Margin and Leverage, and the Risks Involved

For a while, I have been talking a bit about the dangers of highly complex and highly leveraged financial instruments, and how they might contribute to a crask.

It appears that some folks at Barron's Magazineare now beginning to have the same concerns.

Let's give some background on how a lot of these instruments work:

Investing on Margin:

What happens here, is that you borrow money from your broker to purchase stock, which is the collateral to the loan. Let us assume that you want to purchase stock for a company, you have $10,000 to spend.

If the costs $10/share, you can buy 10,000 shares. If the price goes to 11, you make $1,000.

Let us assume that you were to buy those shares on margin. The current US margin limit is 50% (correct me if I'm wrong), so with your $10,000, and the borrowed $10,000, you could buy 20,000 shares, and when they went to $11, you would make $2000, which after loan and margin fees would be around $1700.

The problem is that if the stock drops to $5.00, you will have lost all of your money.

If the stock drops to $3.00, you owe money to your brokerage.

Leverage can improve the upside of investments, but at the risk of significantly larger downside risks.

Securities Futures:

These are similar to commodities futures, except that deal with entities rather than stocks and bonds. They lack the justification that commodities futures do: If a tire manufacturer gets a large OEM contract from General Motors, there is a real business case for them to lock in the price of rubber with a futures contract, but a stock future's contract is just speculation.

You make money with an appreciating stock by purchasing a contract to sell a stock purchased today at a later date, and you make money with a depreciating stock by purchasing a contract to sell a stock today that you are buying at a later date.

Generally, you only have to put down the cost for the contract, and ;">not the cost of the security, so where a typical margin purchase may be 50% leveraged, stock futures might be more than 90% leveraged.

Obviously, if one is in possession of ;">inside information both of margin purchasing and futures can greatly increase the return on this information for an unethical broker.

Just so you know, leverage has increased markedly over the past few years, see below for a picture of the roughly 300% increase in Margin since 1990.


It should be noted that the use of leverage, specifically margin purchasing, was one of the major causes of the stock market crash of 1929. It forced people who got margin calls to unload into a collapsing market. It is why the loan to value rate was set to about 75% in the 1930s (and subsequently lowered to 50% in the mid 1970s).

It should be noted that none of these techniques aid ;">investors, they aid ;">speculators, and they provide perverse incentives for people to cheat in some manner or another.

The repackaged loans that are currently weighing on the market are a rather similar sort of leverage, where the idea was that by packaging a large number of loans together, you would spread the risk of any individual loan defaulting, which allowed people to trade these securities in a brisk, and potentially lucrative manner, particularly for the brokers, who got a commission on each sale.

If we have a 1929 style crash in the stock market, or worse, a 1987 style crash in the stock market (it was a worse one day drop), the swings will be exacerbated by people who will be forced by their brokers to sell on the drop on a roller coaster ride.

If we were to return to the Depression era regulations that FDR implemented, much of the instability and speculation that causes this risk would be eliminated, but it would take years for the exotic financial instruments to work their way out of the market, so it is likely too late now.