Does this business model sound like it was always going to end in tears?

[a_unique_person]

http://www.theaustralian.news.com.au/story/0,25197,23448323-601,00.html



THE controversial share market practice of "stock lending" has spectacularly imploded, with the $1billion-plus collapse of a stockbroking firm, threatening millions of dollars worth of Australian retirees' superannuation savings.
Melbourne-based Opes Prime - a significant provider of margin loans for investors to buy shares - has been put into administration amid accusations of financial irregularities.
ANZ and investment bank Merrill Lynch, which lent $1billion to Opes, yesterday began dumping shares held by Opes on customers' behalf as they sought to recoup their loans. It is thought that customers could lose between $200million and $300million from the fire sale, with some shares being sold at half of current market prices.
The two banks - the ultimate owners of the shares, which are effectively collateral for the margin loans - will rank ahead of other Opes creditors. These include the super funds who loaned shares to the firm to support its "stock lending" business.
This raises the prospect of super funds and the custodian companies who hold shares on their behalf facing significant losses if they are unable to recover the shares loaned to the failed stockbroking firm.
Opes's business model involved lending money for people to take out margin loans to buy shares. Those shares were then transferred to Opes, which lent them to traders such as hedge funds to play the stock market.
Such deals do not have to be disclosed, helping traders engage in practices such as short-selling, a technique that has been used to drive shares in companies such as ABC Learning Centres and Allco Finance Group sharply lower.
To boost its $1.5billion securities lending business, Opes borrowed shares from custodian companies.
Accounting firm Deloittes, which was called in to help the firm last week, could not confirm the amount of stock that Opes had borrowed from custodians to lend to hedge funds, but said that the custodians would now be creditors.






It sounds to me like it would be fine as long as share prices went up, and collapse as soon as they went down. It was like a bank taking deposits in cash, then lending out that cash. Only, in this case, it wasn't cash, it was shares, and, unlike cash, shares can suddenly lose a lot of value.

[godofpie]

http://www.theaustralian.news.com.au/story/0,25197,23448323-601,00.html



It sounds to me like it would be fine as long as share prices went up, and collapse as soon as they went down. It was like a bank taking deposits in cash, then lending out that cash. Only, in this case, it wasn't cash, it was shares, and, unlike cash, shares can suddenly lose a lot of value.

This is just like the sub prime mortgage debacle. Bear Stearns was dealing in these sub prime loans, people are borrowing and lending money on these mortgages and everything is fine as long as people are paying those notes and property values keep going up. But when people defaulted on their loans because their interests rates reset AND the property is only worth 50-70% of the original loan value, the system implodes. What these financiers and fund managers do would be considered illegal if their names were Guido and collected on their loans with a baseball bat.
John McCain was part of the "Keating 5" savings and loan scandal where lots of people lost their retirement money.
http://en.wikipedia.org/wiki/Keating_Five
This is what happens when you let the foxes watch the hen house.

[Gazpacho]

Aren't margin loans normally backed by other, wholly-owned securities instead of the same securities purchased with the loan? That's already suspicious enough. Add the lending out of the shares and it sounds like conversion of assets.

[egslim]

And the worst part is that the people who ran the company will probably walk away with quite large paychecks (at the least), while those who entrusted them with money lose a lot.

As long as those who "play the system" are rewarded for schemes that end in financial disaster to others these things will continue to happen.

[a_unique_person]

I think that's why one of them has disappeared and has the police after him.

[Gazpacho]

Maybe someone can explain the limited circumstances under which margin investing is rational, but it seems to defeat the purpose of investing, which is to make money for yourself rather than for creditors.

[a_unique_person]

Margin lending is very popular in Australia because it lets you write off the interest on the loan against your taxable income. Schemes like this have been very successful at ensuring your taxable income is 0. ;)

[roger]

Maybe someone can explain the limited circumstances under which margin investing is rational, but it seems to defeat the purpose of investing, which is to make money for yourself rather than for creditors.
If you can make better returns than the interest rate. As always, leverage increases your return, and increases your losses. There is, of course, the dreaded margin call, where you the brokerage will ask you to deposit additional funds if your stocks fall to low. If you can't weather a margin call, it ain't too rational, as it will cause the brokerage to sell the securities underneath you, causing total loss of capital.

It's also helpful to have a margin account, even if you don't plan to borrow money long term, as it allows you to make transactions without cash in the account. For example: you have had your eye on a stock, and it finally falls to a price you are willing to pay. You buy it, and initiate a cash transfer, which normally takes 2-3 days. You've borrowed for 3 days, for a very tiny cost, and were able to take advantage of a blip in the market. If you had to wait that 3 days, you may have missed that discount price.

[roger]

Aren't margin loans normally backed by other, wholly-owned securities instead of the same securities purchased with the loan? That's already suspicious enough. Add the lending out of the shares and it sounds like conversion of assets.No, the securities themselves can serve at the collateral, but some of the money has to be your own. For example: you have $10,000. You are allowed a margin % of 50%, so you buy $20,000 worth of stock, borrowing 10K. If the total value of the assets fall to 10K, the brokerage initiates a margin call - you have to provide more money, or they will sell the securities to get their money back. Naturally, they keep the 10K for themselves, and you get whatever change is left over, which is about nothing.

Those percentages aren't exact; typically they aren't going to wait until it falls 50% before initiating a margin call, otherwise they could lose money between the time they do the call and you provide funds. But that's the general idea. A quick google will provide all the details for the country of interest.

[Francesca R]

Aren't margin loans normally backed by other, wholly-owned securities instead of the same securities purchased with the loan? That's already suspicious enough. Add the lending out of the shares and it sounds like conversion of assets.No it's quite normal for securities purchased with the borrowed money to be the collateral for the borrowed money.

[Francesca R]

Maybe someone can explain the limited circumstances under which margin investing is rational, but it seems to defeat the purpose of investing, which is to make money for yourself rather than for creditors.Well, taking out a mortage to buy a property is similar to margin investing. And it's rational because you can then earn/consume the income from the property ("consume" means: live in it) without waiting until you have obtained enough wealth to buy it outright, which would be rather late in life for many people.