Borrowing for booms can lead to busts

TOO much borrowed money is one of the main forces driving the current bear market in shares.

Borrowing for booms can lead to busts

TOO much borrowed money is one of the main forces driving the current bear market in shares, according to one of Australia's biggest investment managers.

MLC executive Michael Clancy says "excessive leverage'' - using too much borrowed money in an effort to increase potential investment gains - has not been given enough attention in the market downturn.

Mr Clancy, general manager of MLC's investment management division, said while leverage could be a powerful tool for creating wealth when used responsibly, it magnified losses when the wrong investment decisions were made.

"Unfortunately, as current market events have proven, not enough investors fully appreciate this most basic relationship,'' he told the Australian Superfunds Summit 2008 in Sydney last week.

The biggest casualties on share markets in Australia and overseas in the past few months have been companies that relied heavily on borrowed money.

Centro Properties, Allco Finance Group and ABC Learning Centres all funded rapid expansion with the use of borrowed funds.

When the cost of borrowed money soared across the globe last year because of the US sub-prime mortgage crisis, these companies' business models collapsed.

In ABC Learning's case, chief executive Eddy Groves lost his multi-million dollar stake in the childcare provider because he had used borrowed money to buy more shares in his company.

Mr Clancy said last month's collapse of giant US investment bank Bear Stearns was a perfect example of not getting the trade-off between risk and return right.

"Bear Stearns had a leverage ratio of around 30:1 and at these levels, it only takes a small number of strategic errors to push a viable institution into insolvency,'' he said.

"While the world is now going through the de-leveraging process, a key issue going forward is how we avoid a repeat of the build-up of excessive leverage in the future.''

Mr Clancy said governments and regulators around the world had started asking what went wrong, and this could lead to more regulation of financial services firms and investment decision makers.

Put the clamp on excessive leverage

He questioned whether most investors and trustees - particularly self-managed superannuation fund trustees - had the skills to assess the risks and returns of what they invested in.

"The recent market events will recur if market participants do not learn and, while we can't expect human nature to change overnight, we must look at how we can set appropriate processes and guidelines to ensure leverage is wisely employed as a wealth creation strategy and not excessively used to take excessive risks.''