Play The Leverage Game With Great Care

Foreword from ShareInvestor

This article “Play The Leverage Game With Great Care” by Genevieve Cua was first published in The Straits Times on 06 Feb 2011 and is reproduced in this blog in its entirety.

Record low interest rates make debt an attractive proposition, and while warnings abound over the dangers of excessive borrowing, debt can present opportunities you otherwise may not be able to access.

One obvious example is the opportunity to own your home. A mortgage is a debt one usually enters at a fairly early stage of one’s career and, with prudent management and discipline, can be paid off before one retires.

When it comes to investments – and mortgages fall into this category as well – it pays to be discerning as to the type of debt you take on. As collateralised long-term commitments, mortgages have in their favour fairly low effective interest rates today. In addition – and this is a big plus – lenders may not actively revalue properties on their books once the contract is in place.

Nor do they strictly monitor loan-to-value ratios of existing customers. These factors suggest that as long as borrowers are faithful in their monthly repayments, banks are unlikely to call in their loans in a downturn.

The same cannot be said, however, of securities lending which uses assets on your personal investment account as collateral for leverage. This is a common and even relatively popular proposition among some types of investors.

Banks and brokerage firms are quite willing to extend leverage. It allows them to make money on both sides of a customer’s balance sheet: They earn fees and transaction commissions on the assets side and collect financing charges on the liabilities side. Arguably, the revenue from the liabilities side is more lucrative as it is a recurring income, unlike transaction charges.

As for clients, the practice makes for fairly efficient use of capital – as long as markets are rising. The last is a fairly obvious caveat but often escapes investors until markets begin to wobble.

As a financial adviser has said: “Everyone who is geared believes he can get off the bus when markets get out of control – and it virtually never happens.”

The problem with leveraged investments is that while the upside may seem lucrative – potentially a multiple of your capital – the downside could be unlimited. The downward spiral is particularly vicious for investors who do not know when to cut their losses.

In the Asian crisis in the mid-1990s, many investors were bankrupted by leveraged trading. In the most recent systemic crisis of 2008, there was also a tidal wave of margin calls on clients’ accounts. The problematic investments could be stocks, currencies or even bonds, which in normal times would have been a fairly low-risk investment to secure borrowings against. And then, of course, there were the notorious leveraged structured products such as accumulator notes.

How extensive is leveraged trading? Banks are tight-lipped. Private banks maintain that they admonish clients to practise prudence and actually help them in terms of early warning systems. In practice, however, so-called early warning systems are paralysed when the market gaps down – as it did in September 2008, to customers’ dismay.

Here are a few things to note about leveraged investing:

• Financing rates offered by private banks are attractive – usually pegged to the Singapore Interbank Offered Rate, or Sibor, and you can negotiate them downwards, particularly if you have substantial deposits. Leverage is therefore very tempting, but a good adviser will tell clients to use it sparingly, and on assets that offer a substantial yield premium over their borrowing cost.

This offers some cushion in case asset prices drop. Such assets are not hard to find today, but the key is to look for quality, liquid assets that offer value.

• Margin calls happen, even to the wealthiest clients, and the institution always has the upper hand. Since the crisis, there have been prominent lawsuits over amounts that banks are claiming from clients for loss-making positions that were forcibly liquidated.

Banks run a risk book, which forms the basis of how much leverage they can offer you. The amount of margin financing will vary according to the bank’s assessment of the risk of the security, as well as the strength of the bank’s or brokerage’s own balance sheet.

Clients who deal with a few banks or brokerages will know that the extent of financing may differ greatly on the same asset. A bank that has a higher risk appetite may offer margin, for instance, on small to mid-cap shares which other banks may eschew in favour of only blue-chip stocks.

This differential treatment was thrown up in stark relief during the crisis, when some banks actually pulled the plug on selected securities – that is, the securities were suddenly deemed not eligible for margin financing.

This predictably caused mayhem among clients, who had to scramble to top up accounts or were forcibly closed out if they had no assets left to pledge. 

• Stop-loss orders may not be executed at prices you specified. Stop-loss orders seem to be an ideal arrangement. You specify a price at which your position will be sold to set a floor on your losses. In practice, however, in a rapidly moving market, your order may not be executed at the price you specified but at sharply lower prices, and you could realise deeper losses than you expected.

• You are your worst enemy. Investor psychology actually works against you. Those who take on leverage are usually fairly confident about their skills and views on the market; they are, in fact, likely to be overconfident.

When the market begins to tank, other foibles come into play – the tendency to be anchored in a specific price, usually the price at which you entered, or some historical high to which you benchmark your investment.

The reluctance to realise a loss is perennial. Fund managers typically report that their assets are very stable in a downturn as clients sit on losses. But they see substantial redemptions when markets are up as investors scout for the next big thing.

The prudent approach is to set a limit on the amount of leverage – a very modest proportion of your assets – and a cut-loss target that is strictly adhered to, in consultation with your adviser.

The good news is that on a macro basis, the household debt picture seems benign, based on the Monetary Authority of Singapore’s (MAS) Financial Stability Review for the period up to November last year.

Singaporeans are benefiting from rising asset values, which always make the debt picture look prettier. The review shows that while household debt has risen due to a hot property market, its growth is outpaced by household assets. The proportion of home loans in negative equity, for instance, fell from 2.9 per cent in the third quarter of 2009 to less than 1 per cent in the fourth quarter that year.

Share financing loans were estimated to comprise less than 1 per cent of total household debt. This, said MAS, is not expected to materially impact household balance sheets.

But it also sounds a caution: “Overextended individual households could, however, be at risk should equity markets become more volatile, especially if there are reversals of capital inflows or if economic growth falters and companies’ earnings disappoint.”

This is a warning investors would do well to take to heart. A positive tone to markets may make debt look attractive, but it is also an opportune time to reduce debt. This ensures that you keep your head when the tide turns.