“Elevator operators and secretaries were buying on margin!”
–My father on the run-up to the Crash of 1929.
Lost in the news over Greece's status in the Eurozone is that investors in China's stock market have seen a stock market crash around 30% in a few weeks. The government has tried desperate measures to halt the cliff-fall, yet they are likely only to put off the day of reckoning.
Chinese investors have been borrowing money like crazy to buy stocks. As with borrowing to purchase any asset, it's painful when the asset declines below the purchase price. But the potential disaster in China likely exceeds anything the U.S. saw in the housing bust and 2008-09 crash.
According to Fortune's Scott Cendrowski, “The otherworldly rise of Chinese stocks—more than 120% in the past year in Shanghai—can be attributed in part to the rise of margin lending, which doubled in the last half of 2014 and which allows Chinese investors, four-fifths of whom are small-time traders, to boost their bullish bets without needing much more cash.” The Wall Street Journal reported that margin lending reached the mid-teens percentage of total Chinese trading this year—a high—and that last fall it passed the margin debt to market capitalization level in the US.
It's time for a refresher on margin.
Brokerage firms will lend you money and charge you interest to buy stocks. Borrowing to buy stock is called buying on margin. Investors use margin because it can boost returns. Let's say you pay $8,000 in cash and use a $8,000 margin loan to buy $16,000 worth of the fictional Rocket Stock. Rocket, as hoped, zooms so that your stake is worth $24,000. That's a 50% gain from $16,000 to $24,000, right?
Wrong! You actually made 100%. If you sell for $24,000 and repay the $8,000 loan, you receive $16,000, putting aside taxes and margin interest. That's double your $8,000, so your “cash-on-cash return” is 100%. You risked $8,000 to make $8,000. This is why margin is so alluring. However, there is a flip side. Investors on margin—the “elevator operators and secretaries” of my father's Crash of 1929 stories—eventually learn that easy money today can kill you tomorrow.
