Learning Guide. Margin Lending. Version: October Advice Solutions is a division of GWM Adviser Services Limited ABN

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1 Learning Guide Margin Lending Version: October 2010 Advice Solutions is a division of GWM Adviser Services Limited ABN

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3 Table of Contents INTRODUCTION...1 ABOUT THIS COURSE... 1 ABOUT THIS GUIDE... 4 GLOSSARY OF TERMS... 5 SECTION 1: MARGIN LENDING FACILITIES...6 MARGIN LENDING OVERVIEW GEARING AND MARGIN LENDING TYPES OF A MARGIN LENDING FACILITIES ELEMENTS OF A MARGIN LENDING FACILITY BENEFITS OF MARGIN LENDING RISKS OF MARGIN LENDING SECTION 2: MARGIN LENDING FACILITY CHARACTERISTICS TYPES OF LOAN TO VALUE RATIOS CALCULATING LOAN TO VALUE RATIOS MARGIN CALLS INVESTMENT REMOVED FROM APPROVED SHARES / FUNDS LIST STRATEGIES TO REDUCE THE LIKELIHOOD OF MARGIN CALLS SECTION 3: MARGIN LENDING OBLIGATIONS AND CONDUCT LEGISLATIVE ACTS IMPACTING ON MARGIN LENDING GENERAL CONDUCT OBLIGATIONS OF AFSL HOLDERS MARGIN LENDING ISSUER - RESPONSIBLE LENDING CONDUCT SECTION 4: MARGIN LENDING INVESTMENT STRATEGIES INVESTMENT STRATEGY CONSIDERATIONS THE IMPACT OF CHANGING INTEREST RATES AND INVESTMENT RETURNS SECTION 5: PROVIDING MARGIN LENDING ADVICE KNOW YOUR CLIENT, KNOW YOUR PRODUCT THE ECONOMIC ENVIRONMENT MEASURING ECONOMIC GROWTH INFLATION ECONOMIC INDICATORS ECONOMIC POLICY THE EXCHANGE RATE DATA COLLECTION DEVELOPING AND PRESENTING FINANCIAL STRATEGIES PRESENT STRATEGIES AND SOLUTIONS TO THE CLIENT NEGOTIATING AND IMPLEMENTING THE FINANCIAL PLAN IMPLEMENTATION OF AGREED PLAN COMPLETING AND MAINTAINING THE FINANCIAL PLAN PROVIDE ONGOING SERVICE... 65

4 SECTION 6: TAXATION...67 SECTION 7: COMPLIANCE LEGAL PRINCIPLES, REGULATORY REQUIREMENTS AND ETHICS MARGIN LOAN PROVIDER ASSET REQUIREMENTS DISCLOSURE AND PRIVACY REQUIREMENTS CLIENTS AND ADVISER RIGHTS AND RESPONSIBILITIES SECTION 8: CASE STUDY - THE COLLAPSE OF STORM FINANCIAL...78 THE STORM FINANCIAL BUSINESS MODEL EVENTS SURROUNDING THE COLLAPSE OF STORM FINANCIAL ISSUES OF CONCERN CONCLUSIONS OF THE RIPPOLL REPORT SECTION 9: REVIEW QUESTIONS...86 SECTION 10: CONCLUSION...88 SECTION 11: ACTIVITY AND REVIEW ANSWERS...89 ACTIVITY ANSWERS REVIEW ANSWERS... 94

5 Gap Assessment Margin Lending Introduction About this Course Welcome Welcome to the Margin Lending Gap Assessment course. This training course and its examination are mandated by the Australian Securities & Investment Commission and are required for all advisers who wish to engage in the provision of margin lending advice. In this course, you will learn about the provision of margin lending, margin lending facilities, the elements and structure of a margin loan and the principles of margin lending for a retail client. You will also analyse the issues and considerations associated with recommending margin lending strategies to clients. You will be required to study these learning materials and then undertake a formal examination on margin lending. Once you have passed the examination and received notification of your compliance, you will have met the updated RG146 requirements for margin lending in line with the new legislative changes. Please note that your licensee may have additional specialist accreditation(s) before you can provide advice in this area (eg. securities and gearing). Learning outcomes At the end of this course you will be able to: Understand the conduct and disclosure requirements imposed by the Australian Securities & Investments Commission in relation to advising and dealing in margin lending as a financial product. Understand how the new suitability rules apply to lenders Identify the types of margin lending facilities Understand how types of margin lending facilities operate Identify types of risks associated with margin lending Understand lender and borrower rights and responsibilities Undertake loan-to-value ratio calculations Identify and understand the requirements for providing advice in margin lending Advice Education Page 1

6 Margin Lending Gap Assessment Understand investment strategies and the implications of margin calls Understand taxation implications for margin lending Understand compliance, ethics and regulatory requirements for margin lending. Course structure and study plan Section 1 Section 2 Section 3 Section 4 Section 5 Section 6 Section 7 Section 8 Margin Lending Facilities Margin Lending Facility Characteristics Margin Lending Obligations and Conduct Margin Lending Investment Strategies Providing Margin Lending Advice Taxation Compliance Case Study The Collapse of Storm Financial Each section includes activities that illustrate and explain the section s advice principles in margin lending. These sections form the content that will be assessed by a multiple choice online examination. It is recommended that you print the course materials and study them in the order presented in the Learning Guide. Prerequisites The Diploma of Financial Services (Financial Planning) or the equivalent Regulatory Guide 146 compliance is a prerequisite for undertaking this gap assessment. In order for you to provide advice in relation to margin lending your Licensee may require you to have also successfully completed their current Licensees Gearing Specialist Accreditation and Securities Specialist Accreditation. Page 2 Advice Education

7 Gap Assessment Margin Lending Unit of Competency and Tier 1 Competency This course meets the performance outcomes, skills and knowledge requirements for current Australian Securities and Investment Commission (ASIC) Australian Financial Services (AFS) licensing at Tier 1 level in the Margin Lending specialist area. These requirements have been determined by the Unit of Competency FNSASICR503A Provide Advice in Margin Lending. Activities and Review Questions This guide contains activities that should be completed by the participant during their study. Correct responses to the activities are located in Section 11: Activity and Review Answers There are also a set of review questions that the participant should undertake upon completion of the Learning Guide to reinforce their study and prepare for the gap assessment examination. Correct responses to the questions are located in Section 11: Activity and Review Answers. Online examination When you have completed studying the Learning Guide, you will be required to undertake an online examination. All details for undertaking the examination are available at The pass mark for the examination is 80%. There is one re-sit examination if you are not successful on the primary examination. Each examination is a timed 60 minute, 23 question, selfdirected assessment and should be undertaken as closed-book. A financial calculator is required for completing the examination. Advice Education cautions participants from undertaking the examination as open book for this may negatively affect their ability to complete the examination in the required time. Note: Full compliance with the margin lending gap assessment is only achieved upon successful completion of the margin lending gap assessment examination. Advice Education Page 3

8 Margin Lending Gap Assessment Examination results Upon successfully completing the examination, your Training Record will be updated to reflect the passing grade on the gap assessment in margin lending. If you do not successfully complete the examination, you will receive feedback on your submitted answers and be given the opportunity to re-sit the examination. CE points This course has been accredited for 4 CE points under WM1022; Gap Assessment Margin Lending. Your Training Record will be allocated these points when you have passed the margin lending examination. References You may obtain further information regarding margin lending from the following website: 20lending About this Guide Disclaimer Any material downloaded or printed by users is issued by Advice Solutions on the basis that, to the maximum extent permitted by law: a) GWM Adviser Services Limited, its directors, author(s) and any other person involved in the preparation of the material expressly disclaim all and any contractual, tortious or other forms of liability to any person, whether a purchaser or otherwise, in respect of such material, including any omission made from such material, and any consequences arising from its use by any person; and b) GWM Adviser Services Limited and other members of the National Australia Group of companies are not liable in any way for any loss, damage, cost or expense incurred by any person as a result of relying, in whole or in part, on such material or its contents. Page 4 Advice Education

9 Gap Assessment Margin Lending Glossary of Terms IAESR AFSL ASIC CPI EDR FSG FSRA GDP GFC GNE IMF LVR PDS RBA RG SOA University of Melbourne Institute of Applied Economic and Social Research Australian Financial Services License Australian Securities and Investment Commission Consumer Price Index External Dispute Resolution scheme Financial Services Guide Financial Services Reform Act Gross Domestic Product Global Financial Crisis Gross National Expenditure International Monetary Fund Loan to Value Ratio Product Disclosure Statement Reserve Bank of Australia Regulatory Guideline Statement of Advice Next section The next section of this guide addresses the types of margin lending facilities, elements of margin lending facilities and the benefits and risks associated with margin lending strategies. Advice Education Page 5

10 Margin Lending Gap Assessment Section 1: Margin Lending Facilities Section overview The following section addresses these knowledge areas: 1.1 Gearing and Margin Lending 1.2 Types of margin lending facilities 1.3 Elements of a margin lending facility 1.4 Benefits of margin lending 1.5 Risks of margin lending. Margin Lending Overview Introduction A margin lending facility is a line of credit that is secured by marketable securities; typically listed shares or unlisted managed funds. The credit, or margin loan, that is provided may be applied wholly or partly for the acquisition of approved investments. Approved investments purchased with the borrowed funds will form part of the secured property. 1.1 Gearing and Margin Lending Overview Gearing is a wealth accumulation strategy whereby a borrower obtains funds from a lender and invests those funds in assets that are expected to provide returns in the form of income and/or growth. The borrower expects that the long term average returns from the investment will exceed the costs associated with borrowing the funds eg. interest and fees, etc. As a result, the borrower will make a profit. There are a number of ways in which a gearing strategy can be structured, including borrowing against property, an internally geared managed funds, instalment warrants and margin lending. Margin lending is a gearing strategy with a focus on marketable securities. Page 6 Advice Education

11 Gap Assessment Margin Lending 1.2 Types of a Margin Lending Facilities Standard margin lending facilities A standard margin lending facility is a financial agreement under which a loan is provided by a lender to a borrower to wholly or partly acquire financial products or investments. The collateral for this margin loan must be secured wholly or partly with cash or marketable securities approved by the lender. In the majority of cases, real property cannot be used as security for a margin lending facility. However, this is dependent upon the terms and conditions of the lender. Standard margin lending facilities are the most common form of margin lending. Effects of provider taking security over client s assets for standard margin lending facility Under standard margin lending facilities, the client retains ownership of their existing securities; however these securities are used as collateral for the margin loan. This means that when certain trigger conditions such as failing to meet a margin call occur, the lender may act to sell some or all of the securities in order to restore the ratio between loan and value of securities should the borrower fail to take action within the agreed timeframe. Non-standard margin lending facilities A non-standard margin lending facility differs from a standard margin lending facility in that ownership of the borrower s securities and/or investments, used as collateral for the loan, are transferred to the lender. The lender then loans the borrower an amount based upon the value of these transferred securities. The loan is then used by the borrower to wholly or partly acquire more financial products or investments. These less common arrangements are typically used in the wholesale market and subject to more complex loan agreements. Effect of provider receiving a transfer of clients assets for non-standard margin loan The transfer of ownership of the client s securities to the nonstandard margin lender potentially exposes the client to additional risks over and above those incurred through standard margin lending. The degree to which the client is exposed to these risks is largely determined by the agreement that is established between the two parties at the commencement of the loan. The main risk that may be incurred by the borrower through non-standard margin lending is that the lender, who now legally owns the client s original securities, may dispose of, or on-lend those securities to a third party. This could result in an inability of the lender to transfer those securities back to the client when requested. Advice Education Page 7

12 Margin Lending Gap Assessment If the lender becomes insolvent, there is a risk that the client will become an unsecured creditor and depending on the assets available and the number of other creditors, the client may not receive the securities or an equivalent amount of money at all. Note Important Point ASIC currently advises that retail borrowers should fully understand the risks of non-standard margin lending. This is because the borrower may not receive the original securities/investments that were transferred to the lender. The lender is only required to return to the borrower marketable securities equivalent to the transferred securities. Page 8 Advice Education

13 Gap Assessment Margin Lending Activity 1 Standard And Non-Standard Margin Lending Facility How do a standard margin and non-standard margin lending facility differ? Advice Education Page 9

14 Margin Lending Gap Assessment 1.3 Elements of a Margin Lending Facility Overview The following is a brief summary of the elements of a margin lending facility. These elements vary between financial institutions and are in no way conclusive of every type of margin loan facility. Types of borrowers Borrowers who can access margin loans for investment purposes can include natural persons, partnerships, incorporated entities and trustees. Range of eligible margin loan security The range of investments that may be eligible as loan security are: unlisted managed funds listed investments; both domestic and international Loan to Value Ratio (LVR) The Loan to Value Ratio (LVR) refers to the maximum percentage of a new investment that a lender is willing to fund. When it is applied to an investment portfolio, it is the weighted average of the LVRs that are applied to each portfolio component. Interest rate terms Margin lending facilities offer both variable and fixed term rates of interest. The adviser and client should collaborate to determine which rate is the most appropriate for the client and the types of investment being undertaken. The adviser should ensure this decision is determined by the client s financial position and financial goals. Page 10 Advice Education

15 Gap Assessment Margin Lending Borrowing Limit The borrowing limit is the lower of the approved credit limit offered to a client and the client s security-based lending limit. For example: Approved credit limit (based on client s financial statement of position) = $250,000* Average LVR of planned asset purchases = 70% Market value of prospective total portfolio = $200,000 Security value of prospective total portfolio = $140,000 Minimum equity contribution from the client = $60,000 Borrowing limit = lower of $250,000 and $140,000 Hence, borrowing limit = $140,000 *The client s ability to fully utilise this approved credit limit is strictly limited by the actual value and nature of the equity contributed by the client, and the value and nature of the investments purchased with the borrowed funds. Advice Education Page 11

16 Margin Lending Gap Assessment Activity 2 Elements of Margin Lending Can margin lending facilities offer both variable and fixed term rates on interest payments? Yes/No Page 12 Advice Education

17 Gap Assessment Margin Lending 1.4 Benefits of Margin Lending Overview There are a number of benefits derived from investing through margin lending. These benefits include: Increased Investment Capacity. Margin lending can provide a simple and flexible option to take advantage of short term market opportunities without being forced to sell current assets to create the required liquidity. Diversification. By having more money to invest, a client can gain exposure to a greater range of growth opportunities without having to liquidate existing assets and trigger capital gains events. Higher Returns. If the investments purchased with the borrowed funds ultimately consistently outperform the cost of borrowing, the borrower will experience additional return that they would not have otherwise received. The out performance may well come from a combination of yield, franking and capital growth. Tax Benefits. If the borrowed funds are used to purchase investments that pay a dividend then there is link between the cost of borrowing (interest expense) and the future taxable income of the borrower. Typically, this combination means that loan interest can be treated as a deductible expense, and be offset against other taxable income. Borrowers should always seek professional taxation advice regarding the deductibility of loan interest. The potential deductibility of loan interest reduces the overall cost of borrowing, and lowers the out performance required for the gearing strategy to be able to deliver additional return. Advice Education Page 13

18 Margin Lending Gap Assessment 1.5 Risks of Margin Lending Overview The following is a list of possible risks associated with margin lending that a potential borrower (or guarantor) should consider prior to committing their equity into a margin loan facility. Risk Increased volatility of client portfolio Portfolio returns may not outperform the costs of borrowing Lack of focus on the cost of borrowing and the expected performance of loan security Be prepared to deal with a margin call Description Margin lending offers a client the opportunity to have greater exposure to share markets and managed funds than their own funds will allow. Consequently, movement in the value of the larger portfolio, now under the client s control, translates into larger relative moves in the value of the client s portfolio; as market movement does not impact the value of the outstanding loan balance. Assuming the underlying investments are identical, a client s equity will always experience greater volatility within a geared portfolio compared to an ungeared version. Margin Lending can deliver increased returns if the assets purchased outperform the costs of borrowing. If this does not occur, the client will have assumed greater risk for no improvement in return, and possibly a lower return relative to an ungeared scenario. Interest rates may rise and growth prospects may fall, creating a situation where a particular geared strategy is unlikely to deliver a positive result. If a client is required to respond to a margin call, they will need to be prepared to act promptly. This may require the contribution of additional cash or approved investments into the loan facility, or the sale of a portion of the current portfolio held as loan security Page 14 Advice Education

19 Gap Assessment Margin Lending Consider the possibility of a negative equity situation Individual loan security LVRs maybe reduced or removed Client is uncontactable for their margin call, or is slow to respond within the required time Guarantees provided by other parties In adverse market conditions, it is possible for the value of assets held as loan security to fall faster than anticipated; to a value less than the current loan balance. In this situation, the client will have to contribute additional funds to their facility as selling assets alone will no longer be sufficient to rectify the position. If the quality of particular approved investment deteriorates; i.e. liquidity decreases or adverse business conditions are present, the LVR on an individual security maybe reduced or set to zero. If the affected security was an important component of a client s loan security, the LVR change may push the client s facility into a margin call position even if the market value has not changed. If the client does not take the necessary action to correct their margin call, they will be deemed to have instructed the lender to decide which assets to sell. Often third parties provide loan security in support of a borrower. In an event of default by the borrower, guarantors can expect that they will be asked to cover any shortfall in the process of recovering outstanding loan obligations. Next section The next section of this guide addresses the characteristics of a margin lending facility including types of loan to value ratios, calculating loan to value ratios, margin calls and margin call strategies. Advice Education Page 15

20 Margin Lending Gap Assessment Section 2: Margin Lending Facility Characteristics Section overview The following section addresses these knowledge areas: 2.1 Types of Loan to Value Ratios 2.2 Calculating Loan to Value Ratios 2.3 Margin calls 2.4 Investment removed from Approved Shares/ Funds List 2.5 Strategies to reduce the likelihood of margin calls. 2.1 Types of Loan To Value Ratios Overview A Loan to Value Ratio (LVR) is an extremely important investment concept that an adviser must understand in relation to margin lending. The LVR for a prospective portfolio of investments determines the maximum portion of the portfolio that a lender is willing to fund. LVRs for individual portfolio components may vary from lender to lender; based on their view of asset quality. Security Unlike other forms of lending, margin loans do not use property, real estate or other forms collateral as security for the loan. Margin lenders use investment portfolios owned by the borrower that hold stocks and managed investments as security for the loan. Margin lending can be provided using either a client s entire investment portfolio or specific investments in the portfolio. In this manner, a client can identify risk only specific investments as security for a margin loan rather than all of their investment holdings. Page 16 Advice Education

21 Gap Assessment Margin Lending Margin Lending Facility LVR Generally, margin lending providers will lend between 40% and 75% of an approved investment s value. For example, if a new borrower wanted to invest $100,000 into 70% rated securities, the lender would fund up to $70,000 of the purchase and the borrower would need to contribute the balance; i.e. $30,000. On an ongoing basis, there is one simple rule that guides the status of the margin loan. The security value of the underlying portfolio (market value multiplied by the LVR) should always be greater than the outstanding loan balance. This rule will guide: 1. the client s ability to make additional purchases using loan funds 2. the client s ability to capitalise loan interest and 3. whether any corrective action is required. Note Important Point The same LVR calculations are used for determining the level of security of both specific investment products and whole investment portfolios. Forms of LVR There are three forms of LVR: The Current LVR This is the borrower s total loans outstanding divided by the market value of their portfolio on that day. This ratio reflects the value of the investment against the current level of the amount owed by the borrower. The Base LVR This is the maximum percentage a lender will advance against the weighted average security value of a portfolio. The lending value of an individual investment is its market value multiplied by its LVR. Margin Call LVR (Base LVR + Buffer) This is the Base LVR plus the relevant buffer amount, expressed as a percentage. If the Current LVR equals or exceeds the Margin Call LVR, the borrower s facility is in margin call. Advice Education Page 17

22 Margin Lending Gap Assessment Buffers To allow for small movements in the markets, product providers allow the borrower to exceed the portfolio s lending value by a given percentage. This percentage is known as the buffer or margin. For the NAB Equity Lending, the buffer is 5% above the lending value for shares and 10% above the lending value for managed funds. For example, if the client has a managed fund portfolio that has a lending value of 70% the lender will allow the portfolio to fall in value until the LVR is equal to or exceeds 80% before making a margin call, i.e. the loan now makes up 80% of the total portfolio. However, some lenders do have different buffers in place for particular securities. 2.2 Calculating Loan to Value Ratios Calculating the Current LVR The Current LVR is the borrowers total loans outstanding divided by the market value of their portfolio on a specific day. This ratio reflects the value of the investment against the current level of the debt owed by the borrower. The Current LVR formula is: Current LVR = Loan Amount/Investment (market) value x 100 Example: $60,000/ $104,231 = 57.56% Calculating the Base LVR The Base LVR is the maximum percentage a lender will lend a borrower on a specific investment. If the borrower has two or more investments that have different lending ratios, the Base LVR will be the weighted average of those investments. For example, an investor has $40,000 to contribute as collateral and borrows $60,000 from a margin lending facility. The $100,000 total is invested into unit trusts with a nil entry fee. The Lender has assigned a 70% LVR against the unit trusts the borrower has invested in. This means the Base LVR is 70%. Initially, then, the borrower s position will be: Current LVR = Loan amount/ Investment value: = $60,000/$100,000 = 60% Base LVR = 70% Page 18 Advice Education

23 Gap Assessment Margin Lending Calculating the Margin Call LVR The Margin Call LVR is the Base LVR plus the buffer. In this instance the lender has assigned the unit trusts a buffer of 10%, so the Margin Call LVR = Base LVR + 10% buffer Base LVR: 70% Buffer: 10%. Margin Call LVR = 80%. In a situation where the investment value has declined by 5% from $100,000 to $95,000. Current LVR = Loan Amount /Investment value $60,000/$95,000 = 63.2% The Margin Call LVR is the Base LVR plus the 10% buffer. So: Margin Call LVR = 80% (i.e. the Base LVR plus 10% buffer) If there was more than one asset in the portfolio, and the assets had different security ratios, the Margin Call LVR would be the weighted average of the various security ratios plus the buffer, which in this case is 10%. Consequences of issuers altering the LVR of individual products A margin lender sets the LVR for each asset that they will lend against. The LVR determines the maximum amount that may be borrowed against that asset. For example, if the margin lender sets a security ratio of 70% for BHP shares, then that means that the loan amount may be up to 70% of the value of the investment. So to establish a $100,000 portfolio of BHP shares, the borrower would need $30,000 of their own funds and would be able to borrow the remaining $70,000. A margin lender reserves the right to alter the LVRs it has set for various assets. A problem may arise for the borrower if they have borrowed the maximum amount allowable in line with the security ratio, and the LVR is subsequently reduced. This lowers the maximum borrowing amount and potentially placing the borrower in a margin call position. Advice Education Page 19

24 Margin Lending Gap Assessment Activity 3 How to Calculate an LVR A client has $100,000 to invest. A margin lending strategy is recommended whereby an additional $100,000 is borrowed via a margin loan and the total of $200,000 is invested in the MLC MasterKey Investment Service Australian Shares managed fund. The lender s security ratio for the fund is 70% and the buffer is 10%. Calculate the following based on the above information: The Current LVR, both initially and after a 10% decline in investment value: The Base LVR The Margin Call LVR Page 20 Advice Education

25 Gap Assessment Margin Lending 2.3 Margin Calls Overview A margin call should be expected by any client who chooses to operate their loan facility near or in the buffer zone. A margin call is a request to restore the Current LVR to at least the Base LVR established by the product provider. A margin call is issued when the Current LVR exceeds the Margin Call LVR; i.e. when the security value of the portfolio plus the buffer is less than the outstanding loan balance. This can be a result of: A decrease in the market value of the investments held as loan security A reduction in the lenders LVR of an investment held as loan security The investment being removed from the lenders approved securities list An increase in the outstanding loan balance via the capitalisation of loan interest. If the Current LVR exceeds the Base LVR of the portfolio by more than the buffer, the lender will make a margin call. The lender will contact the borrower directly, and inform them that they have to bring the Current LVR back under the Base LVR limit. If the lender has been unable to contact the client after making a reasonable attempt to do so, they are entitled to sell part of the portfolio to reduce the loan so that the Current LVR is less than the Base LVR. The client typically will have 24 hours to satisfy the lender that the necessary corrective action has been taken. The exact time period will differ from lender to lender. Advice Education Page 21

26 Margin Lending Gap Assessment Determining a margin call A margin call is made when the Current LVR is equal to or greater than the Margin Call LVR. In the previous example, as the Current LVR (63.2%) is less than the Margin Call LVR (80%), no margin call has been triggered. The portfolio would need to have fallen 25% in value down to $75,000 in order to reach the margin call trigger point of an 80% gearing level. The table below identifies the Portfolio Base LVR on the right and the gearing level that initiates a margin call at the top. For example, a 70% Portfolio Base LVR will have a margin call made at 80% as the margin call buffer is at 0%. Buffer Table Buffer % = 10% Debt $' Portfolio $' Client Equity $' Current LVR % 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% Margin Call 'expected' Margin Call 'rare' Base LVR % Fall of (%) 0% 6% 11% 17% 22% 28% 33% 39% 44% 50% 56% 61% 67% 72% 78% 80% 0% 6% 12% 18% 24% 29% 35% 41% 47% 53% 59% 65% 71% 76% 75% 0% 6% 13% 19% 25% 31% 38% 44% 50% 56% 63% 69% 75% 70% 0% 7% 13% 20% 27% 33% 40% 47% 53% 60% 67% 73% 65% 0% 7% 14% 21% 29% 36% 43% 50% 57% 64% 71% 60% 0% 8% 15% 23% 31% 38% 46% 54% 62% 69% 55% 0% 8% 17% 25% 33% 42% 50% 58% 67% 50% 0% 9% 18% 27% 36% 45% 55% 64% 45% 0% 10% 20% 30% 40% 50% 60% 40% 0% 11% 22% 33% 44% 56% 35% 0% 13% 25% 38% 50% 30% Once the Current LVR (gearing level) exceeds the Base LVR (70%), the facility has moved into the buffer zone (gray area in the Buffer Table). Once a facility has moved into its buffer zone, a client is no longer permitted to execute transactions that will further increase the client s Current LVR. It is also prudent to take some corrective action to move back out of the buffer zone and push away from the margin call boundary. If the Current LVR exceeds the Margin Call LVR (80%), the lender would be expected to make a margin call. The borrower would then be required to restore the loan back to the lenders acceptable lending ratios, usually to a level that does not exceed the Base LVR. Page 22 Advice Education

27 Gap Assessment Margin Lending What loan configuration can absorb a 30% fall in portfolio value without triggering a margin call? The tables below list the fall in portfolio value required to trigger a margin call when the portfolio buffer is 10% and 5% respectively. In the case of a 10% buffer, the combination of a 70% Base LVR and a 55% Current LVR could absorb a 30% fall in portfolio value without triggering a margin call. Actual fall would have to be 31.5% for this to occur. This assumes that the average portfolio LVR remains at 70%. In the case of a 5% buffer, the current LVR would need to be lower (~50%) in order to absorb a 30% fall in portfolio value. 10% Buffer Table Buffer % = 10% Debt $' Portfolio $' Client Equity $' Current LVR % 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% Margin Call 'expected' Margin Call 'rare' Base LVR % Fall of (%) 0% 6% 11% 17% 22% 28% 33% 39% 44% 50% 56% 61% 67% 72% 78% 80% 0% 6% 12% 18% 24% 29% 35% 41% 47% 53% 59% 65% 71% 76% 75% 0% 6% 13% 19% 25% 31% 38% 44% 50% 56% 63% 69% 75% 70% 0% 7% 13% 20% 27% 33% 40% 47% 53% 60% 67% 73% 65% 0% 7% 14% 21% 29% 36% 43% 50% 57% 64% 71% 60% 0% 8% 15% 23% 31% 38% 46% 54% 62% 69% 55% 0% 8% 17% 25% 33% 42% 50% 58% 67% 50% 0% 9% 18% 27% 36% 45% 55% 64% 45% 0% 10% 20% 30% 40% 50% 60% 40% 0% 11% 22% 33% 44% 56% 35% 0% 13% 25% 38% 50% 30% 5% Buffer Table Buffer % = 5% Debt $' Portfolio $' Client Equity $' Current LVR % 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% Margin Call 'expected' Margin Call 'rare' Base LVR % Fall of (%) 0% 6% 12% 18% 24% 29% 35% 41% 47% 53% 59% 65% 71% 76% 80% 0% 6% 13% 19% 25% 31% 38% 44% 50% 56% 63% 69% 75% 75% 0% 7% 13% 20% 27% 33% 40% 47% 53% 60% 67% 73% 70% 0% 7% 14% 21% 29% 36% 43% 50% 57% 64% 71% 65% 0% 8% 15% 23% 31% 38% 46% 54% 62% 69% 60% 0% 8% 17% 25% 33% 42% 50% 58% 67% 55% 0% 9% 18% 27% 36% 45% 55% 64% 50% 0% 10% 20% 30% 40% 50% 60% 45% 0% 11% 22% 33% 44% 56% 40% 0% 13% 25% 38% 50% 35% 0% 14% 29% 43% 30% Advice Education Page 23

28 Margin Lending Gap Assessment Margin call example 25% fall Let s create a margin loan configuration where a 25% fall in portfolio value will trigger a margin call, and calculate the value of 3 separate responses that would satisfactorily re-balance the loan facility status. Loan configuration: 65% Current LVR and a 70% Base LVR. Per the 10% buffer table, a 19% (18.75% to be exact) fall is required to trigger a margin call. The table below details the status of the margin loan; both before and after a 25% fall in portfolio value, and after 3 separate margin call responses; (1) contribute cash to reduce the loan, (2) contribute additional assets to increase the portfolio security value, and (3) sell portfolio assets. Client contribution $35,000 Loan balance $65,000 Investment value at date of purchase $100,000 Security value at date of purchase $100,000 x 70% LVR $70,000 Initial gearing level 65% Investment value after 25% fall $75,000 Security value after 25% fall $75,000 x 70% LVR Current LVR after drop in value of investment $52, % Lender s Base LVR 70% Lender s Margin Call LVR (Base LVR + 10% buffer) Margin Call Amount = Loan Security Value $65,000 - $52,500 80% $12,500 Page 24 Advice Education

29 Gap Assessment Margin Lending This table details the minimum actions required to restore the $12,500 margin call that was triggered. Type of action to correct the margin call Reduce the loan balance so that it matches the current security value; i.e. contribute cash to correct the margin call. New loan balance = $65,000 - $12,500 = $52,500 = security value Hence, margin call satisfied (loan = security value) Increase the security value of the portfolio by contributing additional approved investments. The amount to contribute will depend on the LVR that the lender offers on the security to be added. For example: additional 70% LVR security: The new addition needs to increase the overall security value of the portfolio by $12,500. Amount to contribute = $12,500/0.7 = $17,857 Total portfolio now = $75,000 + $17,857 = $92,857 (x 70% = $65,000) Hence, margin call satisfied (loan = security value) Restore the balance between portfolio security value and the loan balance by selling a portion of the current loan security. Selling assets will reduce the loan balance by a greater value than the associated reduction in portfolio security value; hence the right amount of selling will rectify the situation. Amount to sell = $12,500 / (1-0.7) = $12,500 / 0.3 = $41,667 Magnitude $12,500 cash infusion $17,857 of extra loan security with a 70% LVR $41,667 of portfolio selling Total portfolio now = $75,000 - $41,667 = $33,333 Security value now = $33,333 x 70% = $23,333 Loan balance = $65,000 - $41,667 = $23,333 Hence, margin call satisfied (loan = security value) Note Important Point It is imperative that an adviser check with the product provider on the level of the buffer they offer. Advice Education Page 25

30 Margin Lending Gap Assessment Notification of margin calls Under the provisions of the Corporations Act 2001, it is the legal responsibility of the lender to advise the client when a margin call is made. There are civil penalty liabilities if there is a breach of the notification requirements. Note Important Point The MLC/NAB Wealth position is that its advisers cannot enter into agreements to receive margin call notifications on behalf of clients. It is the MLC/NAB Wealth position that the client is contacted directly by the margin loan provider; the adviser may however be copied in on that communication should the lender have this feature. Consequences of margin calls, and how they may be resolved When a margin loan provider issues a margin call, the borrower has to restore the balance between the security value of the portfolio and the outstanding loan balance. If the borrower cannot meet their margin call obligations, the lender may sell sufficient assets to correct the position. A borrower can, however, combine any of the following three activities to meet their margin call: 1. Lodge cash so that the loan is reduced 2. Lodge additional approved securities to reduce the proportion of borrowed funds relative to equity. These can include: - shares - managed investments 3. Sell part of the portfolio, and use those funds to reduce the loan. Page 26 Advice Education

31 Gap Assessment Margin Lending 2.4 Investment Removed from Approved Shares / Funds List Consequences of removing a product from the approved list A margin lender reserves the right to remove assets from its approved investment list at any time. This would normally occur if the lender perceives the risks associated with a specific investment as being unacceptably high. For an investor that holds this asset in their investment portfolio, the effect is the security ratio is reduced to zero. For example, an investor has a portfolio made up of $50,000 worth of BHP shares and $50,000 worth of Rio Tinto shares. The margin loan that these shares are secured against is $50,000. The Current LVR is $50,000 / $100,000 = 50%. Assume the Base LVR of both BHP and Rio Tinto is 70%, and the Buffer is 5%. Hence, the Margin Call LVR is 75%. Current Security Value = Base LVR (weighted average if different ratios apply however both are 70% here) x Market Value or 70% x $100,000 = $70,000. The margin loan provider now removes Rio Tinto from the approved investment list. The Rio Tinto shares no longer contribute to the security value of the loan portfolio. This means that the Security Value is now 70% x $50,000 = $35,000. The Base LVR for the whole portfolio now equals $35,000/$100,000 = 35%. The Current LVR of 50% now exceeds the Margin Call LVR of 40%; placing the facility into a margin call condition. Advice Education Page 27

32 Margin Lending Gap Assessment Activity 4 Margin Calls 1. Under the provisions of the Corporations Act 2001, who must the lender notify in the event of a margin call? 2. What are the consequences if this does not occur? 3. What is the MLC/NAB Wealth position regarding a margin call notifications to clients? Page 28 Advice Education

33 Gap Assessment Margin Lending 2.5 Strategies to Reduce the Likelihood of Margin Calls Overview As margin calls are a significant risk in margin lending, borrowers can employ a number of strategies to avoid this possibility. These strategies include avoiding maximum lending levels, diversification, strategy consistency and managing cash flows. Avoid maximum LVR A client can reduce the risk of margin calls if they avoid borrowing the maximum amount of the LVR. Per the table below, the combination of higher LVRs and lower gearing levels deliver the most conservative margin loan scenarios; i.e. require the greatest portfolio falls to trigger a margin call. Buffer % = 10% Portfolio '000 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100 Debt' 000 $80 $75 $70 $65 $60 $55 $50 $45 $40 $35 $30 Equity '000 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70 Gearing 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% Margin Call 'expected' Margin Call 'rare' Base LVR % 0% 6% 13% 19% 25% 31% 38% 44% 50% 56% 63% 70% 0% 7% 13% 20% 27% 33% 40% 47% 53% 60% 65% 0% 7% 14% 21% 29% 36% 43% 50% 57% 60% 0% 8% 15% 23% 31% 38% 46% 54% 55% 0% 8% 17% 25% 33% 42% 50% 50% 0% 9% 18% 27% 36% 45% 45% 0% 10% 20% 30% 40% 40% 0% 11% 22% 33% 35% 0% 13% 25% 30% Buffer Zone Diversification Margin calls are triggered when a highly geared portfolio falls in value. Even so, a diversified portfolio is expected to be less volatile than an undiversified one. Diversification itself will not insure against portfolio falls, but it is reasonable to expect that falls in a diversified portfolio will be relatively smaller and slower than undiversified positions given some offsetting in different sectors. Portfolio diversification also assists in avoiding unanticipated margin calls. Advice Education Page 29

34 Margin Lending Gap Assessment Follow original investment strategy A formal or informal investment strategy which utilises margin lending will have a target gearing level. This gearing level will have been set based on a range of factors. These may include: 1. comfort with being a certain distance from a margin call position based on the overall level of gearing, 2. comfort with the expected volatility in equity that comes with a particular underlying investment or asset class, and 3. the gearing level required, based on expected portfolio performance and the prevailing interest rates, to deliver a desired enhanced rate of return. It is recommended that an original investment strategy is developed and assessed against the changing portfolio on a regular basis. If the value of the portfolio falls and the facility moves out of the target gearing zone, being proactive in undertaking the necessary action to restore the facility to its original target zone will avoid margin calls and potentially undesirable actions like selling assets at the bottom of the market. Cash flow management to keep the loan balance in check A strategy for managing cash flow to maintain the margin loan balance is to re-invest dividends or to receive and re-direct them back into the loan facility The client can also establish a direct debit facility to automatically take the monthly loan interest that accrues on a variable loan balance, or the annual interest prepayment for a 1 year fixed loan. Page 30 Advice Education

35 Gap Assessment Margin Lending Activity 5 Responding to a Margin Call An client has the following margin lending position: NAB shares of $30,000 with 70% security ratio & 5% Buffer WBC shares of $25,000 with 65% security ratio & 5% Buffer ANZ shares of $20,000 with 60% security ratio & 5% Buffer CBA shares of $10,000 with 65% security ratio & 5% Buffer Margin Loan of $56,000 secured against the above shares Questions: 1. Calculate the Base, Margin Call and Current LVRs 2. Calculate the Base LVR if CBA is removed from the approved investment list 3. Explain why a Margin Call will occur 4. What action will the lender take? 5. What are the three options the client has to restore the strategy back to the Base LVR? Next section The next section of this guide addresses conduct obligations for margin lending providers including general conduct obligations, responsible lending and suitability assessments for clients who have been recommended margin lending strategies. Advice Education Page 31

36 Margin Lending Gap Assessment Section 3: Margin Lending Obligations and Conduct Section overview The following section addresses these knowledge areas: 3.1 Legislative Acts impacting on margin lending 3.2 General conduct obligations of AFSL holders 3.3 Margin lending issuer responsible lending conduct Introduction Since late 2007, there has been considerable attention to the provision of credit which has included the governance of the margin lending and how financial advice regarding margin loans has been provided to clients. On 25 June 2009, the Corporations Legislation Amendment (Financial Modernisation) Bill 2009 was introduced into Parliament, proposing that the Corporations Act 2001 be amended to include margin lending facilities as a financial product. In late 2009, the Ripoll Inquiry provided its recommendations around the current practices of providing finance to borrowers and customers through margin loans. The Corporations Legislation Amendment (Financial Modernisation) Act 2009 was enacted on 6 November 2009 which amended the Corporations Act 2001 such that from 1 January 2010 margin lending became subject to supervision and oversight by ASIC. This has had a significant impact upon lenders, Australian Financial Services Licence (AFSL) holders, and advisers who provide margin lending facility services as they must now meet additional legislative requirements. This includes adhering to conduct obligations such as know your client, know your product, disclosure, training and meeting established licensing requirements in order to avoid non-compliance. Page 32 Advice Education

37 Gap Assessment Margin Lending 3.1 Legislative Acts Impacting on Margin Lending As the Corporations Act 2009 ( the Act ) now identifies margin lending facilities as a financial product, Australian Financial Services Licence (AFSL) holders must now hold a specific licence authorisation to enable it to deal in, or to provide financial product advice on, margin lending facilities. The Act also imposes a new set of responsible lending requirements on issuers of margin lending facilities (margin lending product providers and lenders) and clarifies the responsibility for providing client notification of margin calls. The provisions within the Act only apply to margin loans provided to natural persons (i.e. individual and joint borrowers, not corporate entities) who are retail clients. The Act requires (among other things): Issuers and advisers of margin lending facilities to be licensed by ASIC under an AFSL. Advisers to only provide personal advice that is appropriate to the client s individual circumstances Margin lenders to meet new responsible lending requirements Consumers to have access to external dispute resolution services, Clarity around responsibility for notifying clients in the case of a margin call. Advice Education Page 33

38 Margin Lending Gap Assessment 3.2 General Conduct Obligations of AFSL Holders Overview AFSL holders are subject to the general conduct obligations under chapter 7 of the Corporations Act. Accordingly, Licensees must have processes and procedures in place to meet these obligations. These are also intended to ensure that Licensees demonstrate the necessary commitment to meeting expected standards of conduct and that advice businesses or advisers who cannot do so, irrespective of the reason, are excluded. AFSL General conduct obligations The general conduct obligations require the AFSL to: undertake all necessary processes to ensure that the activities authorised by the Licence are engaged in efficiently, honestly and fairly have in place adequate arrangements in managing any potential or actual conflicts of interest (including those that may arise in relation to margin lending activities) engaged in by the Licensee or its advisers take reasonable steps to ensure its advisers comply with financial services laws ensure its advisers are adequately trained and competent in providing the financial services authorised by the Licensee have an internal dispute resolution procedure that complies with standards or requirements made or approved by ASIC and covers disputes in relation to the financial services engaged in by the Licensee or its advisers be a member of an approved External Dispute Resolution (EDR) scheme have compensation arrangements, for loss or damage, as a result of breaches of their obligations, in accordance with the regulations or as otherwise approved in writing by ASIC provide a written plan which documents acceptable arrangements and systems to ensure compliance with these obligations Page 34 Advice Education