Contents
- Contents; Introduction
- Margin loan terminology
- Margin Utilisation
- Margin Call
- Summary
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.
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