Investors who watched the drama unfold for Eddy Groves, the founder of ABC Learning Centres, or investors caught up in the turmoil surrounding the collapse of Australian stockbroker, Opes Prime, might be starting to question the merits of using margin lending to fast track wealth accumulation.

As the share price of ABC Learning dived by more than 60 per cent in a day, the millions of shares that Groves had purchased on margin were sold out from underneath him. And for the thousands of investors who took out lending arrangements with stockbroker Opes Prime have realised, they don’t have ownership over their shares – the collateral put down for loans to buy shares in the first place are now held captive in the hands of secured creditor ANZ Bank.

Today, investors are looking at the fine print of margin lending arrangements to see where they stand. Does the lender have the right to sell your shares without contacting you first? Do you hand over legal title of your own shares to the lender before taking out a loan? And what happens if a stock falls off a lender’s approved list?

Groves’ experience was heightened by the fact that he owned 20 million shares in the one stock, ABC Learning, which came under fire by analysts due to hefty debt on its books. Most ordinary investors don’t own 20 million shares, and smart investors definitely don’t place all of their bets on a single stock.

Investors who took out loans with Opes Prime are now caught up in a unique legal structure of margin lending, not common to many players in the industry. In this model (outlined in the company’s Product Disclosure Statement) and referred to as an Australian Master Securities Lending Agreement (AMSLA), in exchange for the margin loan the client typically surrenders legal title of their shares to the broker. Today, 1200 investors are nervously awaiting news from creditor ANZ Bank as to how much out of their initial investment they’ll actually get back. The bad news is that these unsecured investors rank behind the banks in receiving their dues.

It’s important to realise that not all margin loans are alike, and stock-standard margin loans offered by banks and the great majority of margin lending institutions certainly don’t involve handing over legal title of your own shares when signing on the dotted line. This arrangement was unique to Opes Prime and embattled broker Tricom. Reportedly, Lift Capital Partners and Chimaera also offer similar arrangements.

On the contrary, when taking out a stock-standard margin loan your initial investment of shares or cash remains in your hands. Although you’re responsible for any shortfall between the value of the investment and the loan amount should prices fall, you do not hand over legal title of your shares to the margin lender.

With all of this kerfuffle in recent weeks, some investors are probably questioning the merits of taking out a margin loan at all. But, when used correctly, margin lending can catapult returns, as has been the case for many Australians over recent years.

As we all know, ‘it’s money that begets money,’ or in other words, it is easier to make money when you already have money. Investing with a margin loan involves putting a sum of your money together with a sum of money borrowed from the margin lender and investing the combined amount in either shares or managed funds. Investors pay the margin lender interest on the loan (around 10% at present) for the privilege of buying more stock than they could with their own money alone.

Understandably, the popularity of margin lending typically takes off during bullish sharemarkets when share prices are rising; when there are plenty of gains to be had, investors want as much exposure to the market as possible – and the more money on the table, normally the fatter the profits. Look at it this way: a 10 per cent return on a $20,000 portfolio makes $2,000 in profit, whereas the same return on a $100,000 share portfolio brings in $10,000. As at December 2007, Australians had borrowed $37.8 billion of margin loans, up from $28 billion a year earlier, according to the Reserve Bank of Australia’s most recent figures.

The shares you buy using a margin loan entitle you to any dividends and franking credits, as well as capital gains should the share price spike. In essence, you own the shares purchased with a margin loan and can front up to the Annual General Meeting (AGM). So why did margin lenders have the right to sell Groves out of his stake in ABC Learning if he owned the shares via a margin lending arrangement?

Margin lenders have particular rights over your margin-lending portfolio that you should be aware of. The Australian Securities and Investment Commission’s (ASIC) consumer website FIDO, offers a few words of warning:

“Most margin lending products also give the lender the right to sell some or all of your investments. The lender might do this if, for example, you cannot meet a margin call, or if there is a significant fall in the market as a whole…the lender may be under no legal obligation to contact you before selling your investments, and may be entitled to sell any of your investments to meet the terms of your loan agreement…in various situations, including significant falls in the market over which you have no control.”

Clearly, losses can occur if the lender sells your shares when prices are languishing.

The most common time for margin lenders to suddenly sell shares on your behalf happens when your loan is in default (occurring when the gap between the amount that you’ve borrowed and the total value of the investment becomes too small). This gap is determined by a stock’s loan to value ratio (LVR).

Loan to value ratios (LVRs) on shares and managed funds sound complicated but they’re not. Just think of this ratio as the amount the lender is willing to cough up. So if the LVR is 70 per cent, then the lender is willing to lend you 70 per cent of the total value of the share or fund. This means that you must fund the remaining 30 per cent.

Let’s say that you pledge $30,000 of your own shares and borrow a further $70,000 from a margin lender and invest the entire amount, $100,000, into a portfolio of shares. Your LVR in this example is 70%.

Every lender has an approved list of shares and managed funds with their own special LVRs that can be downloaded from their website. On speculative stocks, LVRs can vary as much as 20 per cent between lenders. LVRs on blue chip stocks such as the big banks and miners, however, are fairly uniform, generally sitting at a maximum of 80 per cent. The more “volatile” or “risky” (in the eyes of the lender) the share or fund, the lower its LVR.

Unfortunately shares have a habit of fluctuating over the course of time, occasionally falling sharply. Company analysts might downgrade the company’s earnings, the company might disappoint the market come reporting season, even a turn for the worst in the economy can send a company’s share price into a spin. If such a stock is held in your margin lending portfolio then you’re likely to feel the shockwaves from a fluctuating share price. And depending upon the LVR of the stock in question and your borrowing limit, then the margin lender could sell the shares from underneath you.

To do some quick mathematics using the example above, if the value of the portfolio falls from $100,000 to $90,000, the LVR of 70% will be exceeded and a margin call will be triggered. To calculate the LVR, simply divide the loan amount, $70,000, by the total value of the portfolio, or $90,000, giving an LVR of 78%. Since an LVR of 78% exceeds the permissable LVR of 70%, we’ve entered margin call territory.

Clearly, when a hefty margin loan is taken out over a speculative stock on a high LVR, the outcome can be disasterous.

It’s worth noting that margin lenders offer a buffer margin – typically 5 per cent – before issuing a margin call. Therefore, depending upon the lender, the LVR could rise to, say, 75% in our example before triggering a margin call.

So what recourse do you have should you come face-to-face with a margin call? Investors have a couple of options: they can either lower the loan amount by injecting cash or more shares into their account or, alternatively, sell stock to get the LVR down. Should neither option be taken within 24 hours – and clearly this is what happened to Groves and his ABC Learning shares – the margin lender will take action on the investor’s behalf. The required number of shares will be sold off until the LVR is brought down to its original value.

Occasionally an investor may find themselves fair smack in margin call territory for reasons other than a slumping share price. Investors with margin loans over Allco, Centro and MFS experienced difficulties recently when leading margin lenders either removed these stocks from their approved list, or sharply lowered LVRs. Investors were made to swiftly meet the reduced LVR requirement by injecting cash or shares into the account or selling stock; in the case of stocks that were removed from the approved list altogether, the LVR was reduced to zero.

In many instances, investors without the cash on hand to inject into the account are forced to sell shares. In the worst-case scenario, an unlucky investor might be forced to sell up when the shares are wallowing at a low. (It’s worth considering the reason why a margin lender suddenly reduces a stock’s LVR, or takes the stock off the approved list altogether. The move might be a sign that the risks of investing in that particular stock have risen sharply. You might want to evaluate why this might be the case and how that impacts your investment strategy).

When faced with a margin call it’s worth checking with your lender whether you simply need to reduce the buffer, back to say 3 or 4% over the LVR, or restore it to zero. Depending upon the size of your loan, the difference can be substantial; reducing the buffer back to zero means more shares must be sold (or more cash injected) to make up the shortfall.

In brief, the best medicine for staving off a margin call is to hold a diversified portfolio of stocks across myriad sectors, don’t borrow up to the maximum LVR on offer, reinvest your dividends rather than cashing them out and pay off the interest rather than capitalising it.

And although it’s a little too late for investors in the Opes Prime mess, it’s always worthwhile reading the PDS before taking out a margin loan.