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Margin facilities: Risks to borrower

MANY Nigerians have come to accept the situation that Nigerian banks don’t give loans to encourage business men and women. In truth, every bank thrives on giving out loans but only do so to customers who in their estimation can repay the loans plus interest.

Although loans represent revenue generating opportunities for banks, the same opportunities present an equal risk for losses if a flawed credit risk management system is utilized. For this reason, a business man’s passion and enthusiasm for his dream enterprise, invention or service counts for nothing for a banker if it is not backed by adequate cash flow history, acceptable collateral against intended loan amount and a firm demonstration of payback potential.

For an unstable investment climate as ours, acceptable payback potential may include LPO (Local Purchase Order) from an established and reputable organization, contract award documents, upfront subscription (by high net worth people) for housing development projects, monopoly markets(vaccines, etc), oil and gas production (Crude oil has established market), petroleum products (Diesel, Petrol, Kerosene etc), etc. Innovative products and open market/sales projections particularly by new entrepreneurs or business owners are usually considered high credit risk scenarios for banks.

Many entrepreneurs don’t have the type of collateral required to support loan applications.  When suddenly after the banking consolidation the banks softened their usual hard stand on loans and began granting margin facilities for trading in shares, many Nigerians could not belief their “luck.” With only a share certificate or moderate cash, you could buy shares for up to three-four times your equity contribution by virtue of margin loans. Considering that several share prices had appreciated by over 100 per cent almost every five-six months, the opportunity was too good to miss.

Consider a 30/70 margin facility used to purchase one million units of shares at N10 each totalling N10m plus charges and transaction costs. On the positive side which is where most investors concentrate on, consider a 50 per cent price appreciation. For simplicity, let’s ignore the charges and interest for demonstration purposes.

His contribution on the N10 is N3million. The total value of the investment if he sells at N15 is N15million. This means that he has made a gross profit of N5million on his N3million investment less charges and interest. This is almost 170 per cent profit. At the time of sustained bullish stock market, it was difficult to see any other possibility.

Many share prices achieved 50 per cent price appreciation in less than one month. Where else can you make such huge profits? Many investors and individuals went to great lengths to source funds from all available sources including selling priced property and merged this with margin loans to buy shares. These investors made a number of assumptions and with poor or non-existent risk assessment knowledge, never considered the potential negative consequences presented by the same profit opportunity. Let’s use an initiating event such as “The stock falls below 40 per cent of purchase price” to conduct a simple risk assessment.

Potential causes: Historically, share prices go up and down. Market downturn or unexpected bad year-end result by traded companies. Limitations: Only qualified stock brokers to handle transactions on your behalf.

Potential consequences: At 40 per cent price depreciation, net stock value will be N6million. At this point you’ll become indebted to the bank by about N1million in addition to the loss of all your invested N3million. Inability to pay the bank her balance might lead to embarrassment to you and your family should the bank use debt recovery agents.

If you borrowed the N3m equity from a friend/business associate, you may be forced to continue servicing a loan that was already lost. In a bearish market, further price depreciation could make you liable to repay up to N7million. Safeguards (Assumed).

You trust your stock broker. (Your stock broker also has shares to sell and so would sell off their shares before considering selling yours in a downturn market) and the market will surely continue growing.

Recommendations/risk management action (These would be less risky decisions): Reduce your investment to a more manageable amount of say N500, 000. Something you can lose without traumatic effects on your person or family. Consider using lower margin ratios or disregard loans completely.

Stick to moderate growth in a holding capacity. Better to lose value in your own money than to face the consequences of loan default in the event of price depreciation. Afterall, you haven’t lost until you sell and no one will force you to sell unless you owe. (Wealth is never popular, so being cautious when everyone seems to be making profits from the market is fundamentally safer.) Buy only into a company with solid fundamentals.

Never sell property to buy shares. Research the stock broker and use one that can treat your level of customer with the priority it deserves. Choosing a broker whose clients are multi-millionaires and billionaires may hurt you in more ways than one if you trade below N100, 000. Your sell order may not be given priority.

Investments swing both ways. It is advisable for individuals or companies to consider all credible opportunity directions, assess associated risks against their personality, risk bearing capacity, impact on health, reputation, finances etc before taking the decision.


Disclaimer

Comments expressed here do not reflect the opinions of vanguard newspapers or any employee thereof.