Monday, 19 January 2009

Stock Market Storm Sinks Life Savings

A brief report in the SMH outlines the horrendous impact of the bad investment advice dished out by Storm Financial, who advised many retirees to borrow against their mortgage-free homes in order to use margin loans to invest large sums in the stock market at the tail end of the bull market. While the self-serving (fee generating) "advice" provided by Storm seems completely inappropriate for many of their clients circumstances and actual risk tolerance, I'm sure that many of the investors rendered bankrupt have mostly themselves to blame. It's easy to cry "foul" and engage the lawyers when the market has plunged 40% or more and wiped out your investment portfolio, leaving you with massive loans secured against you home. But I suspect that a lot of these people were only too happy to sign off on dodgy loan applications (some with overstated income figures) and skim-read the fine print of the terms and conditions, when their "financial plan" projected massive gains if the market had returned another year of two of double digit performance. Those who play with fire get burnt - the tricky bit will be sorting out those Storm clients who eagerly grabbed the match box and lit their matches knowing the risks, and those "babes in the woods" would were handed a box of "safety matches" and told that there was nothing to fear.

It's interesting to compare how a Storm client who invested at the market peak in late 2007 would have fared if the market had gone up 15% in 2008, rather than dropping 45%:

Assume: Retiree/investor borrows 50% ($500,000) against mortgage-free home valued at $1,000,000, interest 8% ($40,000 pa interest)
Pays Storm 7% up-front fee on funds invested (ie. leaves $465,000 "capital" to invest after $35,000 in fees up front)
Invests in a stock portfolio using max 70% gearing, interest 10% (capitalised)
Dividend rate 3%
Margin loan amount = $1,085,000 (total invested in market = $1.55m)

If market had gone up 15%, at end of 2008 situation would be:
Debt: $500,000 (home loan) + $1.085m (margin loan) + $108,500 (interest) = $1.6935m
Int paid: $40,000 (home loan int only payments)
Income: $46,500 (dividends)
Cash flow: $6,500 "tax free" income (due to tax deduction for capitalised margin loan interest)
Portfolio value: $1.7825m (15% rise)
Unrealised capital gain: $89,000

I doubt that any of Storm Financial clients would have been complaining in that situation!

In reality, a 45% market plunge occurred, with losses only being realised in late 2008 when portfolios were liquidated to meet margin calls (where clients tapped into their remaining home equity to borrow to meet earlier margin calls - say up to the maximum 80% LVR for owner occupied home loans):

Debt: $800,000 (home loan) + $1.085m (margin loan) +$108,500 (interest) = $1.9935m
Int paid: $52,000 (home loan int only payments, assuming extra $300,000 borrowed during 2008)
Income: $46,500 (dividends)
Cash flow: -$5,500
Portfolio value: $852,500 (45% drop)
Debt remaining after portfolio liquidated: $1.9935m - $0.8525m = $1.141m

Since this is slightly more than the family home is worth, bankruptcy results!

The worst part of the advice provided by Storm (aside from the investment strategy not matching the clients real risk tolerance or level of understanding) appears to have been to continue borrowing against other assets (the family home or other real estate) in order to meet margin calls while the market dropped during 2008. If the investors had simply liquidated their stock portfolio to meet margin calls as they arose, they would have ended up taking a big loss, but not being bankrupted and losing the family home. However, it was all too easy in March 2008 to imagine that the market had bottomed out after a "normal" 20%-30% correction, and try to hang in there, rather than turn paper losses into real ones.

I wonder if there are any Storm clients who started investing in 2003 and liquidated their portfolios in late 2007 when Storm began their IPO process? They're probably sitting on their yachts sipping champagne.

Meanwhile, it will be interesting to see how the court cases against Storm Financial and the banks turn out. (Not to mention ASIC's role in all this)

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1 comment:

Anonymous said...

What would be great to know is how the Storm broker who made massive money for the margin. They don't care if the investors lost, as long as they got their massive cut, who cares? He will just spit you out, and leave your retirement dream in shambles just to get 5% or so of the money for himself.