Margin debt hits a high

(March 2007) Back in the late 1990s and early 2000s, when the tech sector was all the rage, many investors tried their hand at margin borrowing. With a booming tech industry, borrowing money from a broker to buy more securities seemed like a good idea. But then came the crash.

“I know someone who borrowed $500,000 to buy Nortel,” says Robert Abboud, president of Wealth Strategies, based in Orleans, Ont. “Now this half a million is worth something like $30,000. He was ruined.”

With memories of those trying times fading, margin borrowing is making a comeback. According to Jack Rando, assistant director of capital markets for the Investment Industry Association of Canada, outstanding client margin debt has reached $12.2 billion. That’s almost double the amount from August ’02 to August ’03, when the outstanding debt margin was $6.9 billion. The current figure also surpasses the $11.6 billion high in 2000, at the height of the tech boom.

“Following the stock market bubble, we saw a steep decline in the amount of margin debt outstanding,” says Rando. “That’s because some investors were burnt bad by the tech meltdown. What the increase signals, though, is investors have more confidence in the marketplace.”

It’s easy to see why margin borrowing is a popular investment choice — a client can make huge returns by putting up a small amount of his or her own cash — but it doesn’t take much to lose money either. That’s why Abboud, who considers himself a conservative financial planner, doesn’t usually offer margin investing to clients.

“I would say this is suited for a very small part of the population,” he says. “Clients traditionally cannot cope with the fact that they borrowed $100,000 and now their investment is worth $80,000.” A client who loses money, says Abboud, will often sell stocks to pay off the loan but will still be $20,000 in debt. “You have to be a very sophisticated and patient investor.”

Other, less conservative advisors are offering margin borrowing to investors, but Abboud suspects it’s not because they’re trying to make the most money for their clients. “Advisors are offering way too much on the margin,” he says. “For some advisors, every client gets offered margin.” Abboud cites a case where an 81-year-old client of his was approached by another advisor who suggested the octogenarian borrow $300,000. “That’s illogical,” says Abboud.

He says some advisors might be pushing clients to margin borrow because of higher commissions. “There’s huge incentive for advisors to put clients in margin because the more assets advisors manage, the more income they derive.”

Of course, it’s a minority of advisors who are in the business solely for the big commission. Rando says responsible planners should have a thorough conversation with a client to make sure margin borrowing is appropriate. They should find out if the client is an experienced investor — and discussing risks is a must. If a client loses money, it won’t just send him or her to the poorhouse; it will reflect poorly on the advisor.

“Ultimately, the decision relies on the advisor as to whether or not margin investing would be suitable for the client,” says Rando.

Even if an advisor gives the go-ahead, there will be times when a margin account needs topping up. If an account falls below a certain amount (it varies with each investor), the advisor will have to make a margin call, a phone call telling a client he or she needs more money in the margin account.

“No investor likes to receive a margin call from their advisor, and advisors hate calling clients for margin calls,” says Rando, who had to make a few margin calls himself when he was an investment representative at a retail brokerage. He says it’s important for advisors to make sure their clients maintain excess margin in their accounts in case of a downturn in the market. Still, having that dreaded conversation is “part of the business,” he says. “If you’re going to open a margin account for a client, you’re going to have to make that difficult call.”

Abboud, who hasn’t had to make a margin call himself, says that he’d tell a client to stay patient and that they’ll work things out. “We’re given the responsibility to make sure our clients make it to the finish line and have enough money.”

On February 27, when the U.S. market had its biggest one-day drop since September 11, 2001, it’s likely that more than a few investors were anticipating a margin call. Neither Rando nor Abboud think the drop affected margin borrowers too much, but there are lessons to be learned from the market slump.

“It stresses the importance of diversifying and working with an investment professional who can build a portfolio that can withstand the ups and downs of the marketplace,” says Rando.

Abboud says the drop gave investors a much-needed wakeup call. “That aggressive itch is coming back. It’s reminiscent of the tech run-up,” he says. “The markets have been going up the last four years, so people have already forgotten how a market can savage a portfolio in a matter of days.”

Many investors, however, know full well that markets are volatile, and that margin borrowing carries risks. But clearly, the risks haven’t deterred people from margin investing. Rando says margin borrowing’s increased popularity is due to more sophisticated investors and more complex financial needs.

“Investors are becoming more aware of the various strategies available to them,” he says. “They’re also working more closely with financial advisors who would, at the very least, consider or discuss whether or not a margin investing account would be appropriate for them.”

Because of this, Rando doesn’t anticipate the margin borrowing trend to slow down anytime soon. “As investors become savvier and do more research, margin investing will only increase.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(03/13/07)

Bryan Borzykowski