Want to make some real money? Just take out a loan, and buy some stocks (equities). Mortgage your house if you can, say for $400,000, and invest the proceeds in the stock market. Your broker will lend you another 50 per cent, so you can double the size of your stock portfolio. Through using this additional leverage (called buying on margin), when the value of your stock goes up by 20 per cent, you make 40 per cent instead.

Interest charges on your broker’s loan are tax-deductible from income, because you used it to invest. In other words, you get to pay tax at one-half of the usual rate (for high income earners) up to the total of your interest costs (in the U.S. but not Canada that includes mortgage interest). Meanwhile, your stocks pay dividends that are taxed at a preferential rate, about one-half of the regular income tax rate. So, carrying charges on the loan are minimized.

Leverage — taking on debt to invest — works for companies as well.Investors ante up cash, and then borrow three, or four times that amount so as to magnify their chances of making a fat return. Instead of receiving 20 per cent, they might look forward to 60 or 80 per cent, thanks to the borrowed money.

As we saw last week, the only problem with this scenario is that stocks can go down, as well as up, and business investments can go bad.

When a panic hits the stock exchange, the value of stocks pledged against the loan goes down, say by 20 per cent, and the broker wants you to put up more money. Since you are cash strapped, he sells your portfolio at a loss to you of 20 per cent overall, but of 40 per cent to you on your mortgage loan.

You had a mortgage debt of $400,000, and a broker’s loan of $400,000. Your $800,000 investment has gone down by 20 per cent; now it is worth $640,000. When the broker sells it, to pay off the $400,000 in margin debt, you still have a mortgage of $400,000, but your investment is worth only $240,000. You have made a loss of $160,000.

Suppose your house is falling in value, not increasing. When you come to renew your mortgage the appraised value is down 20 per cent. Instead of $400,000 you will get $320,000. So you have to come up with $80,000 in order to stay in your house. Selling stock brings in the $80,000. Now your stock portfolio is worth $160,000, not the initial cost of $400,000.

John Kenneth Galbraith pointed out that financial genius is a rising market. So long as stock prices go up, leverage pays off, buying stock on margin doubles your gains.

Last week the Federal Reserve chose to bailout the levered business investors, and help out those awaiting the dreaded margin call.

By making an unscheduled announcement of a reduction in the Fed fund rate of three-quarter of a percentage point (or 75 basis points in financial language) the Fed chairman’s message was clear for the world to see. With a troubled U.S. housing market getting worse, major U.S. banks adding capital from Middle Eastern and Asian investors, a domestic recession looming, and a U.S. credit crisis at hand, the Fed would bail-out the levered investors first, and not worry about inflation, and the international role of the dollar.The result has been to accentuate the rifts between the Europeans and the Americans. The European Central Bank president as much as said the Fed chairman was not doing a proper job.

After the Fed rate cut, U.S. stocks, which had plunged, turned right around, and went back to their opening trading level. The U.S. Administration joined Congressional leaders to announce a fiscal stimulus.

Interest rate deductibility from income tax, preferential tax rates on dividends, central bank money to bail out the stock market, investors get a lot in the U.S. and Canada. No wonder investments of borrowed money look like real money.

Duncan Cameron

Duncan Cameron

Born in Victoria B.C. in 1944, Duncan now lives in Vancouver. Following graduation from the University of Alberta he joined the Department of Finance (Ottawa) in 1966 and was financial advisor to the...