Partying with borrowed cash

By allowing me the thrill of leveraging my investment, the markets and regulators are amplifying risks and rewards, triggering potentially irresponsible behaviour and, in fact, are lending grenades to a monkey!

Print Edition: January 24, 2008

Dipen Sheth

Dipen Sheth, Head of Research, Wealth Management Advisory Services dipen@wealthmanager.ws 

Here’s a thought that can trigger extreme reactions from financial pundits, market regulators and investors: what if leveraged buying was eliminated from asset markets? At the risk of sounding outdated, unduly conservative and financially illiterate, I’d say stock markets (and many other asset markets) would get a lot saner.

Consider the fact that most asset markets (stock markets included) allow investors to take a buying or selling position in a tradable item for extended periods, without him having to pay the entire value of the transaction. This is what the futures market is all about.

Sure, a margin is charged but it’s usually a sixth (or even less) of the value of the traded securities. This, and the margin trading that brokers allow you to indulge in, is a perfectly legal process governed by a proper legal framework and decent risk management mechanism.

It leads to more active markets, and provides the much welcome trading volumes that allow investors to enter and exit their favourite scrips. The question I am raising is whether this is a socially and financially desirable thing to have.

Let’s check what happens when you get to “indulge” in leveraged trading. You can, for example, buy Tata Steel at Rs 900 a share by putting up only Rs 135 (or 15%) as margin with your broker.

What’s wrong with leveraging

Double-edged sword
Leveraging allows you to buy stocks worth up to 5-6 times the margin you deposit. While potential gains are amplified, so are the potential losses

Artificial liquidity
Investing borrowed money can be a double whammy if your bet goes wrong.You pay a high interest rate of 18-24% and suffer capital erosion

Margin calls
If a stock price falls, the margin money is used to cover the loss. The investor has to then provide additional margin. If he can’t, shares are sold to recover the loan

Double leveraging
Buying shares anyway amounts to leveraging on future earnings of the company. But the futures market and margin trading offer instant and another layer of leveraging which could be disastrous for the small investor

If Tata Steel shares rise by 5% (Rs 45) over the next few days, you could sell out and be richer by 33% on your initial investment of Rs 135! Sweet, huh? What your broker doesn’t tell you is that this leverage can work against you with the same ferocity.

What if the stock was to fall by 5%? Not only would you lose sleep, your broker would demand more margin to cover the loss. If you can’t pay, he would sell the shares to recover his loan. Not all stocks have futures contracts. But you can still indulge in leveraged buying through margin trading.

Brokers fund your purchases against a 50% “margin” deposited by you. You are charged 18-24% interest per annum on the loan and can buy from only an approved set of scrips. After this deal is signed, you are bombarded with midcap and other “ideas” from the relationship managers, technical analysts, derivatives experts and market gurus (who get incentives according to the brokerage they generate, not on your returns).

Essentially, they are selling you the ammunition and then exciting you enough to fire at moving targets. Of course, the risk and the returns are entirely yours. Meanwhile, your broker’s lending is rendered virtually risk-free, courtesy the efficient risk management systems he uses.

If you include brokerage, the more evolved brokers earn around 30% a year on their loans. Investing in an NSE membership, systems and a hyperactive sales and analyst team is the only other requirement. As a serious investor, I buy a brick in a business whenever I buy a share. And I am willing to shell out whatever I feel is the right price for that share.

The price of the share is already a leveraged play on the future profits of the business. By allowing me the thrill of leveraging my investment today, the markets and regulators are further amplifying risks and rewards, triggering potentially irresponsible behaviour and, in fact, are lending grenades to a monkey! An interesting analogy is the subprime mess in the US.

This is a market where runaway asset inflation (home prices have skyrocketed) has been triggered by years of irresponsible and excessive lending to undeserving (and often incapable) borrowers.

The same market is now coming to grips with a possible implosion, as borrowers are defaulting or trying to sell their houses. This forces down the prices of all houses and results in severe losses for everyone. Banks often end up possessing houses that are valued at less than the loans taken against them.

The artificially induced liquidity (banks willing to lend to just about anyone) has led to asset deflation fears in the otherwise safe US housing market. If there is excess liquidity in the global or American financial system, let it sanely decide whether to chase equity or debt, or whether to chase emerging markets or developed economies.

Why create collateralised debt obligations out of subprime loans and palm them off to banks sitting on piles of liquidity? Likewise, if Indian retail investors are feeling rich, let them sanely decide whether to invest in stocks, real estate, fixed deposits, etc. Why make it easier (and more exciting via leverage) to buy risky assets such as stocks? Remember, we are investing in a business here.

Actually most of us don’t. We are mostly induced by rumours, tips, research reports, fund managers and brokers. We just buy into the price, which we feel will rise so that we can sell once we find a bigger fool. Except that nobody knows what the last fool in the queue will do.

India is a great place to invest in right now. I can’t think of many economies of this size and variety aspiring to grow at 9% sustainably for the next few years. Add the effects of infrastructure spending picking up in the past few years.

The markets will surely keep pace with the growing economy. But to provide investors plentiful (but rented) bullets to shoot at moving targets in the market looks like an irresponsible thing to do.

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