Buying securities on credit in five examples
Not only houses, cars and other durable goods are bought on credit. Securities are also bought on credit. They are also expensive, and lending is a natural means of competition between sellers of securities. What motivates investors to buy securities on credit and pay interest? This is done in the expectation that the value of securities will grow faster than the interest on the loan. If lending is so profitable, then why not everyone and not always do it?
Not only houses, cars and other durable goods are bought on credit. Securities are also bought on credit. They are also expensive, and lending is a natural means of competition between sellers of securities. The market only becomes civilized when the buyer can take a cash loan on the security of his purchase, and the seller can borrow securities if he does not have his own or does not want to part with them.
What motivates investors to buy securities on credit (and pay interest)? This is done in the expectation that the value of securities will grow faster than the interest on the loan. If securities deserve to be bought, then you need to buy on credit. The more money a client takes, the higher his return on investment.
Example 1. Suppose a client thinks that ABV shares will rise in price from $ 1 to $ 5 per year. He has $ 2,500 for investments. You can buy now 2,500 shares and get $ 12,500 in a year. The profit will be $ 10,000, and the rate of return is 400% ($ 10,000 / $ 2,500 * 100%). Or you can borrow another $ 2,500 from a broker at 100% per annum and buy 5,000 shares in order to get $ 25,000 for them in a year. From this amount you need to subtract the loan and interest – only $ 5,000. There remains $ 20,000. Profit the customer is $ 17,500 ($ 20,000 – $ 2,500), and the profit margin is 700% ($ 17,500 / $ 2,500 * 100%).
If lending is so profitable, then why not everyone and not always do it?
First, a loan is a double-edged sword. Leverage affects both the profitability of investments (when the market is growing) and their loss (when the market is falling). In the previous example, the rate of return with credit is 1.75 times higher than the rate of return without credit. But if stocks had fallen in price by 5 times, then the loss without a loan would be 1.75 times less than the loss with a loan. Many investors cannot stand such a statement of the question.
Secondly, with an unchanged share price, an investor loses money. This is the interest on a brokerage loan. In order for the investor to remain at least at his own, the price must grow at the same pace as interest.
Thirdly, not all securities are allowed to be bought on credit. What can and cannot be bought is decided by the regulatory and self-regulatory bodies for the investor. For example, the Board of Governors of the US Federal Reserve occasionally publishes a list of what is “possible” and what is “not.” The more reliable the securities and the higher their price, the greater the share of credit in the cost of their purchase. In the case of bonds, maturity is also taken into account.
These official restrictions, as well as the appearance of the Fed, are associated with the credit “outrage” of the 20s. Then, some American banks willingly financed up to 90-95% of the cost of buying shares. And if the stock price went up by at least 5-10%, then the investor could use this gain for a new purchase on credit without putting a cent out of his pocket. Using this “pyramid”, even people with a small income made up huge portfolios.
Conversely, a fall in the rate of the same 5-10% could destroy the entire investor contribution. The stock market crash of 1929 is largely due to credit “outrage” in the securities market. When the market began to decline, many investors were forced to sell, because they could not put additional “live” money on the market. As a result, prices fell again and the number of sellers increased. Sales escalated into a general panic that triggered the Great Depression.
This is how Rule T appeared, requiring Americans to personally contribute at least 50% of the market value of the purchase. This contribution is referred to as initial margin, or simply margin. The Fed then lowers the margin level to stimulate the purchase of stocks, then raises it to calm speculators. Recognizing that the rate of securities is changing all the time, the law does not require that margin always be at least 50% of the market value of securities. The investor must make an additional contribution if the margin drops below 25%. This figure is determined by regulators and is called the recovery minimum for margin (through an additional investment, the investor restores the margin to the official level, i.e. up to 25%). Without this flexibility, lending turns into a disservice.
Reinsured, firms introduce their own, more stringent standards. For example, the recovery minimum for margin is not 25, but 30%; on new accounts, the margin (the difference between the market value and the loan) should be at least 10 thousand dollars; transactions are not conducted if the margin drops to 5 thousand dollars; a loan may not exceed 25 thousand dollars