What is Double Gearing?
Double gearing refers to the practice of borrowing money against an asset, with the money being used to buy shares of stock. Then, more money is borrowed against the shares to establish a margin loan that can be used to purchase even more shares. In short, double gearing is a form of leveraged investing.
Basically, it means the investor burdens himself with a significant amount of debt. The risk? The best case scenario is the investor recovers more than enough to pay back the borrowed funds. In the worst case situation, the investor loses, can’t repay his debts, and ends up underwater.
introduction of Double Gearing
Double gearing is a practice that takes place in the corporate world. Companies may pool their resources together—notably their capital—in order to cut back on their risk. This happens when one company involved in the agreement puts money into the other(s).
Companies that engage in double gearing often operate in the same industry or sector. For instance, a bank may loan money to an insurance company that, in turn, invests capital in the bank.
Not only does the practice serve to cut down on risk, it also disguises risk exposure. That’s because more than one business entity may claim the same assets as capital protecting against risk. Sharing seems to be a way that helps to mitigate risk but does not adequately document the actual exposure to risk for each company.
Using double or multiple gearing can result in the overstatement of capital in a conglomerate. Subsidiaries, which function as separate business entities, are often deliberately formed by a parent company to segment its business.
This structure allows the parent to file consolidated tax reports with the ability to offset gains and losses between different subsidiaries and enjoy lower taxable revenues.
As funds move around into separate business accounts, the assessment of a group’s true financial health becomes muddled. The practice leads to leveraging and overleveraging. It is also possible to create mid-tier entities whose only assets are the investments they make into dependent tiers.
Double Gearing Between Companies
Between companies, double gearing looks slightly different. At least two companies pool their capital in order to mitigate risk. The companies often loan money to one another to fund different investment projects, purchases, and the like.
It can cause a shift in the perception of the health of said companies because it skews their accounts and tends to make them look more profitable or financially sound than they actually are.
The practice is common among complexly structured corporations. Often, it involves a parent company and its subsidiaries, each with their own balance sheet, but often funding one another’s purchases and investments. The loaning between such companies can result in the borrowing company becoming overly burdened with debt.
Regulatory Impact of Doubling Gearing
Standard & Poor’s (S&P) lowered the insurer financial strength and counterparty credit ratings of five Japanese life insurance companies in 2002. The discovery of double gearing between those insurers and the Japanese banks caused the rating agencies to take action, realizing the double gearing increased the risks of the entities.
The Australian Securities and Investments Commission (ASIC) reviewed the practices of six margin lenders representing 90% of the Australian market in 2016. ASIC found that five margin lenders approved margin loans that were double geared.
Following the ASIC review, margin lenders have taken action to better address the risk of double geared margin loans. Although not illegal in Australia, one lender ended the practice after the ASIC’s review while the others took steps to make sure margin loans met higher standards for responsible lending.
Major Risks of Double Gearing
The two primary risks related to double gearing are the following:
- Double gearing is a high-risk strategy with the goal of gaining a still higher reward. More investments mean the potential for greater returns. However, as with any leveraged sort of investment, it also magnifies the potential for serious losses.
- If the anticipated returns are not generated, the double-geared investor won’t make any profit on his investments, and he may not be able to repay his loan.
Double gearing is an incredibly risky strategy of borrowing to make purchases that can be borrowed against or used as collateral to borrow even more. The potential for higher than normal returns is present; however, the borrower can become overburdened by his debt. It is a strategy best used sparingly and only by experienced investors.
Example of Double Gearing
Here’s a hypothetical example to show how double gearing works. Financial holding company First Holdings owns Corner Banking and Space Leasing. In turn:
- First Holdings lends Space Leasing money. This capital appears on First Holdings’ balance sheet as funds due to them through the loan.
- Space Leasing buys shares of Corner Banking stock with the loaned funds. Space Leasing list these shares as an asset on their balance sheet.
- Corner Banking uses the funds it received from the sale of shares to buy debt securities to help fund First Holdings.
- The money that First Holdings initially lends out has cycled its way back to it in the form of the debt securities that Corner Banking purchased from them.
- The same capital that is on First Holding’s balance sheet lent out as funds due from Space Leasing is also capital received from Corner Banking to fund operations.
The bank and leasing subsidiaries may appear to have appropriate capitalization when viewed independently but since some of the assets belonging to the leasing company are shares of the bank, it is putting both businesses at risk.
If one subsidiary holds capital issued by the other subsidiary, the entire holding company may be overleveraged. Leveraging is using borrowed capital as a funding source. As these companies take on more debt, their chance of default risk increases.