buffer size.
     
  3. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Margin Utilisation

    Margin Utilisation

    The current buffer is determined by the difference between the maximum gearing ratio the margin lender will allow you to use, and the actual gearing ratio you choose to use, or more specifically, the current gearing ratio of your portfolio at today’s prices. Of course, this buffer changes on a daily basis, as the value of your portfolio increases and decreases due to fluctuations in the underlying asset prices.

    Unfortunately, just comparing our gearing ratio to the maximum gearing ratio isn’t really enough to give us an accurate indication of our buffer size. More specifically, the figure we’ve been using called MGR only applies to one particular share or fund. The difficulty arises when you invest in a range of shares or funds, each of which may have a different MGR.
    Lenders tend to use the term “margin value” to represent the maximum amount that they will lend you against the portfolio of shares or funds that you hold. The term the lenders use to determine how much of your margin you are using, is "margin utilisation", which is also sometimes called "loan utilisation". This is the ratio of your current loan amount to the margin value of your security.

    Just to confuse matters, lenders also use a term “margin buffer”. The margin buffer is how much they will allow you to go above 100% of your margin utilisation. Lenders typically allow a 5% or 10% margin buffer – which means the true maximum margin utilisation can be as high as 105% or 110%.

    An example:

    You have borrowed $150,000 to buy shares, and put in another $100,000 of your own money, so your portfolio has a value (initially) of $250,000. The margin utilisation is the ratio of the loan amount to the margin value amount - showing how much of the loan you have used.

    Loan (L) = $150,000
    Value (V) = $250,000
    Maximum Gearing Ratio (MGR) = 70% (let’s assume this is the same across the entire portfolio)
    Gearing Ratio (LVR) =

    [​IMG]

    Margin Value of shares (MV) =

    [​IMG]

    Margin Utilisation (MU) =

    [​IMG]

    So in this case, where the lender was happy to lend us up to 70% of the value of the shares or funds we had invested in, yet we had actually only borrowed 60% of the value of our portfolio, then the margin utilisation is actually 85.7% - meaning we had only used 85.7% of the margin loan that we were allowed to use.

    Effects of market fluctuation on margin utilisation

    Let's play market fluctuation – market drops the value of our shares by 20% to $200,000

    Loan (L) = $150,000 (this hasn’t changed!)
    Value (V) = $200,000 (down from $250,000 – ouch!)
    Maximum Gearing Ratio (MGR) = 70%
    Gearing Ratio (LVR) =

    [​IMG]

    (our gearing ratio has increased from 60% to 75% as a result of the drop in value)

    Margin Value of shares (MV) =

    [​IMG]

    Margin Utilisation (MU) =

    [​IMG]

    Note that now the MU is above 100% - currently we are using 107.1% of the margin our lender allows us. But this is okay – provided that the lender allowed us a 10% margin buffer, taking the maximum margin utilisation allowed to 110%.
     
  4. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Margin Call

    Margin call

    In our previous scenario, if the margin lender only allowed a 5% margin buffer, meaning that the maximum margin utilisation allowed was only 105%, then our 107.1% margin utilisation would put us in what they term "margin call". A margin call is named that because they call you (literally) and demand that you increase your portfolio value (or more likely, reduce your loan value) to restore that margin utilisation to below 100%.

    The easiest way to do this is by depositing some cash into your loan account, thus decreasing the outstanding loan, and decreasing the margin utilisation. Alternatively, you could allocate additional funds or shares to the margin lender, to increase your margin value (and hence decrease the margin utilisation), but since this often takes time to complete, it may not be a suitable method – policies on what is acceptable vary between lenders.

    If you cannot provide extra cash or other collateral within the margin call period (usually 24 hours!), then the lender will take their own steps to minimise their risk and sell down some of your portfolio so they can pay down some of your debt, and hence lower your margin utilisation.

    When does margin call occur

    A commonly asked question is about when a margin call would be made with a particular set of circumstances. Let’s start with a 70% maximum gearing ratio and 80% margin utilisation with a 10% margin buffer offered by the lender.

    MU = margin utilisation, MV = margin value, L = loan amount, MB = margin buffer, MGR = maximum gearing ratio, V = portfolio value.

    Margin call happens when:

    [​IMG]

    ... or MU > 110% in our example with a 10% margin buffer.

    To cause a margin call, this means that our margin utilisation has increased from 80% to 110%, which is a 37.5% increase in MU.

    Let’s call the original margin utilisation = MU1, the margin utilisation at margin call = MU2, and the original margin value = MV1, with the margin value at margin call = MV2.

    Margin call will happen when:

    [​IMG]

    ... but:

    [​IMG]

    ... and:

    [​IMG]

    (the loan is constant, but the margin value changes as the value changes).

    Hence margin call will happen when:

    [​IMG]

    But also:

    [​IMG]

    ... or more specifically:

    [​IMG]

    ... and:

    [​IMG]

    (in other words, the MGR is constant, while the margin value changes as the portfolio value changes).

    So margin call occurs when:

    [​IMG]

    ... and if we cancel our L and MGR constants on both sides then margin call happens when:

    [​IMG]

    ... or, rearranging, margin call happens when:

    [​IMG]

    ... or more specifically, when the value of our portfolio drops by at least 27.3% (when V2 is 1/1.375th of V1, the original value).

    In other words, if we have 80% margin utilised, and we are allowed to go to 110% margin utilisation, (a 37.5% increase in MU), then the value would have to drop by:

    [​IMG]

    ... to cause a margin call.

    So all you need to do is work out how much your margin utilisation has to increase by before you hit 100% + your margin buffer (X), and you can plug that number into the formula:

    [​IMG]

    ... to work out how much the portfolio value has to decrease by before you get a margin call.

    An easier way

    If you want an easier way to work out when margin call will occur:

    X = your current margin utilisation
    Y = maximum margin utilisation = (100% + margin buffer)
    You will get a margin call after a drop in market value of:

    [​IMG]

    If you want it even easier still (by not having to work out margin utilisation), try this formula:

    L = Loan amount
    V = Initial market value
    MB = margin buffer amount (eg 5%, 10%)
    MGR = maximum gearing ratio (max LVR)
    Then, margin call will happen after a drop in market value of:

    [​IMG]

    Just to make it easier, I've made up a spreadsheet to show you how it all works and put it in the Spreadsheet Repository: Market Drop Before Margin Call.
     
  5. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Summary

    Summary

    Margin loans are a powerful tool, allowing you to leverage into shares and managed fund investments, without necessarily needing to put up any other collateral (such as the family home) as security for the loan. The shares and funds themselves form the security for the loan, but the catch is that the lender insists that you maintain a healthy buffer to ensure that they (and you) don’t get caught with zero or negative equity in a falling market.

    Margin calls can be a worrying issue for investors, especially in a market that’s already dropping – being forced to sell some of your shares or units at this time may not be part of your plan. With some care and planning – and some good professional advice, you can be prepared for the situation where a margin call arises, or perhaps even avoid them all together.

    See also