¬© John A. Tyler
Many investors and security speculators have recently felt the effect of financial leverage as expressed in the current decline in the securities markets.
Here is an example:
You want to make an investment of $100,000 and expect that your investment will increase by $20,000 in a year.
Your rate of return is 20 percent.
However, an investment consultant shows you that you can earn more by borrowing to make an investment of $200,000 in the same security.
You supply $100,000 and borrow $100,000 for a total investment of $200,000. Under the Federal Reserve Bank rules, if you borrow to buy stocks you cannot “initially” borrow more than 50% of the total investment. This is called the “initial margin”.
If the $200,000 increases 20%, you have a gain of $40,000. The interest rate on your borrowing is at 5 per cent, so your annual interest costs are $5,000 a year, and your investment gain is $35,000, which is 1.75 times the unleveraged investment gain shown above.
On an ongoing basis, the lender requires that the value of your total investment must equal 133% of the borrowed funds, that is if you have borrowed $200,000, the value of the investment must be $266,667. This is called the “maintenance margin”.
In a declining securities market the market value of your investment drops from $300,000 to $250,000, or 20 percent. And the amount of your loan is still $200,000. However the lending limit formula says that your loan amount now cannot exceed $187,500. You will have to pay off $12,500 of the outstanding loan.
If you cannot come up with the additional $12,500 the lender can sell the security and payoff the loan. So the security is sold for $250,000, the lender is paid off $200,000 and you have only $50,000 left.
You have been forced into a loss of $50,000, instead of a net gain of $40,000, a $90,000 shift.
This is a dramatic example which shows both the potential positive and negative effects of borrowing to increase your investment results.