[Sharing] Margin Financing - Smart way to earn money or route to financial ruins?

Background

Met my friends over dinner on saturday, and one shared about some financial tips. He shared that he was earning 3.88% from a higher interest yielding account.

Some key points are:

• he is a bank employee
• he optimises charges to hit all criteria
• earn 3.88% up to 100K
• does not need pay transaction fees on UT investments

Liens away his UT to buy more UT

He shared that he found a UT that pays 6-7% yield on a near monthly basis and quite steadily, and buys it regularly (because no transact fees), and then liens away the UT so that he can get 70% of the value to buy more of this UT at a financing rate of about 2-3%(could not remember). So he pockets the additional 4% of interest.

Sounds like margin financing

When I first heard about it, earning that extra 4% out of "nothing" sounds like a good deal! But then in the deep recesses of my mind, i thought it sounded like margin financing. while i could not find anything on his banks' charges when one liens away their UT. I could find something similar. So it goes something like this... 

• you get varying % of security you pledge based on quality to buy more securities
• finance charge up to 2.88% pa
• Even illustrated how to "earn" more returns using this financial tool by buying reits.

So i guess what my friend shared was not too different from margin financing!

Downside

I thought, how can be so good ! free money? but  i realised  banks or brokerages do this to earn in 2 folds!

1. interest earned through financing in a secured manner
2. process/transaction fees when you buy the financial product

what this means is that they actually i) reduce their risk by getting you to pledge securities, and ii) induce you to pay more transaction fees -highly profitable biz. and in doing so, the consumer actually undertake more risks than they are willing to do so and the risks could be beyond their acceptable threshold.

Potential scenario to a route of financial ruin illustrated

As it is "free" money, each month putting money in and lien-ing it away will induce you to have a bigger and bigger position, since one can get another 70% of what they put in. The accumulation of positions becomes huge! then maybe one day there is a market correction that causes a margin call! because most of your money is in such perceived "safe" instruments, not enough liquid cash, and the bank/brokerage has to sell off your security at correction prices... This is a double whammy!

Conclusion

In most materials by banks/brokerage, the good points are brought up, emphasized and illustrated, while the downsides are usually quickly glanced upon. What we not able to see it, does not mean the risks is not there.  We need to think of the possible negative scenarios, write it down, compare it with the proposed upsides in brochures, and assess if it is indeed something worth while.

My sensing is that margin financing is only useful for a limited absolute value, anything beyond might expose oneself to irreversible financial ruins. so always do your own due diligence!