{"id":97388,"date":"2015-12-21T07:00:00","date_gmt":"2015-12-21T12:00:00","guid":{"rendered":"https:\/\/www.investmentexecutive.com\/uncategorized\/margin-of-error-why-advisors-shouldn-t-be-off-book-loan-distributors\/"},"modified":"2019-11-10T16:13:43","modified_gmt":"2019-11-10T21:13:43","slug":"margin-of-error-why-advisors-shouldn-t-be-off-book-loan-distributors","status":"publish","type":"post","link":"https:\/\/www.investmentexecutive.com\/inside-track_\/neil-gross\/margin-of-error-why-advisors-shouldn-t-be-off-book-loan-distributors\/","title":{"rendered":"Margin of error: Why advisors shouldn\u2019t be off-book loan distributors"},"content":{"rendered":"

Archimedes, the ancient Greek mathematician and engineer, is best known for his depiction of the power of leverage. Give him a big enough lever, he said, and he could move the world.<\/p>\n

Imagine, though, if instead of physical leverage, Archimedes had been talking about financial leverage \u2014 about borrowing to invest. He probably would have described it as something equally powerful, yet somewhat sinister. He might well have said that with a big enough leverage loan, he could ruin the world.<\/p>\n

Excessive investment borrowing really is ruinous. It’s what made the 1929 stock market crash so devastating. It also pulverized legions of “margin millionaires” when the dot-com bubble burst in 2000 and when the global financial crisis struck in 2008.<\/p>\n

Margin debt in Canada stood at $11 billion in 2000. Evidently, though, the pain that followed wasn’t enough to loosen leverage’s magnetic pull, so by 2008 Canadians were more than $16 billion deep in dealer-supplied loans. And today? More than $21 billion.<\/p>\n

But that’s not the full picture; that’s just what’s on-book. You need to add the indebtedness from off-book borrowing \u2014 that is, if you can find reliable data. Regulators don’t have any. Yet, a single lender in that space, B2B Bank, reputedly holds a $5-billion portfolio of investment loans. Heaven knows how much the rest of them have lent.<\/p>\n

Interestingly, B2B Bank doesn’t consider its clients to be the people who borrow from it. In its own corporate profile, B2B says its “client communities” are advisors and dealers. It sees itself as a lender “that serves a network of 27,000 financial professionals.” It reassures them that “we don’t compete with our clients by offering products directly to the public.”<\/p>\n

No, indeed. Under this business model the manufacturer doesn’t sell its products (investment loans) directly to consumers. Instead, the manufacturer’s clients (advisors and dealers) are utilized, in effect, as product distributors. They’re the sales force for these loans.<\/p>\n

And what could be more potent than a sales force that comes equipped with special influence over the consumer? An army of 27,000 distributors who consumers depend upon for advice about financial matters and entrust with their life’s savings \u2013 what financial product producer wouldn’t love that?<\/p>\n

Better still, this distribution arrangement costs off-book lenders nothing as advisors get paid in commissions from extra securities bought with the loan proceeds.<\/p>\n

And from the advisor’s perspective, the investment loan practically sells itself these days: their clients can borrow at 2% or less, invest for a modest return of 3.5 or 4%, and pocket the difference. It’s like printing money, right? Lots of clients would listen to this pitch \u2014 and lots do, though, too often. But the pitch they hear downplays the strategy’s risks.<\/p>\n

Those risks can’t be ignored. With interest rates having virtually no place to go but up and markets barely able to contain their jitters from hour to hour, leveraged investing is more hazardous now than ever. It shouldn’t be mainstream. Yet, the numbers show it is \u2014 and it’s growing by leaps and bounds.<\/p>\n

Regulators should be alarmed by this proliferation, particularly as it’s occurred against a backdrop of evidence in many cases where advisors indiscriminately recommended the use of leverage to boost their own compensation and their firm’s assets under administration.<\/p>\n

Moreover, regulatory warnings, in the form of guidance notes about leverage suitability, are having no impact. On-book margin lending increased<\/em> by more than 23% after the Investment Industry Regulatory Organization of Canada issued guidance on this in February 2014. More telling, it’s up by 40% since the Mutual Fund Dealers Association of Canada’s policy took effect in 2013.<\/p>\n

This is a potential disaster in the making and it can’t just be allowed to occur. The investment industry’s easy willingness to promote leverage \u2014 much to its own advantage \u2014 needs to be changed. But guidance won’t make that happen. Neither, it seems, will targeted prosecutions.<\/p>\n

What’s needed are mandatory constraints that impose sensible limits on leveraging. At a minimum, these should include:<\/p>\n