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Double Gearing

The practice of borrowing money against an asset, with the money being used to buy shares of stock

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.

 

Double Gearing

 

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.

 

Summary

  • Double gearing is a high risk, high reward strategy
  • Double-geared investors set themselves up to become overburdened by debt that they cannot pay back unless they generate optimum returns
  • Double gearing is best suited to experienced investors

Responsibility of Lenders

It is widely believed that double gearing can be eliminated, or, at least, the danger to investors will be limited if lenders do their due diligence and don’t over-supply investors with loans.

If lenders let their clients take on too much risk, it’s irresponsible for the sake of the client but also for the lender. A client who becomes overburdened by borrowing may end up being unable to pay back the lender in a timely way. In some cases, they may never be able to pay the lender back.

Therefore, it’s critical that lenders do their due diligence. Double check a client’s credit, how many loans they’ve taken out in the past, how quickly they’ve paid those loans back, and how many loans they already have at the time they attempt to take out another. Double-geared loans can be dangerous for the client and to the lender.

 

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.

 

Major Risks of Double Gearing

The two primary risks related to double gearing are the following:

  1. 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.
  2. 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.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Bankruptcy
  • Credit Event
  • Revolving Debt
  • Stockholders Equity

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