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Leverage and stock market crashes

By David Luhman on Sun, 05/10/2009 - 00:49

Leverage and stock market crashes

People borrowed to buy Japanese stocks

The low interest rates also encouraged people to borrow money to buy stocks. Near the height of the craze I saw a brochure from a finance company which pictured some rich-looking Europeans.

The brochure said that to join the world's aristocracy, all you had to do was to borrow against the value of your real estate, and put the money into the rising stock market. And with a typical Tokyo home selling for a million dollars, you could borrow plenty against the supposed value of your real estate.

Leverage in America in the 1920s

Unfortunately, borrowing money to buy stocks like this is generally a bad move. In the late 1920s in America, using a margin loan, you could borrow up to 95 percent of the value of your stock holdings.

You could then take the proceeds from your loan and buy more stocks. As more people used margin loans to buy more stocks, the stock market went up, and you could borrow even more against the increased value of your stock holdings. A perpetual motion machine, right?

This is called leverage, but a more accurate term would be to call it dangerous. The high degree of leverage in the 1920s played a key role in building a bubble which had to pop.

The problem with leverage

The problem with using leverage is that the whole thing unwinds pretty quickly if interest rates rise. When interest rates rise, stocks become less attractive relative to bonds. This causes stocks to fall.

As the interest rate on your margin loan increases, you have to pay more to your lender. To meet the increased interest payments you owe to your broker, you'll probably have to sell some of your stocks. This puts further downward pressure on stock prices.

As stock prices fall, the broker, which is using your stocks as collateral for the margin loan, gets worried. Suddenly, he doesn't have as much money backing up his loan to you.

This is when you get the notorious margin call. Your broker will ask you to put up more money as collateral for your margin loan.

If you don't have the cash, and you probably don't since you're borrowing to buy stocks in the first place, the broker will sell your stocks which are acting as security for the loan. This selling, of course, puts even more downward pressure on stock prices.

By borrowing against the value of their property to invest in the stock market, many Japanese were using a high degree of leverage. Just like in 1929, the effects of a market pumped up by leverage were not good.

The bursting of the Japanese bubble

The Bank of Japan had been increasing interest rates gradually throughout 1989, but in early 1990 the Bank of Japan increased it's discount rate to 5 percent. The same discount rate had been only 2.5 percent only six months before.

I remember the day this happened, and I commented to my coworkers that the stock market was in for a beating. I didn't know how far down the market would go, but I knew the game was over. That same day the market dropped quite a bit, but no one panicked.

The economy continued to be strong for several quarters, and this helped to prop up the market, but the highly leveraged stock and real estate markets were unwinding, and it wasn't pretty.

The Nikkei average dropped from nearly 39,000 in December, 1989 to a low of about 14,000 in 1992 -- a drop of over 60 percent. Commercial real estate, which was serving as collateral for many of the loans made to buy stock, also lost about 60 percent of its value in the early 1990s.

The collapse of both markets left Japanese banks with about $400 billion in bad loans. In comparison, in America, the savings and loan disaster of the 1980s cost American taxpayers only $200 billion.

This is the end of side 1

This is the end of side 1. To listen to side 2 please fast-forward the tape and turn the cassette over.

Will the same thing happen in America in the 1990s?

Unfortunately, I think the same thing that happened in Japan in the late 1980s could happen in America, at least on a smaller scale. A long bull market in American equities has continued for the past 15 years, with stocks returning an average of 15 percent per year over those 15 years.

People have become comfortable with the notion that stock returns will always outpace bond returns, so they're willing to borrow indirectly to buy stocks.

Recently a friend told me how he plans to buy a new car. He has plenty of money in stock mutual funds, but he won't cash out of his stock funds to pay for the car. Instead, he'll finance the car and remain fully invested in stocks.

He said, "Why get out of stocks that are returning 15 percent a year when I can borrow at 9 percent?"

Whether he knows it or not, he's using a form of leverage. It's true that over the long run, borrowing money to buy stocks probably will increase your returns.

The problem is that you can go bankrupt in the short run.

What would have happened if you borrowed heavily to buy American stocks in 1968? The Dow had been racing up to 1,000, and short-term Treasuries were yielding only 5 percent. Why not borrow at maybe 5 percent and buy into the hot stock market?

Unfortunately, this strategy would have cost you dearly. By 1974 the Dow was down to 577, and short-term Treasuries were yielding 8 percent.

The moral of the story is don't use borrowed money to buy stocks.

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