The true measure of financial strength
By Robin Bowerman
Smart Investing
18th February 2009
Principal & Head of Retail, Vanguard Investments Australia
If there is one lesson from the global financial crisis, surely it is that too much borrowing is explosive and destructive when underlying asset values fall.
Banks and other major financial institutions around the world are frantically "deleveraging" their balance sheets. In other words, they are reducing borrowings and restoring capital ratios to more normal levels.
The jump in household savings rate in Australia late last year suggested investors had heard the message and were doing their own repair work on household balance sheets.
But at an investor seminar recently, a product provider was promoting the fact that loan facilities were available on a 95% loan-to value ratio on a range of investment products. What was surprising was the positive reaction that seemed to engender from the crowd.
This in a week that the Storm Financial group had the last rites read by the administrators and it is now expected that creditors will vote to liquidate the financial planning company.
Storm, for those who have somehow managed to miss news of the high profile collapse, heavily promoted gearing strategies through its financial planning network as a way of building wealth rapidly.
Given the speed and severity of the global market downturn, it was inevitable that those strategies unraveled as quickly as markets fell. Regrettably, that level of gearing has had devastating and catastrophic effects on the investors who were clients of Storm Financial. Media reports of families losing everything - millions of dollars in superannuation, homes having to be sold to meet margin loans and the real prospect of bankruptcy for many people - are testimony to the devastating impacts.
In many ways the Storm collapse and its impact on individuals is more relevant for investors than the respective bailouts of some of the world's largest financial institutions by their respective governments. It is hard to relate on a personal level to another multi-billion dollar bailout of a major company.
But someone in Queensland losing their super and their property demonstrates the impact of too much borrowing at a real-world level for most people.
Recessions are a painful but powerful way of purging the capitalist system of business models that are simply not strong enough to survive. Economists will tell you that is a good thing for the overall health of the economic system. As hard-hearted as that may sound, it is true.
Indeed, when the economic history of this crisis is written, one of the findings may well be that central banks became too adept at keeping markets growing and the cyclical purge of a downturn was avoided - which simply built up more pressure and led to the more extreme downturn we are working our way through now.
Borrowing to build wealth will continue to be a sensible, long-term strategy. But just as the world's leading financial institutions are now paying much closer attention to their debt exposure, so should investors.
Just because a product provider will lend you up to 95% of an investment's value does not make it a good idea. Investors need to take responsibility for investment decisions, and to do that they need transparency and understanding about both the product and the level of gearing involved. When you hear people plaintively blaming the bank for lending them the money, you know that understanding and responsibility were both absent.
A fundamental question to ask is what is your household gearing ratio? The ASIC website has a simple budgeting tool that allows you to quickly fill in assets and liabilities and it calculates three measures of financial strength.
Your financial plan should also answer the question - particularly when you considering setting a retirement target date - is when will you be debt-free? As many banks around the world will attest - that is a true test of financial strength and independence.
