Russian Roulette: why is borrowing to invest so ingrained in Canadian culture?

I am not talking about the obvious “commission incentive” here for advisors.  No, I am talking about the laissez fair attitude (almost a belief in a divine right) towards the risks of inappropriate leverage and the easy assumption, including the apparent complicity of regulators, that a mere insufficient disclosure of risks using unrealistic assumptions (if any) is enough to provide due warning to/inform a client when the accompanying sales practises are ignored by regulators. 

Yes, if you read the OSC document on leverage it does list a number of factors someone should consider (in a one dimensional cardboard cut out kind of way), but it is doubtful whether investors who are recommended leverage ever see this document, or ever have the risks and their impact properly illustrated and communicated.  Irrespective the psychological endorsement by a regulator (….can be an effective way to boost your potential returns) emphasises the benefits of leverage while supporting the allusion, of marketing communication, that leverage requires some insight to appreciate these benefits. 

Irrespective, even under the regulation of the transaction, the boundaries in which leverage is considered acceptable are far too wide, the risks and the returns misrepresented and the recommendation itself hardly one that could be considered client originated in quite probably a vast majority of cases.

Risk seems a secondary issue when in fact it needs to be treated as something through which you first have to drive……  

  • Perhaps the regulators also believe that leverage, all the time, is a long term no brainer and that the only differential worth considering is the ability of the investor to cope with short term volatility and to finance the debt as markets work through that volatility.   Now of course, the ability to finance a loss is a bit of misnomer unless some analysis is conducted to assess the impact of that loss on financial security – again there is a complete absence of downside risk impact that appears to travail through the transaction world in general and that investors have a right to.
  • Perhaps the regulators need to fully justify their position on leveraged investment, and why it is considered suitable for a rather large part of the investor universe!   They need to work off detailed modelling of the actual costs and the risks because retail investor costs are a significant risk that is overlooked in all the borrowing to invest marketing material that I have looked through.

For those building up capital, what is often forgotten is that many individuals are struggling to save out of their income, and often have significant mortgage and other household debt as well as significant financial commitments to make.   Taking on large lump sum debt to fund high cost investment not only exposes them to much higher levels of short term risk through which they must emerge but also limits their financial flexibility to weather difficult economic conditions.  

Those with significant leeway to fund investment will have little need to leverage up while those who are close to or currently depending on their capital should be focussed on reducing the risks to the ability of their assets to meet their financial needs. 

Investors are taking on risk by investing in risky assets, irrespective.  Most investor aversion to risk is framed outside of a leveraged environment.  Investors who are especially risk taking and who have significant risk capacity may well be able and willing to accept leveraged investment, but in my experience, those who are willing to actually lose capital tend to be very few and far between.   It is not only borrowed money, but because of the additional funding costs, the margin on the additional risk is much smaller than the margin on conventional saving options.

In the days when I used to advise individuals, I do not think I ever had one client who was so far out on the risk spectrum that they would have been comfortable accepting leverage, and if they were this was outside my area of focus.   And this is key because leveraged investment requires much greater attention to valuation and timing.  Far too many advisors lack the valuation, modelling and management expertise to be able to properly assess, communicate and manage the risks of leverage. 

The only reason that leverage is allowed as is is because retail investors, under advisory regulation, are deemed to be responsible for the transaction, and because regulators seem to have accepted financial institutions’ deeply flawed marketing message of the almost guaranteed long term return differential on leveraged investment.     

If we look at the MFDA’s own regulations on borrowing to invest we can see that the boundaries for recommending leverage are quite wide – they are not just constrained to those able to accommodate capital loss or who are truly well out on the risk spectrum. 
 
(a) investment knowledge of low or poor (or similar categories); (b) risk tolerance of less than medium (or similar categories); (c) age of 60 and above; (d) time horizon of less than 5 years; (e) total leverage amount that exceeds 30% of the clients total net worth; and (f) total debt and lease payments that exceed 35% of the client’s gross income, not including income generated from leveraged investments. Total debt payments would include all loans of any kind whether or not obtained for purpose of investment. Total lease payments would include all significant ongoing lease and rental payments.
 
Even then, these are not barriers, since the criteria do not actually bar an investor from being recommended leverage. 
 

The minimum criteria listed below are intended to prompt a supervisory review and investigation by the Member of a leverage strategy. While Members must consider all the criteria in assessing the suitability of the leverage strategy, the triggering of one or more of the criteria may not necessarily mean that the leverage strategy is unsuitable.

And this is what concerns me.  It is not just the steady stream of IIROC disciplinary proceedings, OBSI naming and shamings, or the many concerns expressed by regulators over excessively aggressive leverage practises. The boundaries in which leverage is allowed are far too wide while the risk assessment of the strategy non existent to woefully inadequate.  Even given these wide open barriers regulators have uncovered increasing amounts of “inappropriate” leverage strategies:

IIROC’s Business Conduct Compliance examination unit has found an increasing number of cases where inappropriate leveraging strategies have been recommended to clients. Staff has also noted several situations where clients were not provided with sufficient information to properly understand the risks associated with such strategies or the details of the debt servicing obligations that clients had taken on as a consequence of using leverage.

NBSC staff recently completed a review of leverage practices within New Brunswick. Staff conducted this review because staff discovered, during routine compliance reviews, a number of firms registered in New Brunswick appeared to be overly aggressive and in some cases careless with the use of leverage for their clients. The findings from the routine reviews are not included in the results of this report, but are simply referenced to provide the context for our leverage sweep.

In a recent Investment Executive article, To leverage, or not?, we see further evidence of what I would term very wide and inappropriate criteria for recommending leverage:

Stevens has devised the following questionnaire for clients considering leveraged investing. He calls it “the emotional acid test”:If my leveraged investments drop by 30% in value three weeks from now, I will:

  • A: want to buy more, because investments now are “on sale”;
  • B: have faith and hold, committed to the long-term plan;
  • C: hold somewhat nervously, questioning why I leveraged;
  • D: want to sell, unable to sleep at night;
  • E: insist on selling, stressed and upset with my advisor;
  • F: shoot (or sue) my advisor, who introduced leverage.

If the answer is D, E or, especially, F, your client should wait until he or she is more emotionally ready for leveraging. If the answer is C, Stevens says, your client may want to reconsider, wait or start with a smaller amount until he or she gains more confidence and understanding of the process.

This questionnaire hardly considers any of the issues associated with leverage (extra costs, reduced margin for error, valuation risks, negative impact on financial security).  The only allusion to risk assessment is the question over the ability to bear a downward 3 week market movement, which in itself is not an indicator of either a willingness or an ability to accept a leveraged risk/return profile.

Leverage is a no brainer if we look at very long term historical average stock market returns, ignore many of the costs of investment, ignore short term market and economic risk, ignore the virtual suicidal strategy of loading up in high markets and holding for the long term and ignore the interaction of client financial needs and their assets over time.  The actual investment universe in which the client inhabits is much less able to accept the downside risks of leverage, but everyone, regulators included, seem to be blinded by the rewards of successful outcomes.

Leverage should only be considered as a strategy for those investors who have expressed extreme risk preferences (via robust risk profiling and not the rudimentary pigeon holes we see in KYCs) and are able and willing to accept the risk of absolute loss, something which can only be validated by asset and liability modelling using conservative risk/return assumptions .  But even here leverage strategies should pay careful attention to valuation and other risks.  Leverage is not a slam dunk and the level of sophistication required to model and manage its risks is beyond the capacity of the industry to deliver.  

Our regulators are remiss to allow such high risk complexity to be delivered, virtually unsubstantiated, to the ordinary investor via channels whose sophistication, at times, is incapable of managing the mundane.   Canadians love affair and casual acceptance of leverage needs a reality check!

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